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Essays in financial economics

Papadimitriou, Dimitris (2019) Essays in financial economics. PhD thesis, The London School of Economics and Political Science (LSE).

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Abstract

This thesis consists of three essays in financial economics. In the first chapter, I present an asymmetric information model of financial markets that features rational, but uninformed, hedge fund managers who trade against informed and noise traders. Managers are uncertain not only about fundamentals, but also about the proportion of informed to noise traders in the market and use prices to update their beliefs about these uncertainties. Extreme news leads to an increase in both types of uncertainty, while it decreases price informativeness. Prices react asymmetrically to positive and negative news, with higher expected returns at times of increased uncertainty about market composition. The model generates a price-volume relationship that is consistent with established stylized facts. I then extend to a three-period model and study the dynamics of expected returns and volatility. In the second chapter, we study a dynamic model featuring risk-averse investors with heterogeneous beliefs. Individual investors have stable beliefs and risk aversion, but agents who were correct in hindsight become relatively wealthy; their beliefs are overrepresented in market sentiment, so \the market" is bullish following good news and bearish following bad news. Extreme states are far more important than in a homogeneous economy. Investors understand that sentiment drives volatility up, and demand high risk premia in compensation. Moderate investors supply liquidity: they trade against market sentiment in the hope of capturing a variance risk premium created by the presence of extremists. In the final chapter, we consider a continuum of potential investors allocating funds in two consecutive periods between a manager and a market index. The manager's alpha, defined as her ability to generate idiosyncratic returns, is her private information and is either high or low. In each period, the manager receives a private signal on the potential performance of her alpha, and she also obtains some public news on the market's condition. The investors observe her decision to either follow a market neutral strategy, or an index tracking one. It is shown that the latter always results in a loss of reputation, which is also reflected on the fund's flows. This loss is smaller in bull markets, when investors expect more managers to use high beta strategies. As a result, a manager's performance in bull markets is less informative about her ability than in bear markets, because a high beta strategy does not rely on it. We empirically verify that flows of funds that follow high beta strategies are less responsive to the fund's performance than those that follow market neutral strategies.

Item Type: Thesis (PhD)
Additional Information: © 2019 Dimitris Papadimitriou
Library of Congress subject classification: H Social Sciences > HG Finance
Sets: Departments > Finance
Supervisor: Martin, Ian
URI: http://etheses.lse.ac.uk/id/eprint/3913

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