Essays on information and asset pricing

Abstract

This thesis consists of three essays on information and asset pricing. In the first chapter, I study how corporate bond mutual funds signal their ability to investors through prospectus. I provide a model to illustrate that when the abilities of fund managers are unobservable, high-skill mutual fund managers can signal their ability by taking on extra investment risk. This practice is more costly for low-skill fund managers, and thus they do not mimic it. Consistent with the model predictions, I find that some U.S. corporate bond mutual funds intentionally remain silent on risk-related goals in their prospectuses, and the alpha of those funds is higher than that of their peers. In addition, high-skill funds have higher exposures to indexes with higher risk levels. The signaling practice of high-skill funds influences the choices of investors. Specifically, investors with high risk aversion concentrate on low-skill funds, which could exacerbate the fragility of low-skill funds and distort incentives for high-skill funds. Empirically, I find that investors of low-skill funds are more sensitive to bad performance and that high-skill funds are more likely to misreport to Morningstar to boost performance and attract fund flows. The second chapter of my thesis examines the roles of information differences among informed investors (information asymmetry) in the determination of a firm’s cost of capital in a competitive market. I model information asymmetry by the dispersion of the precision of the private signals. I show that when there is no non-learnable component in asset’s payoff (residual uncertainty), information asymmetry will not affect cost of capital and price informativeness when market is fully competitive, which is consistent with Lambert and Verrcchia (2015). In contrast, with residual uncertainty, a higher level of information asymmetry will lead to higher cost of capital and lower price informativeness in a competitive market. The results highlight the importance for regulators to alleviating information asymmetry to improve market efficiency. The third chapter of the thesis investigates the market information contained in short selling and options trading. Splitting stocks into groups with and without options, I find that only the aggregate short interest on stocks without options predict market returns in both in- and out-of-sample tests. Similarly, grouping stocks based on short selling risks, only the aggregate option implied volatility spreads on stocks with higher short selling risks predict market returns. Overall, the results reveal a substitution effect between short selling and options trading in predicting aggregate stock returns. This effect could explain why aggregate short interest does not predict market returns in recent years given the rapid development of the options market.