Market crashes, stock return asymmetries and cross-sectional predictability

The financial economics literature on asset pricing has identified several patterns in the cross-section of stock returns that do not seem to be consistent with any rational equilibrium pricing models. Collectively, these empirical facts have become known as ‘stock return anomalies’. On the one hand, the existence of these phenomena may indicate the inadequacy of the asset pricing models that are being used. For instance, there might exist additional economic risk factors, which current theory has yet to uncover. An alternative interpretation is that capital markets are inefficient, and various frictions in the economy allow deviations from rational equilibrium to persist. Hence these stock return anomalies may represent some behavioral biases of market participants that manifest themselves through market inefficiencies. My thesis is an investigation into which one of these two alternative explanations is better able to explain the cross-sectional patterns in stock returns.; This investigation begins with a study of whether the cross-sectional predictability patterns can be explained with an intertemporal asset pricing model that allows economic conditions to change across time. Specifically, I examine whether the cross-sectional variations in stock returns can be linked to the time-series variations in the investment opportunity set of the economy characterized by the expected return of the market and the volatility of the market. Using the aggregate budget constraint to link current and future consumptions to current and future market returns, I develop an intertemporal asset pricing model in which an asset earns a risk premium if it performs poorly when the prospects for the future turn sour. However, the estimates of this model reject the hypothesis that the cross-sectional predictability patterns can be linked to the time-series variations in the expected return or the volatility of the market.; My thesis goes on to investigate the implications on market equilibrium of introducing frictions and investor behavior into the economy. In particular, I consider an environment in which short-sales constraints are binding and investors disagree on stock valuations. Put together, these two features imply that negative information is being withheld from the market. One testable prediction of such a model is that the market is more susceptible to extreme downside movements—which characterizes market crashes—after periods of high disagreement among investors. Another empirical implication is that the cross-section of stock returns exhibit more correlated movements on the downside than on the upside—which is one characterization of stock market contagion. Additionally, this framework suggests that the breadth of stock ownership can measure the amount of negative information that is being withheld from the market. My thesis presents empirical evidence that supports these predictions.