Exploring deviations between prices and values in capital asset markets

This dissertation consists of three essays that present theoretical and empirical evidence of deviations between asset prices and fundamental values. The deviations are linked to the institutional market structure end strategies for exploiting them are derived. Essay 1, joint with Joshua Coval and Erik Stafford, examines the pricing of structured finance securities (e.g. collateralized debt obligations) using a state-contingent pricing model in the spirit of Arrow (1964) and Debreu (1959). We show that the process of pooling and tranching concentrates the risk of default in the most adverse economic states. Although theory predicts such securities should offer their investors large risk premia, we find that tranches offer far lower yields than tradable alternatives with comparable payoff profiles constructed using equity index options. Essay 2, joint with George Chacko and Erik Stafford, derives a model of transaction costs in a setting where the market maker has transitory pricing power relative to investors demanding immediate execution. Agents submit their demands using limit orders, which are shown to be American options. The limit prices inducing immediate exercise determine the bid and ask prices, and the option's value measures the price of immediacy. By solving for the bid and ask prices as a function of the demanded quantity, we demonstrate that the market maker's supply curves imply proportional transaction costs that are concave in quantity. The model's predictions find considerable empirical support in the cross- section of NYSE firms, and the model produces unbiased, out-of-sample forecasts of abnormal returns for firms added to the S&P 500 index. Essay 3, joint with Halla Yang, derives the optimal dynamic trading strategy for a finite-horizon, risk-averse arbitrageur with access to a mean-reverting mispricing. Arbitrageurs bet against the mispricing until a critical bound is reached, beyond which further increases in the misvaluation precipitate a reduction in the allocation. We demonstrate that intertemporal hedging demands play an important role in the optimal strategy, and that performance-related fund flows effectively increase the arbitrageur's risk aversion. When applied to Siamese twin shares, the optimal strategy delivers a significant improvement in the realized Sharpe ratio and welfare relative to commonly employed threshold rules.