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This thesis consists of one hedge fund study and two credit default swap (CDS) studies. The first study investigates the relationship between mega hedge funds (the largest 25% of funds) and two bond yields (U.S. Treasury yield and Baa yield). Using a merged sample of 9,725 hedge funds from 1994 to 2012, I find that hedge fund outflow produced a more significant relationship than inflow, and the dollar outflow of large hedge funds can predict the increase in the bond yields. The association is also more pronounced for large funds with a short notice period prior to redemption. The results suggest that hedge fund flows provide predictive information for the movement of bond yields. The second study investigates the systematic and firm-specific credit and liquidity risks of CDS spreads. Using data on CDS spreads of 356 U.S. firms from 2002 to 2011, I find that systematic credit and liquidity risks are important in cross-sectional prediction of CDS spreads. In addition, the importance of systematic liquidity risk becomes substantial since the financial crisis in 2007. This finding challenges the current Basel III procedures for counterparty credit risk regulations, in which only pure default should be used. In addition, the systematic credit and liquidity factors can be used as a proxy for CDS spreads of firms that do not have traded CDSs. The last study extends Carr and Wu (2010), in which deep out-of-the-money (DOOM) put options and CDSs are associated as they both provide credit insurance for credit protection buyers. Using the Nelson-Siegel (1987) model, I obtain the credit and illiquidity components for DOOMs and CDSs over the period from May 2002 to May 2012. I show that, after controlling the factors that explain the difference between the DOOM and CDS markets, the components converge over time in these two markets. Thus, I can exploit the observed convergence pattern by constructing a simple trading strategy, and this benchmark strategy produces a positive return. I further construct two other strategies based on the component information, and these two refined strategies outperform the benchmark strategy by the Sharpe ratio and Carhart alpha. My three studies contribute to the literature in hedge fund systemic risk and CDS credit and liquidity risks.

This thesis studies the trading of the Chinese American Depositories Receipts (ADRs) and their respective underlying H shares issued in Hong Kong. The primary intention of this work is to investigate the arbitrage opportunity between the Chinese ADRs and their underlying H shares. This intention is motivated by the market observation that hedge funds are often in the top 10 shareholders of these Chinese ADRs. We start our study from the origin place of the Chinese ADRs, China’s stock market. We pay particular attention to the ownership structure of the Chinese listed firms, because part of the Chinese ADRs also listed A shares (exclusively owned by the Chinese citizens) in Shanghai. We also pay attention to the market microstructures and trading costs of the three China-related stock exchanges. We then proceed to empirical study on the Chinese ADRs arbitrage possibility by comparing the return distribution of two securities; we find these two securities are different in their return distributions, and which is due to the inequality in the higher moments, such as skewness, and kurtosis. Based on the law of one price and the weak-form efficient markets, the prices of identical securities that are traded in different markets should be similar, as any deviation in their prices will be arbitraged away. Given the intrinsic property of the ADRs that a convenient transferable mechanism exists between the ADRs and their underlying shares which makes arbitrage easy; the different return distributions of the ADRs and the underlying shares address the question that if arbitrage is costly that the equilibrium price of the security achieved in each market is affected mainly by its local market where the Chinese ADRs/the underlying Hong Kong shares are traded, such as the demand for and the supply of the stock in each market, the different market microstructures and market mechanisms which produce different trading costs in each market, and different noise trading arose from asymmetric information across multi-markets. And because of these trading costs, noise trading risk, and liquidity risk, the arbitrage opportunity between the two markets would not be exploited promptly. This concern then leads to the second intention of this work that how noise trading and trading cost comes into playing the role of determining asset prices, which makes us to empirically investigate the comovement effect, as well as liquidity risk. With regards to these issues, we progress into two strands, firstly, we test the relationship between the price differentials of the Chinese ADRs and the market return of the US and Hong Kong market. This test is to examine the comovement effect which is caused by asynchronous noise trading. We find the US market impact dominant over Hong Kong market impact, though both markets display significant impact on the ADRs’ price differentials. Secondly, we analyze the liquidity effect on the Chinese ADRs and their underlying Hong Kong shares by using two proxies to measure illiquidity cost and liquidity risk. We find significant positive relation between return and trading volume which is used to capture liquidity risk. This finding leads to a deeper study on the relationship between trading volume and return volatility from market microstructure perspective. In order to verify a proper model to describe return volatility, we carry out test to examine the heteroscedasticity condition, and proceed to use two asymmetric GARCH models to capture leverage effect. We find the Chinese ADRs and their underlying Hong Kong shares have different patterns in the leverage effect as modeled by these two asymmetric GARCH models, and this finding from another angle explains why these two securities are unequal in the higher moments of their return distribution. We then test two opposite hypotheses about volume-volatility relation. The Mixture of Distributions Hypothesis suggests a positive relation between contemporaneous volume and volatility, while the Sequential Information Arrival Hypothesis indicates a causality relationship between lead-lag volume and volatility. We find supportive evidence for the Sequential Information Arrival Hypothesis but not for the Mixture of Distributions Hypothesis.

