Essays on Asset Pricing and Financial Stability

Abstract

Title of Document: ESSAYS ON ASSET PRICING AND FINANCIAL STABILITY Jeong Min Lee, Doctor of Philosophy, 2014 Directed by: Professor Albert S. Kyle Professor Mark Loewenstein Department of Finance Robert H. Smith School of Business My two-essay dissertation revolves around understanding the financial crisis of 2008. First I focus on the repo market, a major funding source of the shadow banking system, and show the repo market can create and amplify the fragility of the system. Then I investigate a broader economy with heterogeneous agents and demonstrate how the dynamics of equilibrium asset prices and wealth distributions are determined. In Essay 1, I develop a dynamic model of collateral circulation in a repo market, where a continuum of institutions borrow from and lend to one another against illiquid collateral. The model emphasizes an important tradeo . On one hand, easier collateral circulation makes repos liquid and increases steady state investment through several multiplier e ects, improving economic e ciency. On the other hand, it can harm financial stability because less capital is sitting on the sidelines waiting for investment opportunities. This fragility is further exacerbated by the endogenous repo spread through a positive feedback loop, and can result in an ine cient repo run. The model is relevant for understanding the repo markets during the financial crisis of 2008. In Essay 2, I study the dynamics of the wealth distribution and asset prices in a general equilibrium model. Agents face heterogeneous portfolio constraints that limit the shares of risky investments relative to wealth. The setup is motivated by empirical evidence that many households do not participate in the stock market and portfolio shares are heterogeneous and persistent conditional on stock market participation. There are two main results. First, one state variable can summarize the wealth distribution regardless of the number of types of agents. Second, when the economy is bad, it becomes more sensitive to additional negative shocks, meaning that not only magnitudes of the shocks but also their frequency matters. ESSAYS ON ASSET PRICING AND FINANCIAL STABILITY by Jeong Min Lee Dissertation submitted to the Faculty of the Graduate School of the University of Maryland, College Park in partial fulfillment of the requirements for the degree of Doctor of Philosophy 2014 Advisory Committee: Professor Albert S. Kyle, Co-Chair Professor Mark Loewenstein, Co-Chair Professor Richmond Mathews Professor Haluk Unal Professor John Shea c • Copyright by Jeong Min Lee 2014 Dedication I dedicate this dissertation to my parents, Jongtae Lee and Keunae Kwak. ii Acknowledgments This dissertation would not have been possible without the help and support of many people. First and foremost I want to thank my advisors, Pete Kyle and Mark Loewenstein, for their constant guidance, advice, support and encouragement through the six years of my PhD study. They have always been great mentors, inspiring scholars, and the best role models. I also thank my committee members, Rich Mathews, Haluk Unal and John Shea, for their insights and support throughout the process. I thank alll the faculty members and PhD students in the Finance Department for their help and kindness. Last but not least I am grateful to my husband, Leland Crane, whose love has been essential through this process. iii