Essays in Financial Economics

Abstract

This dissertation comprises three essays in financial economics. The first essay uses a general equilibrium model to explain the cash flow risk and the dynamics of the equity term structure. I propose a novel explanation for cash flow risk that accurately captures the decomposition of forward yields into expected dividend growth and risk premium components. Addition- ally, it explains the upward sloping term structure during expansions and its inversion during recessions. In the model, asset prices respond instantly to aggregate shocks in the economy (financial effect), but the real effect of the shock is delayed. When a negative shock impacts the economy, cash flows either continue to increase or remain flat due to firms selling their capital and distributing the proceeds as dividends. This phenomenon arises from both the decreased productivity of capital and the high value that households place on dividends during challeng- ing times. Furthermore, the economic mechanism behind the endogenous cash flow process and the discount rate risk is micro-founded using a heterogeneous firm model matched to firm-level data for the US. Additionally, the essay explains the economic mechanism behind the value premium (as the risk premium between long and short duration firms) and the decomposition of forward yields across firms with different durations, taking advantage of the richness of the heterogeneous firm model. The second essay investigates the relationship between competition, common ownership, and inequality. While previous studies have documented the decrease in competition, the increase in common ownership, and the rise of inequality, no paper has explored the connection between common ownership and inequality. This essay presents empirical evidence, through structural estimation, that common ownership contributes to the increase in income inequality through declining competition given the common ownership hypothesis is true. I aim to provide quantitative answers to the following questions: 1) What percentage of the increase in the share of profits (increase in markups) in the last three decades can be attributed to the increase in common ownership? 2) What portion of the increase in income inequality can be attributed to common ownership? According to our model, based on the common ownership hypothesis, the rise of common ownership has contributed to an increase in the total income Gini coefficient from 27.62 to 41.73. The final essay explores the dynamics of equilibrium asset prices in an economy with wishful thinkers (as defined in Caplin and Leahy, 2019) and rational agents. The optimism of wishful thinkers, their attraction to high-return projectswith low success probabilities, and their occa- sional wealth accumulation contribute to the formation and bursting os stock market bubbles. The extend of wishful thinking’s impact on asset prices depends on the level of wishful thinking, wealth distribution, and the learning pace within the economy.