Essays in financial economics

Abstract

This thesis consists of three essays on various topics in Financial Economics. Underwriter analysts issue recommendations that are on average more favorable than recommendations of other analysts. In Chapter 1, I investigate whether this bias matters for returns, and whether it matters for wealth redistribution between institutional and individual investors. I find that underwriter 'Strong Buy' recommendations for IPOs exhibit inferior performance. For other positive recommendations - 'Buys' for IPOs, and 'Strong Buys' and 'Buys' for SEOs - there are no significant differences between affiliated and unaffiliated analysts. Institutional reaction to analyst recommendations is broadly consistent with these results. For IPOs, institutions increase their holdings only in response to unaffiliated recommendations. For SEOs, the response to underwriter recommendations is actually somewhat stronger than to non-underwriter recommendations. In addition, there is little evidence that individual investors as a class incur losses by following the 'Strong Buy' recommendations issued by IPO underwriters. Further analysis indicates that conflicts of interest is an unlikely explanation for the favorable bias in underwriter analyst recommendations. Chapter 2 is joint work with professor Jiang Wang. In this essay, we develop a methodology to identify money managers who have private information about future asset returns. The methodology does not rely on a specific risk model, such as the Sharpe ratio, CAPM, or APT. Instead, it relies on the observation that returns generated by managers with private information cannot be replicated by those without it. Using managers' trading records, we develop distribution-free tests that can identify such managers.

(cont.) We show that our approach is general with regard to the nature of private information the managers may have, and with regard to the trading strategies they may follow. In Chapter 3, I study welfare implications of increased market transparency in a context of a three-period model with risk-averse investors and constrained risk-neutral market makers. Market makers' constraint can take one of two forms: they are either required to have non-negative final wealth, or they cannot borrow. In addition to fundamental uncertainty about a risky payoff, there is uncertainty about total market-making capacity in the economy. Increased transparency is associated with reduction in this uncertainty. The more transparent equilibrium improves the sharing of fundamental risk, and is Pareto optimal for most parameter values. I also find that market makers' equilibrium positions are socially optimal; a small exogenous change in their positions does not lead to Pareto improvement.