Essays on Asset Pricing with Frictions

Abstract

Classical asset pricing theory hinges on a few implicit assumptions. First, there're no feedbacks from derivatives to underlying assets. Second, interest rate variations can be endogenized by structural US fundamental shocks. Third, informational heterogeneity plays little role in driving hedging demand and risk premium. However, I show that these assumptions are rejected empirically due to financial frictions in reality. This dissertation bridges the gap by building modern asset pricing theory with frictions to reconcile the empirical challenges.

Chapter 1 examines derivatives' feedback frictions via the dealer hedging channel. Does the increasingly popular passive investment via Exchange Traded Products (ETF/ETNs) affect underliers? Yes, at least for the most liquid ETP sector: VIX ETPs. The first chapter exploits rich instruments on VIX as a perfect laboratory to test both level and roll effects of ETP demand on underlying futures. Given reduced-form evidence of dealers' ETP-hedging feedback channel, I construct a structural model with preferred-habitat demands to endogenize VIX futures' “carry”. My estimates indicate that the tail wags the dog.

Chapter 2 (with Hao Chang) reveals the information contents of treasury term premium and emphasizes demand-based frictions from foreign flows in driving US Treasury yields. We find that foreign carry trades and cross-border investments have been the main economic drivers of long-term interest rates in recent years due to monetary divergence. These evidences pose challenges to conventional structural models using US-exclusive macro variables to explain treasury dynamics. We show superior out-of-sample performance of our extended model with foreign demand. The 2016 negative treasury term premium was mainly crushed by foreign flows reaching for yield.

Chapter 3 studies informational frictions in commodity markets. I develop a continuous-time general equilibrium model that highlights asymmetric information and dynamic risk-sharing, in order to understand why hedgers trade so much. Each commodity producer exploits firm-specific informational advantage over financial traders on the long side to learn about the fundamental heterogeneously through Bayesian updates, and strategically shorts commodity futures for risk-sharing. Information asymmetry between two sectors becomes severe when the fundamental deteriorates, which amplifies endogenous risk. Regulatory policies like countercyclical margin requirements are beneficial when confronting frictions.