Three essays on asset pricing

Zhang, Yilin

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Description

Title

Three essays on asset pricing

Author(s)

Zhang, Yilin

Issue Date

2014-05-30T17:07:32Z

Director of Research (if dissertation) or Advisor (if thesis)

Johnson, Timothy C.

Doctoral Committee Chair(s)

Johnson, Timothy C.

Committee Member(s)

• Almeida, Heitor
• Deuskar, Prachi
• Choi, Jaewon

Department of Study

Finance

Discipline

Finance

Degree Granting Institution

University of Illinois at Urbana-Champaign

Degree Name

Ph.D.

Degree Level

Dissertation

Keyword(s)

• asset pricing
• commodity
• returns predictability
• inequality
• incomplete market
• heterogeneity

Abstract

This dissertation consists of three chapters, each corresponding to an essay on one topic in asset pricing. Chapter 1 is titled “How Do Oil Shocks Affect Stock Market Risk” and aims to explain some documented comovements between crude oil market and stock market and the predictability of oil prices on stock returns. Firstly, I illustrate a mechanism for oil shocks to translate into stock market risk under a 2-consumption good CCAPM model framework. Then I use U.S. data and a bivariate EGARCH-DCC model to estimate the dynamic second moments of crude oil price changes and stock returns. I find that oil price changes have significant effects on the second moments of the stock market returns but not the other way around. Furthermore, I find remarkable time-variation in both the empirical conditional volatilities and correlations. Based on these estimations, I construct the time-varying empirical risk premia. A preliminary test is done at the end of this paper to see if the empirical risk premia are able to explain the observed predictability of oil price changes on stock returns. The results point to the need for more sophisticated modeling of the interactions between oil and stock market risk. In Chapter 2 “Income Inequality and Asset Prices: A Cross-country Study”, I study the asset pricing implication of cross-country differences in income inequality. Using panel regression with year fixed effects, I document a strong negative relationship between cross-country stock market levels (as measured by each market’s P/D ratio) and cross-country income inequality levels after controlling for an extensive set of variables including conventional risk factors, country characteristics and degree of global market segmentation. I argue that this relationship should be interpreted as the negative impact of income inequality on market price. This effect is both statistically and economically significant: On average, one unit increment in inequality (a 0.01increament in income Gini, which ranges between 0 and 1) is shown to decrease the market P/D ratio by up to 2%. The inverse relationship between income inequality and price is stronger in developed countries than in developing countries. It is robust to alternative measures of stock market levels and income inequality. By decomposing price into expected excess returns and risk-free rates, I empirically identify the main channel through which inequality influences price: The inverse relationship observed between inequality and P/D ratio can almost be completely attributed to strong positive link between income inequality and interest rates; while I find no supporting evidence that cross-country excess returns are correlated with income disparities. These findings have important implications both for asset pricing modeling and for policy making. Chapter 3, titled “Income Heterogeneity, Inequality and Interest Rates” is an extended work of Chapter 2. It aims to explain the significant positive correlation between the cross-country differences in inequality and the cross-country differences in real interest rates documented in Chapter 2. In a discrete-time asset pricing model with heterogeneity, untradable income risks and CARA utility function, equilibrium interest rate, gross saving rate and consumption inequality are derived in closed-form solutions. It is shown analytically that both consumption inequality and the real interest rate are positively related to income heterogeneity (defined as the dispersion in idiosyncratic income risks in terms of their correlations to the aggregate risk). It is also shown that gross saving rate and the ratio of average consumption risk to average income risk can be used to proxy for income heterogeneity. Empirical tests confirm that saving rate helps reducing the positive role of income inequality in explaining cross-country variations in interest rates.

Graduation Semester

2014-05

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Copyright 2014 Yilin Zhang

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