This dissertation comprises three chapters, each of which studies the effect of an unanticipated event on a financial market. This helps us understand what variables influence changes in security prices, and what information is embedded in these price movements. The first two chapters test the effect of financial asset supply on asset prices, whereas the third chapter examines if there are limits to government policy reversals when there are political regime changes.
In the first chapter, I examine the effect of a change in the relative supply of bonds issued by the Government Sponsored Enterprises (Fannie Mae and Freddie Mac) on their relative prices. This issue is important because most academic exercises assume that the aggregate demand curve for financial assets is perfectly elastic, industry practitioners believe that supply effects on security prices are non-trivial. However, this is difficult to test because we observe ex-post prices and quantities, changes in which can be driven by movements in either investor demand or issuer propensity to supply. In my work, I find that, after an unanticipated negative supply shock to Fannie Mae bonds following an undercapitalization announcement, Fannie Mae spreads are tighter than Freddie Mac spreads and issuance volume and spreads get positively correlated. Differential effects across the term structure are also identified. Collectively, these findings provide evidence that supply of financial assets affects prices, implying that the demand curve for financial assets is not perfectly elastic.
The second chapter borrows its main ideas from the first chapter, but considers a different and more familiar setting to generalize the result. Here, I analyze how prices of Treasury securities reacted following the announcement by the US Treasury on October 31, 2001 to discontinue 30-year Treasury Bonds. I find that the spreads on the 30-year on-the-run bond tightened by 33 basis points, whereas the spreads on the two-year on tightened by only 4 basis points. This large increase in long-dated Treasury bond prices relative to the shorter maturities suggests a supply effect. Consistent evidence is found in the Treasury Inflation Protected Securities market, as well as in swap spreads. An examination of the reintroduction of 30-year Treasury bonds in February 2006 also provides evidence of a supply effect.
The third chapter exploits yet another unanticipated event to ask a different question: does the market believe that there are forces that hinder the whimsical reversal of government policies when the political regime changes? Through what mechanisms do these forces operate? Along with co-authors Ray Fisman and Tarun Khanna, I attempt to answer this question by examining the effect of regime change on market expectations of privatization policy using a surprising election result in 2004 in India, where the pro-reform BJP was unexpectedly defeated by a less reformist coalition. Stock prices of government-controlled companies that had been slated for definite privatization by the BJP dropped by 3.5 percent relative to private firms, whereas government-controlled companies that were only under study for possible privatization fell by 7.5 percent relative to private firms, a much larger number. We interpret this as evidence of investor belief of policy irreversibility, where reforms may reach a stage beyond which future regimes have difficulty reversing those policies. Further analysis suggests that layoffs, combined with the privatization announcement, served as a credible commitment to the government's privatization agenda.
The chapters thus explore questions that can be answered by studying security price movements around natural experiments, and have not been resolved by prior work. The relevance of asset supply in determining asset prices, for instance, appears particularly striking, since the single largest change in the slope of the Treasury yield curve over the last decade has been a supply-related event, yet asset pricing models do not explicitly consider the effect of investor propensity to supply securities. The evidence on the limits to policy reversal is an initial step in understanding the political economy of multi-party democracies, and the nature of checks and balances required to prevent short-sighted governments from taking opportunistic actions.