Three Essays in Financial Economics

Abstract

This dissertation examines i) how market structure and the beliefs of market participants impact U.S. corporate bond mutual funds as well as the underlying bond market, and ii) whether personal experiences affect central bankers' belief formation and their decision making.

In the first chapter of the dissertation, entitled ``Returns to Scale among Corporate Bond Mutual Funds'', I document a (within-fund) hump-shaped relation between fund size and subsequent fund alpha among U.S. corporate bond mutual funds. When funds are small, they exhibit increasing returns to scale but when they become large, they exhibit decreasing returns to scale. This sharply contrasts with the previous finding of decreasing returns to scale among equity mutual funds. Further, I show that the nature of trading costs in the corporate bond market---in particular, a U-shaped relation between trade size and unit trading cost at the corporate bond level---is relevant for explaining hump-shaped returns to scale. Interpreting these empirical patterns is not straightforward, though. In a rational expectations framework, we expect a fund's net alpha always to be zero and hence, there should be no time-series relation between fund size and subsequent fund alpha. To help interpret the empirical findings, I propose a dynamic model in which investors learn about a fund's ability to manage its trading cost from the fund's past returns. The evolution of investors' beliefs provides a source of variation in fund size and further, in fund alpha over time.

In the second chapter of the dissertation, entitled ``The Making of Hawks and Doves'' and co--authored with Ulrike Malmendier and Stefan Nagel, we argue that central bankers' personal inflation experiences significantly alter their inflation forecasts, votes, and speeches. First, we show that inflation experiences have a direct impact on Federal Open Market Committee members' inflation forecasts in their semi-annual Monetary Policy Reports to U.S. Congress. Second, members with higher inflation experiences are significantly more likely to cast a hawkish dissent. Over the FOMC's voting history since March 1951, an increase in a member's experience-based inflation forecast by one within-meeting standard deviation raises the probability of a hawkish dissent by about one third, and decreases the probability of a dovish dissent also by about one third. Third, higher inflation experiences also predict a significantly more hawkish tone in speeches. Finally, aggregating over all FOMC members present at a meeting, the average experience-based forecast helps predict the federal funds target rate, over and above conventional forward-looking Taylor rule components. Our findings indicate strong and long-lasting effects of personal inflation experiences even among monetary-policy experts, and point to the importance of FOMC members' selection.

In the third chapter of the dissertation, entitled ``Electronic Trading in the U.S. Corporate Bond Market'', I study how the addition of electronic trading affects the U.S corporate bond market overall, which primarily depends on conventional voice trading. Motivated by the empirical trade-off between price improvement and execution risk of electronic trading, I develop a model of strategic trading-platform selection by investors and show that i) the equilibrium market share of electronic trading decreases as the capacity of dealers' balance sheets becomes smaller, and further ii) the inclusion of electronic trading may not benefit every single dealer---those with small balance sheet capacity would prefer the market structure with voice trading only.