The Chinese equity market where firms do not die is saddled by an increasing number of zombie financially distressed firms resulting from a relatively low delisting rate, a weak Enterprise Bankruptcy Law process and a profit-based delisting system that is undermined by earnings management. As a result, it is difficult for investors and creditors to assess or predict the financial distress state of firms to reduce loss. This research uses panel data of 1,415 Chinese non-financial listed firms on the Shanghai and Shenzhen Stock Exchanges for the period 2009 to 2018. Using a two-stage multinomial logit model, this research models financial distress as a multiple state process of four financial distress states (NFDIS, FWEAK, FWEAK, FDIST) which is an improvement on the conventional binary state approach. The empirical findings show a nonlinear relationship between financial ratios and corporate governance factors and financial distress. Specifically, a change in a firm’s financial leverage and cash flow from finance has a significant positive effect on the probability of the firm in a financially distressed state: FDECL, FWEAK or the FDIST state. Inversely, a change in a firm’s asset management efficiency, profitability, liquidity, cash flow from operations, dividend payment, market valuation, board structure or ownership structure has a significant negative effect on the probability of the firm in a financially distressed state: FDECL, FWEAK or the FDIST state. Notably, the further a firm’s financial health deteriorates, the lesser its probability of recovery. Further to the two-year consecutive loss criteria, this research found that firms in the early FDECL state (ST firms) do experience distress symptoms of poor asset management efficiency, high cash flow from finance, low dividend pay-out, poor board structure and low percentage of institutional ownership. Firms in the FWEAK state also experience, in addition to the same symptoms as firms in the FDECL state, poor liquidity, cash flow from operations and poor market valuation. Firms in the terminal FDIST state experience the same symptoms as firms in the FDECL and FWEAK states in addition to high financial leverage. Although firms across the four financial distress states may experience similar distress symptoms, the magnitude of these symptoms at each distress state is significantly different as they are incremental. The empirical findings imply that early financial distress may not be detected relying solely on accrual or market information as the case of the ST delisting criteria. This is because accrual-based ratios and market-based ratios are less effective in diagnosing the symptoms experienced by firms in the early FDECL state than they are in identifying the symptoms in the late FWEAK state or terminal FDIST state. Cash flow-based ratios and corporate governance factors improve the predictive and explanatory power of accrual and market-based ratios assessing aspects of financial distress not assessed by accrual-based ratios or market-based ratios.

Financial analysts have increasingly investigated a wide variety of nonfinancial factors to better understand their potential impact on the valuation of a firm. This dissertation examines whether a firm’s negative environmental, social and governance (ESG) issues covered by media influence the assessment of financial analysts regarding its future prospects. Specifically, I investigate whether a firm’s media coverage of its ESG activities has an impact on analysts cash flow forecasts and cash flow forecast accuracy. I provide evidence that corporate social irresponsibility (CSI) coverage of ESG issues is negatively associated with analyst issuance of cash flow forecasts. I also find that a firm’s CSI coverage of ESG issues is negatively related to the firm’s analyst cash flow forecast accuracy. The results hold for additional tests including propensity score matching models and Heckman’s two-stage analyses. However, I do not find strong evidence that a firm’s media coverage of environmental issues, social issues or governance issues is positively related to the firm’s analyst cash flow forecast accuracy. Using Liu (2006)’s liquidity-augmented capital asset pricing model (LCAPM), I find that a firm’s media coverage of ESG issues is positively related to accounting-related liquidity risk, indicating that investors may expect higher compensation for liquidity risks when they invest in firms which receive higher CSI coverage. Additionally, I find that an analyst’s decision to issue a cash flow forecast does not play a role in the relation between media coverage of ESG issues and accounting-related liquidity risk.This dissertation provides insights into the link between CSI information and information asymmetry by examining the relation between the third-party-disclosed negative ESG information and accounting-related liquidity risk. The findings of this study have implications for managers, investors, financial analysts, regulators, and other market participants.

