Cross security effects in equity financial markets

Abstract

The fundamental paradigm of asset pricing is changing fast. Over time financial economists have grown more accepting of incorporating human fallibility into formal asset pricing models. Today, many economists agree that the central task of asset pricing is to examine how expected returns are related to both risk and investor misvaluation as opposed to risk only. There is accumulating evidence that misvaluation can occur indirectly. In the presence of cross security effects, the risk and misvaluation associated with an asset are channeled not only to its own expected return but to the returns of other unrelated assets. With this in mind the focus of this dissertation is to examine such effects. Results from the dissertation suggest that pessimism associated with the returns on an asset can be channeled into the prices of and returns on an asset whose return distribution is not associated with pessimism. The price of the latter can be higher, lower, or remain unchanged as compared to its price under no pessimism. An empirical investigation of the effect of the return on a broad market index on the return on an index of gold stocks in the period January 1998 to April 2003 reveals that pessimism was directly channeled from the market into the index of gold stocks. Finally, results from the dissertation suggest that the existence of growth stocks affects the prices of and returns on value stocks. In the late 1990's the skyrocketing prices and valuations of the high growth companies formed a striking contrast to the considerably lower prices and valuations of more traditional companies. Analysis conducted with experimental data indicates that the trading prices of a value asset are generally higher in the presence of a growth asset that experiences positive updates in its fundamental value. In addition, lower prices observed in the growth market have a positive effect on the returns on value assets.