Asset Prices and Liquidity
Date Issued
2009
Date
2009
Author(s)
Tsai, Feng-Tse
Abstract
This thesis studies financial asset pricing issues with market liquidity and credit risks from both theoretical and empirical perspectives. It respectively consists of three independent essays on portfolio choice, option valuation, and the bid/ask price dynamics of credit default swaps (CDS), with the main thread of the three articles being the topic of “asset prices and liquidity.” In the first essay I investigate the robust portfolio rule in the present of illiquidity. When the agent faces trading liquidity risk and fears about the model may be misspecified, he desires a robust portfolio choice under illiquid environments. This paper contributes in three aspects. First, I derive the optimal robust portfolio choice under illiquidity. Second, I find the clientele effect, whereby the buy-and-hold investors prefer to invest in illiquid assets, depends on two trade-off intertemporal hedging demands. Third, I provide another explanation of “home bias puzzle” based on the insufficient liquidity risk premium to attract investors in foreign stock markets. The second essay explores the stock price process induced by market price impacts from random arrivals of buy orders and sell orders. I develop an option pricing model with liquidity risk and volatility risk in either a one asset or multi-asset framework. Empirically, I find that the buy-order induced price impacts are smaller than the sell-order driven price impacts on average both in intraday and daily stock markets, i.e., the so-called “asymmetric liquidity.” In the event studies of the housing subprime crisis and the terrorist attack, the result shows that the option prices on the event days imply that the market expects high trading activities in stock markets and large asymmetric liquidity in the future. I analyze the interaction between credit risk and liquidity risk from the bid and ask prices in CDS markets in the third essay. Using the CDS data during the global financial tsunami in 2008, several facts are worth highlighting here. First, the short-term rate is relatively hard to calibrate comparing with medium-term and long-term swap rates. In addition, the market anticipates an advanced interest-rate cut in the future. Second, low-rated firms generally inherit higher private information risk, which is one source of liquidity risk. Third, CDS for non-financials have more persistent counterparty default risks. Fourth, traders in different classes have distinct inventory considerations, but the result shows that inventory risk is asymmetric in all classes. Fifth, the increase in CDS premium accompanies a decrease in the bid-ask spread for high-rated non-financials based on sample statistics and model prediction.
Subjects
liquidity
portfolio choice
option pricing
credit default swaps
credit risk
SDGs
Type
thesis
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