Financial market imperfections and their asset pricing implications

Abstract

This thesis consists of two studies on financial market imperfections. The first study (Chapters 2 and 3) investigates illiquidity, which is a reflection of different imperfections, and its pricing implications in the corporate bond market. The second study (Chapter 4) evaluates the impact of a short-sale ban, which is a form of financial constraints, on the equity and derivatives markets. In Chapter 2, we propose illiquidity measures that outperform existing ones statistically and economically. We estimate various illiquidity measures in the corporate bond market, using transaction-level data from 2002 to 2010. In the cross-section, we find illiquidity measures to be related to bond characteristics often used as illiquidity proxies. In the time-series, we show commonality in the aggregate illiquidity measures, increasing during the sub-prime crisis and peaking in October 2008. We then identify that time variation in aggregate illiquidity measures is linked with market variables such as the VIX index. In Chapter 3, we examine pricing implications of the illiquidity measures. We find that illiquidity level is priced both at the aggregate level and at the bond level throughout the sample period. However, the role of illiquidity risk in pricing bond yield spreads is weaker, and is driven by the 2008 financial crisis. In Chapter 4, we study the 2008 short-sale ban. We find that the banned stocks have positive cumulative abnormal returns and become more volatile when the ban is imposed. We document greater demand and abnormalities in the futures market and option market under the short-sale ban. This evidence suggests that a short-sale ban may not stabilize a financial market in crisis.