Essays in finance

This dissertation combines three autonomous academic papers in Finance. The common thread that binds them is that each represent a study in the area of Investments.; The first essay shows that the option to default on foreign debt increases the equity risk premium, and hence the cost of equity capital, in emerging economies. This result arises in a consumption-based asset pricing model in which the decision to default on foreign debt is endogenous. The optimal default decision implies that stock prices in emerging economies become more sensitive to real economic shocks, and therefore more volatile, as the probability of default increases. Since stock markets are not integrated internationally, the increase in volatility is compensated by an increase in the expected excess return to stocks. When calibrated with plausible structural parameters, the model shows that time variation in volatility and expected return can be economically relevant. The model can be solved in closed-form, and provides testable implications connecting stock market to the spread over US Treasuries at which the country's foreign debt is traded in international markets. The model's time series predictions are confirmed in Brazilian data from January 1992 to October 2005. Stock market returns and changes in the sovereign yield spread are contemporaneously negatively correlated. The expected excess return and volatility of the emerging stock market increase with the sovereign yield spread. A cross-sectional implication of the model is also supported empirically: a conditional CAPM, in which the sovereign yield spread is the conditioning variable, explains a larger fraction of the dispersion of average excess returns across Brazilian industry portfolios than a static CAPM.; The second essay studies the impact of uninformed trading imbalances on stock prices using an untapped dataset covering hundreds of stocks over an eight year period. The paper presents a dynamic multi-stock model in which risk-averse investors accommodate trading imbalances but require compensation in the form of predictable return reversals. Sorting stocks based on the current week's trading imbalances, and combining them into portfolios, the paper shows that reversals of 77 by over the following week can be forecasted. Prices take ten weeks to fully revert to pre-sort levels. The model predicts that trading imbalances create cross-stock price effects whenever two stocks' cash flows are correlated, and that the magnitude of the cross-stock price effect is increasing in the correlation of cash flows. Regressions of stock returns on trading imbalances see the adjusted R2 increase from 5.73% to 21.66% when other stocks' trading imbalances are included as explanatory variables. Regressions also show that the cross-stock price effect is 3.77 times stronger when two stocks belong to the same industry (and thus have more correlated cash flows) than when the stocks belong to different industries. The essay ends by linking uninformed trading imbalances to excess volatility and excess co-movement of stock returns.; The third essay tests whether market timing strategies using deviations from the long-run log consumption-wealth ratio (cay) deliver superior investment performance. Using several statistical tests, the paper concludes that true cay contains economically significant information about future market returns. However, constraints such as the need of using estimated rather than true cay and the delays in availability of macroeconomic data cast doubt over the possibility of timing the market via mechanistic strategies based on cay. Further research is needed to ascertain whether successful timing strategies based on cay can be implemented.