Financial Market Dislocations - University of Miami School of Business

Financial Market Dislocations Paolo Pasquariello 1 January 15, 2013 1 c° 2013 Paolo Pasquariello, Department of Finance, Ross School of Business, University of Michi- gan, ppasquar@umich.edu. I am grateful to CIBER and the Q Group for financial support, and to Deniz Anginer, Kenneth French, Tyler Muir, Lubos Pastor, Jeremy Piger, and Adrien Verdelhan for kindly providing data. I benefited from the comments of Rui Albuquerque, Torben Andersen, Andrew Ang, Deniz Anginer, Ravi Bansal, HankBessembinder, Robert Dittmar, BernardDumas, WayneFerson, John Griffin, Mark Huson, Ming Huang, Charles Jones, Andrew Karolyi, Ralph Koijen, Francis Longstaff, Darius Miller, Lorenzo Naranjo, Lubos Pastor, Lasse Pedersen, Joel Peress, Amiyatosh Purnanandam, Uday Rajan, Angelo Ranaldo, Gideon Saar, Ken Singleton, Elvira Sojli, Jules van Binsbergen, Clara Vega, Adrien

Verdelhan, Frank Warnock, Ivo Welch, Jeff Wurgler, Xing Zhou, and seminar participants at the 2011 NBER SI Asset Pricing meetings, 2011 FRA conference, 2012 SFS Finance Cavalcade, 2013 AFA meetings, University of Michigan, Michigan State University, Cornell University, Panagora, Univer- sity of Utah, Erasmus University, Tinbergen Institute, World Bank, ESSEC, INSEAD, and University of Minnesota. Any remaining errors are my own. Abstract Dislocations occur when financial markets, operating under stressful conditions, experience large, widespread asset mispricings. This study documents systematic dislocations in world capital marketsandtheimportanceoftheirfluctuations forexpectedasset returns. Ournovel, model-free measure of these dislocations is a monthly average of six hundred abnormal absolute violations of three textbook arbitrage parities in stock, foreign exchange, and money markets. We find that investors demand economically and statistically significant risk premiums to hold financial assets performing poorly during market dislocations. JEL classification: G01; G12 Keywords: Asset Pricing; Dislocations; Expected Returns; Financial Crisis; Arbitrage; Law of One Price 1 Introduction Financial market dislocations are circumstances in which financial markets, operating under stressful conditions, cease to price assets correctly on an absolute and relative basis. The goal of this empirical study is to document the aggregate, time-varying extent of dislocations in world capital markets and to ascertain whether their fluctuations affect expected asset returns. The investigation of financial market dislocations is of pressing interest. When “massive” and “persistent,” these dislocations pose “a major puzzle to classical asset pricing theory” (Fleck- enstein et al., 2012). The turmoil in both U.S. and world capital markets in proximity of the 2008 financial crisis is commonly referred to as a major “dislocation” (e.g., Matvos and Seru, 2011). Policy makers have recently begun to treat such dislocations as an important, yet not fully-understood source of financial fragility and economic instability when considering macro- prudential regulation (Hubrich and Tetlow, 2011; Kashyap et al., 2011). Lastly, the recurrence of severe financial market dislocations over the last three decades (e.g., Mexico in 1994-1995; East Asia in 1997; LTCM and Russia in 1998; Argentina in 2001-2002) has prompted institutional investors to revisit their decision-making and risk-management practices. Financial market dislocations are elusive to define, and difficult to measure. The assessment of absolute mispricings is subject to considerable debate and significant conceptual and empirical challenges (O’Hara, 2008). The assessment of relative mispricings stemming from arbitrage par- ity violations is less controversial. According to the law of one price – a foundation of modern finance – arbitrage activity...

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