Essays on Empirical Asset Pricing

Abstract

My dissertation investigates the interaction between macroeconomy and asset prices. On one hand, asset returns can be explained by the riskiness embedded in the economic variables; on the other hand, the aggregate economy is affected by the appropriate distribution of productive resources, arising from firm's financing capability. My dissertation contains two chapters which study these two questions respectively. Chapter one explores the role of investor sentiment in the pricing of a broad set of macro-related risk factors. Economic theory suggests that pervasive factors (such as market returns and consumption growth) should be priced in the cross-section of stock returns. However, when we form portfolios based directly on their exposure to macro-related factors, we find that portfolios with higher risk exposure do not earn higher returns. More important, we discover a striking two-regime pattern for all 10 macro-related factors: high-risk portfolios earn significantly higher returns than low-risk portfolios following low-sentiment periods, whereas the exact opposite occurs following high-sentiment periods. We argue that these findings are consistent with a setting in which market-wide sentiment is combined with short-sale impediments and sentiment-driven investors undermine the traditional risk-return tradeoff, especially during high-sentiment periods. Chapter two studies capital misallocation and its implication on output losses. Financial market frictions may lead to capital misallocation and, thus, reduce the aggregate output. This paper empirically quantifies the fraction of total factor productivity (TFP) loss that is attributable to financial frictions. A simple model is set up to map the dispersion in firm's borrowing costs into TFP loss. Equity cost of capital contains information of firm's expected profitability; and, is used as a proxy for firm's borrowing cost. I find that the misallocation due to financial frictions can reduce TFP by a magnitude from 3.2% to 6.4%. TFP losses can be stronger during times when credit is tightening and among firms that have more severe financial constraints. The time series of TFP losses is countercyclical, which suggests more heterogeneity in firm's borrowing costs during the recession. The paper also shows that Hsieh and Klenow (2009) may overstate the output loss caused by the misallocation which is attributable to financial frictions.