Graduation Year

2012

Document Type

Dissertation

Degree

Ph.D.

Degree Granting Department

Finance

Major Professor

Delroy M. Hunter

Keywords

Arbitrage, Asset Pricing, EGARCH, Idiosyncratic Risk, Market Integration, Risk Prices

Abstract

Most papers in empirical finance implicitly or explicitly assume the same price of risk, for each priced systematic risk factor, across all risky assets within a given domestic market. In doing so, they rely on the assumption that markets are domestically integrated and, as such, that the price of risk is determined independently of individual investors attitude towards risk. This is true in frictionless markets where investors have complete information, homogenous beliefs, and hold the mean-variance efficient combination of the market portfolio and a risk-free asset. However, investors might not hold the market portfolio because of exogenous reasons. In fact, several recent papers have provided evidence that US investors do not, holding instead vastly undiversified portfolios. There are two main implications to the above. First, if one group of investors does not hold the market portfolio, then the remaining set of investors will also not be able to hold the market portfolio and will rationally expect to be compensated for bearing idiosyncratic risk. Therefore, idiosyncratic risk will be priced in expected returns. Second, the price of risk need not be the same across all assets in which case domestic markets are not integrated.

In the first essay titled "Is Idiosyncratic Volatility Really priced?" I show that the positive relation between idiosyncratic volatility (IV) and returns found by Fu (2009) only exists for firms that are difficult to arbitrage. The relation between IV and returns is strong for small and illiquid stocks, but decreases with size and liquidity and becomes non-existent for the largest and most liquid firms. Furthermore, zero-cost portfolios based on IV and size do not yield positive returns when conservative trading costs are considered. This evidence is consistent with an efficient market, in which arbitragers exploit profitable investment opportunities and by doing so they prevent systematic mispricing in financial markets.

In the second essay titled "Are the U.S. Equity Markets Domestically Integrated?" I investigate whether the three main U.S. equity markets are domestically integrated by comparing the price of commonly used risk factors across the NYSE, Amex, and Nasdaq. I find that the markets have significantly different prices of risks for several risk factors, indicating that the markets are segmented. The magnitude of the difference is both statistically and economically significant, and is not due to arbitrage constraints or model misspecification. Instead, I find evidence consistent with the investor-segmentation hypothesis, in which different investors choose to hold different subsets of firms and demand different prices of risk among the different groups of securities. I do not find that segmentation is restricted to a specific time period. On the contrary, it is present in all sub-periods. In contrast to the results regarding the pricing of idiosyncratic volatility, these results highlight the value of diversification and suggest that domestic equity markets are not fully efficient.

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