Three essays in financial economics

Abstract

Chapter 1 studies endogenous medium term cycles in a Schumpterian growth model. New firms are created by imitating existing firms and they drive the least productive firms out of business. In this manner, firm entry speeds up the process of creative destruction, reallocating economic resources from less to more productive firms. Furthermore, the rate of firm entry and intensity of reallocation are procyclical in this model, and therefore transient business cycle shocks are propagated into persistent medium term swings in productivity. While the model generates substantial amount of medium term cycles, their magnitudes are not as large as those found in the data. This is due to an endogenous tension arising from business stealing effect of Schumpeterian models that weakens the basic transmission mechanisms in this model. Chapter 2 develops a model of explicit marketplace competition between firms. Firms compete through technological innovation; a firm with superior technology captures larger market share and earns higher profits than its rival. Arrow's replacement effect in this model implies that industry followers have more to gain from innovations than leaders, and consequently followers invest more heavily than leaders. Therefore, followers derive higher proportions of their firm values from present value of growth opportunities, and this implies that technological leaders and laggards are value and growth firms, respectively. A novel, central empirical prediction of the model is that when realized return on the value-minus-growth portfolio is positive, value firms decrease their investments relative to growth firms, and vice versa. This prediction holds for capital expenditures, but not for R&D expenses in the data. Chapter 3 (joint with Yichuan Liu) presents three sets of empirical results pertaining to cross-sectional patterns in stock returns associated with various accounting ratios such as return on assets, return on equity, gross and net profit margins, and turnover ratios of accounts receivable and payable. First, we show that recent changes in these accounting ratios, rather than their levels, are responsible for large returns spreads. Second, we document fundamental momentum; long-short portfolios formed by sorting on recent changes in these accounting ratios have significant alphas after controlling for Fama-French three-factor and Carhart four-factor models. Third, we examine the findings of Chordia and Shivakumar (2006) who conclude that the well-known price momentum effect is a manifestation of earnings momentum. We find, on the contrary, that price momentum is not fully explained nor subsumed by earnings momentum.