Essays on asset classes, traders, and stock prices

This thesis examines the relationships between stock prices and different asset classes and types of traders.;In "Omitted Markets, Idiosyncratic Risk, and the Cross-section of Stock Returns," I examine the effects of a number of asset classes on U.S. stocks through idiosyncratic risk. Previous studies show that idiosyncratic risk is priced and that profits can be gained from portfolios loading on idiosyncratic risk. These results depend on the asset pricing model used for calculating the residuals. I find that a modest change in the estimation procedure of idiosyncratic risk eliminates the risk premium as well as most of the profits identified earlier. Absent from the Fama and French (1993) specification, markets outside the traditional U.S. stock universe could represent priced factors and account for about 20% of the residual variance from the Fama-French model.;My joint work with Mila Getmansky and Heather Tookes, "Convertible Bond Arbitrage, Liquidity Externalities, and Stock Prices," studies more specifically the impact of an individual asset class, convertible bonds, on the underlying equity markets. In particular, we use changes in equity short interest following convertible bond issuance to identify convertible bond arbitrage activity and analyze its impact on stock market liquidity and prices for the period 1993 to 2006. There is considerable evidence of arbitrage-induced short selling resulting from issuance. Moreover, we find strong evidence that this activity is systematically related to liquidity improvements in the stock. These results are robust to controlling for the potential endogeneity of arbitrage activity.;"Bad News Isn't So Bad: A Microstructure Model with the Disposition Effect" studies the short-term price impact of the disposition traders. In a microstructure model, market makers quote prices that are less sensitive to sales for stocks trading at capital gains, as they rationally anticipate further uninformed disposition-motivated sales. Disposition-motivated trades effectively decrease the speed of the price discovery process for bad news prior to unscheduled public announcements, but increase it for good news. Bad news is associated with volatile prices. This behavior creates an incentive for managers holding stock options to disclose bad news when the disposition effect is strong.