Essays in asset pricing and monetary policy

Xiao, Song (2024) Essays in asset pricing and monetary policy. PhD thesis, London School of Economics and Political Science.

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Abstract

In this thesis, I explore the economic mechanisms by which financial institutions shape asset returns. Additionally, I study the impact of uncertainty on the decision-making processes of the Federal Open Market Committee (FOMC). The first chapter documents that major equity anomalies earn more than half of their annual risk-adjusted returns during the week before scheduled Federal Open Market Committee (FOMC) announcements. These risk-adjusted returns are primarily driven by equity duration. The duration-driven returns (i) increase with monetary policy uncertainty, (ii) are procyclical, co-moving with the market expectation of federal funds rate changes, and (iii) are reversed after FOMC announcements. I rationalize these findings within a model of temporary price pressure generated by institutional investors facing leverage and tracking-error constraints. Empirical evidence from institutional holdings and trading is consistent with the model’s mechanism. The second chapter (with Anna Cieslak, Stephen Hansen and Michael McMahon) studies how uncertainty affects decision-making by the Federal Open Market Committee (FOMC). We distinguish between the notion of Fed-managed uncertainty vis-á-vis uncertainty that emanates from within the economy and which the Fed takes as given. A simple theoretical framework illustrates how Fed-managed uncertainty introduces a wedge between the standard Taylor-type policy rule and the optimal decision. Using private Fed deliberations, we quantify the types of uncertainty the FOMC perceives and their effects on its policy stance. The FOMC’s expressed inflation uncertainty strongly predicts a more hawkish policy stance that is not explained either by the Fed’s macroeconomic forecasts or by public uncertainty proxies. We rationalize these results with a model of inflation tail risks and argue that the effect of uncertainty on the FOMC’s decisions reflects policymakers’ concern with maintaining credibility for the inflation anchor. In the third chapter (with Riccardo Sabbatucci and Andrea Tamoni), we estimate a demand system linking 401(k) plans ownership of individual stocks and funds to their demand for equities, and quantify the effect of 401(k) stock holdings on investor behavior. We introduce a new variable, stock-level 401(k) ownership, and find it to be a key determinant of investor demand, with a one standard deviation increase in 401(k) ownership leading to 11-19% increase in stock demand. We also estimate the equilibrium price impact of a change in stock-level 401(k) ownership to be positive and increasing over time, consistent with the shift from active to passive investing. Lastly, we document that funds managing a larger fraction of 401(k) assets tilt their portfolios toward winners, high beta and long duration stocks, and they hold less cash.

Item Type:	Thesis (PhD)
Additional Information:	© 2024 Song Xiao
Library of Congress subject classification:	H Social Sciences > HG Finance
Sets:	Departments > Finance
Supervisor:	Vayanos, Dimitri and Lou, Dong
URI:	http://etheses.lse.ac.uk/id/eprint/4640

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