Essays in asset pricing

This work consists of three essays that investigate the effect of investor behavior on asset prices. In the first essay, titled "Transaction Costs and Investment Decisions of Individual Investors," I study the liquidity decisions of 66,000 households from a large discount brokerage. My paper provides an empirical link between investors' optimal trading decisions and the liquidity premium observed in the market. In particular, I show that transaction costs are an important determinant of investors' holding periods which determine how transaction costs are amortized and priced in asset returns. I also show that there is correlation in the demand for liquid assets across households, and consistent with the notion of flight to liquidity, this demand increases during times of low market liquidity. Households with higher incomes and with higher wealth invested in the stock market supply liquidity when market liquidity is low.;The second essay, "Is there a Distress Risk Anomaly? Bond Spreads as a Proxy for Default Risk," investigates the pricing of default risk in stock returns. The results show that credit spreads predict corporate defaults better than previously used measures, such as, bond ratings, accounting variables and structural model parameters. Contrary to previous findings, using corporate credit spreads to proxy for default risk, this study finds no significant pricing of default risk in the cross-section of equity returns. Exposure to market volatility innovations is shown to explain much of the returns to distressed stocks previously documented.;The final essay, "Affect in a Behavioral Asset Pricing Model, " investigates the role of psychological heuristic Affect in asset pricing. The paper outlines a behavioral asset pricing model where expected returns are high when objective risk is high and also when subjective risk is high. High subjective risk comes with negative affect. Investors prefer stocks with positive affect and their preference boosts the prices of such stocks and depresses their returns. Empirical support for the model is provided by studying the preferences of investors as reflected in surveys conducted by Fortune magazine during 1983-2006. The returns of admired stocks, those highly rated by the Fortune respondents, were lower than the returns of despised stocks, those rated low. This is consistent with the hypothesis that stocks with negative affect have high subjective risk and their extra returns compensate for that risk.