Essays on Market Frictions

Abstract

This thesis investigates market frictions arising from technologies and tools designed to enhance efficiency and convenience in financial markets. In the first chapter, entitled “Visual Deception in Financial Markets”, I examine how the widely used auto-scaled digital charts distort investors’ risk evaluations, thereby affecting risk premium in the cross-section of stock returns. In the second chapter, entitled “Rating Driven Risk Shifting by Mutual Funds”, we demonstrate how the discrete nature of star ratings leads to deliberate risk shifting. Due to the widespread use of star ratings, rating-driven risk shifting accounts for 21% of the market-wide risk shifting, which has previously been shown to hurt performance. In the third chapter, entitled “Luck and Skill in the World of Diseconomies of Scale”, we find that most of the variation in mutual funds’ realized alphas is driven by luck. We show that lucky funds tend to underperform, raising concerns about performance-based, backward-looking metrics such as star ratings.

The results indicate that forward-looking qualitative metrics provide better insights and are neutral to luck.