This thesis studies the interactions between market frictions and investor trading behavior, as well as their implications on asset pricing.

Chapter 1 investigates the issue from the perspective of information production. The chapter studies volume-return dynamics under a framework with endogenous information production that is linked to a firm's investment activities. My framework generates time-varying differences of opinion and trading volume, especially when a firm receives (unexpected) positive or negative news. In addition, my framework predicts cross-sectional variation regarding the ability of volume shocks to predict future returns (often referred to as the high volume return premium). Using standard CRSP monthly data, I document that the high volume return premium is...[ Read more ]

This thesis studies the interactions between market frictions and investor trading behavior, as well as their implications on asset pricing.

Chapter 1 investigates the issue from the perspective of information production. The chapter studies volume-return dynamics under a framework with endogenous information production that is linked to a firm's investment activities. My framework generates time-varying differences of opinion and trading volume, especially when a firm receives (unexpected) positive or negative news. In addition, my framework predicts cross-sectional variation regarding the ability of volume shocks to predict future returns (often referred to as the high volume return premium). Using standard CRSP monthly data, I document that the high volume return premium is economically and statistically stronger (increases from 6% to 12% per annum) for firms that exhibit poor stock market or operating performance prior to volume shocks; for firms that receive "positive news" when volume shocks hit; and for firms that have high degrees of information asymmetry. I also examine volume shocks around earnings announcements, and find additional supporting evidence for my framework.

Chapter 2 focuses on two market frictions: short-sale constraint and limited risk bearing capacity. The chapter studies Chinese dual-listed companies that are traded both in China(Mainland) and Hong Kong. When China has a short-sale ban, Chinese stock prices are l.8x as high as Hong Kong prices (on average). Stock pairs with higher fundamental volatilities or more volatile order flows have higher price disparities (on average). The average stock pair's return difference is volatile and has a standard deviation of 8.8% per week. This paper shows that order flows can affect both a company's fundamental price and/or its transitory prices. In Hong Kong, transitory variance accounts for 39% of a stock's total variance. These results are surprising because the average market capitalization is over USD 8 billion for the Hong Kong-listed shares and the turnover is over 2.5x per annum. We exploit a quasi-natural experiment in which the short-sale ban is lifted for some Chinese stocks but not others. After the ban is lifted, the affected shares trade at parity. We estimate that lifting the short-sale ban in China (mainland) reduces weekly transitory volatility in Hong Kong by 49 bp per week because it enables a hedging mechanism.