This thesis consists of three stand-alone studies relating to liquidity, information, and the financial crisis. The first study examines how the measures of liquidity risk estimated over the period before the global financial crisis of 2008-2009 predict global stocks crisis performance. Results show that the stocks with higher pre-crisis returns sensitivity to the global market liquidity exhibit greater declines in price during the crisis. The evidence is consistent across emerging, developed, and global samples, and remains robust whether the percentage effective spread or the percentage quoted spread is used as a liquidity measure. Overall, this finding provides some additional insights to the question as to why a stock s exposure to a market-wide liquidity shock is a priced systematic risk factor. The second essay investigates whether institutional investors contribute to spreading liquidity risk during the global financial crisis of 2008-2009. This study finds that stocks with high pre-crisis institutional ownership significantly underperformed during the financial crisis period. More importantly, stocks which are sensitive to liquidity shocks and have a high pre-crisis exposure to institutional ownership exhibited even greater price decline. Further analyses show that the spread of liquidity risk by institutions is attributable to non-block holding investors and independent institutional investors, who are more likely to face liquidity constraints during a crisis. The third study investigates how a country s institutional and information environment affect variation in firm-specific information relative to market-wide information in news produced by the media, as reflected in co-movement in news, and the consequence of news co-movement on the stock market. Three main findings are documented in this study. First, news at the firm level co-moves with market-wide news across sample countries. This result suggests that the information produced and provided to the market by the media has both firm-specific detail and market-wide content. Second, this study finds that high news co-movement is associated with a country s opaqueness and poor institutional characteristics, indicating that less firm-specific information is available to the public in these countries. Finally, there is clear evidence that higher news co-movement leads to both greater co-movement in stock returns and higher co-movement in liquidity.

We use the CoVaR approach to identify the main factors behind systemic risk in a set of large international banks. We find that short-term wholesale funding is a key determinant in triggering systemic risk episodes. In contrast, we find weaker evidence that either size or leverage contributes to systemic risk within the class of large international banks. We also show that asymmetries based on the sign of bank returns play an important role in capturing the sensitivity of system-wide risk to individual bank returns. Since short-term wholesale funding emerges as the most relevant systemic factor, our results support the Basel Committee’s proposal to introduce a net stable funding ratio, penalizing excessive exposure to liquidity risk.

The dissertation is divided into two chapters. Chapter I examines the impact of capital gains distribution rules on a closed-end fund (CEF) manager’s incentive to collect and trade on information. The central hypothesis is that the treatment of realized capital gains embodied in the U.S. tax code, combined with the form of compensation contract offered CEF mangers, creates an “overhang” effect on CEF managers’ incentives to optimally trade the fund portfolio. We model the overhang effect and show that (1) there exists an equilibrium in which CEF managers collect private information in the early stages of the fund (when no lock-in effect exists) but then choose to be uninformed in later stages (when the lock-in effect exists), and (2) rational-expectations pricing of the expected cash flows and risk resulting from the information equilibrium results in CEFs initially trading at a premium and subsequently trading at a discount. In addition, we examine the empirical implications from the model and find, consistent with the model, a significant negative relation between future risk adjusted performance and current unrealized capital gains as well a significant positive relation between NAV premiums and future risk adjusted performance. In addition we show there are two separate effects from unrealized capital gains: (1) the Malkiel (1977) tax effect on CEF investors and (2) the manager incentive-capital gain related effect. Chapter II examines the economic significance of idiosyncratic risk in the context of arbitrage profits as well the robustness of idiosyncratic risk estimates relative to additional known systematic risks. We estimate idiosyncratic risk using both rolling and single time-series EGARCH methods and form high and low idiosyncratic risk portfolios. After controlling for liquidity risk and momentum, we conclude that abnormal returns to idiosyncratic risk arbitrage strategies are not statistically and/or economically significant. Furthermore we find no evidence of priced idiosyncratic risk in closed-end funds. Finally, we find no relation between idiosyncratic risk and stock returns in Fama-MacBeth cross-sectional regressions.