Essays in Empirical Asset Pricing

Chapter 1 provides a survey of research on consumption-based asset pricing. A fundamental question in asset pricing is about how the time-series and cross-section of stock prices are related to changes of fundamental macroeconomic variables. The consumption-based capital asset pricing models deliver an intuitive but important message that, when risk averse investors can use asset investment to smooth their consumption, asset returns should reflect their ability to smooth. The survey begins with a summary of the key elements of the representative-agent model developed by Breeden (1979) and Lucas (1978), outlines the main assumptions and model implications. Section two describes and discusses the quantitative puzzles that arise from the discrepancies between theoretical predictions and empirical observations, highlighting two most well-known ones, namely, the equity premium puzzle and the risk-free rate puzzle. In section three, we review a vast literature that seeks to resolve these puzzles. The survey ends with a list of other successful review papers written in this topic.;Chapter 2, jointly with Zhuo Chen, develops a consumption-based asset pricing model (CCAPM) with adjustable durable goods consumption and studies the asset pricing implications. In contrast to past studies that assume service flow to be a constant fraction of the stock, we model the utilization of the stock of durable goods to be time-varying. We propose an innovative measure of the unobserved usage of durable goods from carbon dioxide emissions. Emissions provide a convenient aggregation of energy consumption that has become an important complementary input for durable goods in recent decades. We find that the time-varying utilization of durable goods is a valid asset pricing factor. Our model exhibits a stronger cross-sectional pricing power than the CAPM and several consumption-based capital asset pricing models (CCAPMs), including Yogo's (2006) durable good model. Finally, our model mitigates the joint risk premium and implied risk-free rate puzzle.;Chapter 3, jointly with Zhuo Chen and Zhuqing Yang, examines whether international political instability is a pricing factor for cross-country return variations. We exploit a unique dataset of country-specific military expenditures and construct a proxy for the international instability, measured as the growth rate of the global military expenditure to GDP ratio, to capture political tensions and international conflicts. Using the market indices of 49 countries, we find that the international political instability is a valid pricing factor for international stock markets. Our factor helps explain the cross-country return differences, complementary to existing global asset pricing models. In addition, emerging countries have higher exposures to the international political instability risk than developed countries. Such higher exposures contribute to the higher returns observed in emerging countries.;Chapter 4, jointly with Zhuo Chen, constructs a tradable funding liquidity factor that exploits information in both the time series and cross-section of stock returns. We show that in an economy where investors face asset-specificc funding constraints (margins), the risk premium of a market-neutral portfolio that longs leveraged low-beta stocks and shorts deleveraged high-beta stocks, as in Frazzini and Pedersen (2013), depends on both the market-wide funding conditions and stocks' margin requirements. We isolate funding liquidity shocks as the return difference between two zero-beta portfolios constructed using stocks with high and low margins. Our market-based funding liquidity measure is highly correlated with other proxies proposed in the literature, and cannot be explained by existing pricing factors, such as the Fama-French three factors. Moreover, our measure helps explain the cross-section of hedge fund returns: hedge funds with the lowest funding liquidity sensitivities earn 10.7% per year higher returns than their peers whose returns strongly comove with funding liquidity shocks. We provide a possible explanation for this finding: some funds have the ability to manage the funding liquidity risk and thus can earn higher returns.;Chapter 5, jointly with Zhuo Chen, investigates the source of price momentum in the equity market using information from options markets. Consistent with Hong and Stein's (1999) gradual information diffusion model, we show that a successful identification of stocks' information diffusion stage helps explain momentum profits. We construct a momentum portfolio by selecting winner (loser) stocks with large growth (decline) in call options implied volatility. Our portfolio generates a risk-adjusted alpha of 1.8% per month over the 1996-2011 period, during which a simple momentum strategy performs poorly. The results are stronger if we use call options, compared with put options, and robust to a battery of alternatives.