Essays in Capital Markets

This thesis consists of three essays in capital markets. The first essay presents a dynamic asset pricing model with heterogeneously informed agents. Unlike previous research, the general case where differential information leads to the problem of "forecasting the forecasts of others" and to non-trivial dynamics of higher order expectations is studied. In particular, it is proved that the model does not admit a finite number of state variables. A comparison of equilibria characterized by identical fundamentals but different information structure shows that the distribution of information has substantial impact on equilibrium prices and returns. In the second essay we explore several sources of serial correlation in returns of hedge funds and other alternative investments. We show that the most likely explanation is illiquidity exposure, i.e., investments in securities that are not actively traded and for which market prices are not always readily available. For portfolios of illiquid securities, reported returns will tend to be smoother than true economic returns, which will understate volatility and increase risk-adjusted performance measures such as the Sharpe ratio. We propose an econometric model of illiquidity exposure and develop estimators for the smoothing profile as well as a smoothing-adjusted Sharpe ratio. For a sample of 908 hedge funds drawn from the TASS database, we show that our estimated smoothing coefficients vary considerably across hedge-fund style categories and may be a useful proxy for quantifying illiquidity exposure. In the third essay our objective is to study analytically the effect of borrowing constraints on asset returns. We explicitly characterize the equilibrium for an exchange economy with two agents who differ in their risk aversion and are prohibited from borrowing. In a representative-agenlt economly with CR.RA preferences, the Sharpe ratio of equity returns and the risk-free rate are linked by the risk aversion parameter. We show that allowing for preference hetterogeneity an(l imposing borrowing constraints breaks this link. We find that anll econony with borrowing constraints exhibits simlultaneously a relatively high Sharpe ratio of stock returns and a relatively