This dissertation provides empirical evidence of how market frictions generate significant effects on asset prices. I identify two forms of frictions that restrict the risk-bearing capacity of investors in international financial markets. The first form is slow moving capital, which limits this capacity in the short run. The second form is a lack of investor awareness, which limits this capacity in the long run. These frictions bear different implications on asset prices. Specifically, the short run restriction produces temporary price reversals while the long run restriction produces more permanent price impacts.
Slow moving capital provides a basis for the short-run phenomenon, and it is the first form of friction examined in the dissertation. The idea here is that when exogenous shocks are introduced into the markets, investors could experience temporary capital constraints and subsequently engage in a search process to find new sources of funding. However, this process takes time, and the lack of instantaneous flows of funds into the assets creates the need for provision of immediacy.
I look at the case of Brazilian privatization as an example of exogenous supply shocks to Latin American markets. The additional supply of shares introduced by the Brazilian government generated temporary price declines of privatized assets because international and local Brazilian investors required higher expected returns to absorb the additional supply. Furthermore, international investors rebalanced their portfolios by selling correlated assets in other Latin American markets. Given limited the risk-bearing capacity in these markets, these portfolio reallocations caused spillover of price pressure effects there as well. I exploit the market segmentation between foreign and domestic share classes in Mexico to distinguish price pressure effects from other possible explanations. Finally, I show that patterns of international institutional fund flows between Latin American countries and flows into Latin American mutual fonds are consistent with the provision of immediacy and spillover theory.
Overall, the evidence of the impact from privatization on equity markets in Brazil and other Latin American countries is consistent with a framework in which the risk-bearing capacity of international investors (e.g., emerging markets mutual funds) is limited in the short run.
The second part of the dissertation examines investor unawareness as a form of friction that constrains the risk-bearing capacity in the long run. The lack of investor awareness in certain stocks could stem from investors' incomplete information about all available assets because of the information acquisition cost. Assets that are well recognized by the majority of investors would have larger investor base and be able to achieve greater risk-sharing. Consequently, investors demand lower expected returns for holding these less risky assets, relative to expected returns of assets with less recognition and smaller investor base.
I test this investor recognition effect by distinguishing stocks with different investor awareness through redefinitions in the MSCI Emerging Markets Index. While such events convey no new fundamental information about the affected stocks in the index, an inclusion of a previously unknown stock does increase its recognition by investors. Once a stock becomes known, its investor base widens, generating a lower expected return and permanent price increase.
I examine a particular group of stocks that have been included in the MSCI index once and also been deleted. I define this group of stocks as "known stocks", having already been recognized by investors. I compare cumulative abnormal returns of known stocks during their repeat inclusions with cumulative abnormal returns of new stocks during their initial inclusions. Under the assumption that investor recognition of stocks persists after their deletions, these known stocks should experience no permanent price increases at the time of their repeat additions because persisted awareness should create no significant change in investor base. In support of the investor recognition hypothesis, I find economically large difference in cumulative abnormal returns of known and new stocks.
The findings in this dissertation point to the importance of frictions that international investors face and their significant impacts on asset pricing both in the form of short run price reversal and in the form of permanent price impact.