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Stocks, bonds and volatility in financial markets

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Title: Stocks, bonds and volatility in financial markets
Author(s): Lee, Jae Hoon
Director of Research: Pennacchi, George; Johnson, Timothy
Doctoral Committee Chair(s): Pennacchi, George
Doctoral Committee Member(s): Pearson, Neil; Ye, Mao
Department / Program: Finance
Discipline: Finance
Degree Granting Institution: University of Illinois at Urbana-Champaign
Degree: Ph.D.
Genre: Dissertation
Subject(s): Risk Premium Volatility
Abstract: The first essay, Funding Liquidity and Its Risk Premiums, presents a new approach to measure funding liquidity and demonstrates that the estimated funding liquidity can predict future stock market returns. The key idea is that, as capital constraints become more binding, speculators withdraw first from small stocks and then from large stocks. Given that asset liquidity is provided by speculators, the asset liquidity of large and small stocks would covary differently with shocks to speculators' capital depending on their participation in the markets. Based on this intuition, funding liquidity is measured as the difference of rolling correlations of stock market returns with large and small stocks' asset liquidity. The estimated funding liquidity appears positively correlated with aggregate hedge fund leverage ratios, stock market sentiments, and the total number of M\&A activities, and negatively correlated with bond liquidity premiums and Moody's Baa-Aaa corporate bond spreads. The funding liquidity is able to predict future stock market returns, and its forecasting power is significant in both in-sample and out-of-sample tests. It is also robust to various equity premium predictors, subsample periods, long-horizon forecast bias, and small-sample bias. The second essay, Treasury Bill Yields: Overlooked Information, considers whether the term structure of Treasury bond yields reflects all risk premium factors that affect their rates of return; that is, whether risk premium factors are spanned the cross-section of Treasury bond yields. The findings reveal that bond risk premiums consist of two factors with different frequencies: long term and short term. The long-term factor raises the slope of a yield curve, has the forecastability horizon of longer than one year, is related to value premiums in the stock market, and predicts macroeconomic growth. In contrast, the short-term factor is completely hidden from Treasury bond yields yet apparently lowers Treasury bill yields, has the forecastability horizon of less than one quarter, is related to stock market returns, and is largely attributed to liquidity premiums. The third essay, Systematic Volatility of Unpriced Earnings Shocks, focuses on the different implications of two stochastic volatility factors. Some important puzzles in macro finance can be resolved in a model featuring systematically varying volatility of unpriced shocks to firms' earnings. In the data, the correlation between corporate debt and stock markets valuations is low. The model accounts for this via the opposing effect of firm-level uncertainty on levered debt and equity prices. The model also explains the low (or non-existant) risk-reward relation for the market portfolio of levered equity, via the opposing effects of firm-level and aggregate uncertainty (both components of stock volatility) on the levered equity risk premium. A testable implication of the model is that the disagreement between debt and equity markets may be a good proxy for systematic changes to unpriced earnings uncertainty. Comparison with direct measures of micro volatility supports this interpretation. The proxy shows strong forecasting power for market returns.
Issue Date: 2012-05-22
URI: http://hdl.handle.net/2142/30993
Rights Information: Copyright 2012 Jae Hoon Lee
Date Available in IDEALS: 2012-05-22
Date Deposited: 2012-05
 

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