Two essays in empirical finance

Abstract

This thesis contains two essays in the area of empirical finance. The first essay tests and supports the hypothesis that short sales constraints reduce price informativeness by hindering negative information from being fully incorporated into price. The analysis is based on a unique regulatory setting in the Hong Kong market. By using two measures for price informativeness, I find that stock prices become more informative when restrictions on short sales are lifted and less informative when restrictions are re-imposed. The results are robust after controlling for the relevant firm characteristic variables which affect equilibrium level of information in stock price. Further analyses demonstrate that allowing short sales mitigates the downward drift following negative earnings surprises and enhances the ability of stock prices to forecast future earnings. The second essay investigates the cross-sectional pattern of the relation between stock returns and inflation. Previous studies have shown a negative relation between stock returns and both expected and unexpected inflation on the market level, which contradicts the Fisher's theory and the conventional wisdom. Two explanations have been suggested in the literature. The proxy effect hypothesis states that the negative relation is merely a proxy for the negative relation between expected future real economic activity and inflation, and the money illusion hypothesis assumes that investors erroneously discount real earnings by nominal discount rates. In this thesis, I support the rational explanation to the negative return-inflation relation by examining the cross-sectional pattern of return-inflation betas. I show that, consistent with the proxy effect hypothesis, there is much cross-sectional variation in return-inflation betas, and further the cross-sectional variation in return-inflation betas can be explained by the differential associations between firm fundamentals and inflation. I also examine the impacts of some observable firm characteristic variables on the return-inflation relation and the results are generally consistent with the prediction based on the proxy effect hypothesis.