Essays in financial economics

Chapter 1 analyzes strategic behavior of dealers under different post-trade transparency regimes. It constructs a game-theoretic model in which dealers interact on a regular basis and face uncertainty about the size of the uninformed demand. We argue that higher post-trade transparency of the order flow might result in wider spreads and higher profits for the dealers. The reason is that public and timely dissemination of information on all past trades gives the dealers a highly informative commonly observed signal about the size of the uninformed demand. As a result, dealers can fine tune their spreads based on this signal and earn high expected profits.; Chapter 2 sheds light on the sources of the excess return on the aggregate institutional portfolio relative to the rest of the market. It shows that outperformance of the aggregate institutional portfolio can be explained by institutional preferences for stocks with high accounting profitability. In particular, risk-adjusted excess return on the institutional portfolio over the rest of the market during the 1982--2001 period can be explained by the fact that institutions avoided small stocks with low accounting profitability and overweighted large stocks with high accounting profitability. We also show that in a dynamic cross-sectional model of expected returns on individual stocks, the fraction of institutional ownership is not a statistically significant predictor of firm-level stock returns once we take into account book-to-market, return on equity, size, and biases caused by high positive correlation between the fraction of institutional ownership and stock size.; Chapter 3 argues that institutional strategy in small stocks during 1980s and 1990s was largely driven by factors other than expectations of stock returns. We propose a decomposition of institutional excess return into three components: stock picking within a particular class of stocks, capital allocation across stock classes, and class timing. We show that institutions consistently avoided small stocks, and small stocks consistently underperformed the rest of the market. However, the underperformance of small stocks is dominated by stocks with low return on equity (ROE) and new stocks. We show that institutions consistently avoided all groups of small stocks without much regard for ROE. Had institutions avoided small low-ROE and new stocks while still allocating the same share of their capital into the two smallest size quintiles, they would have significantly increased their excess return over the rest of the market.