Three essays in asset pricing
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This dissertation consists of three essays. In the first essay, we present evidence that market sentiment is positively priced in the cross-section of stock returns in low-sentiment periods. We estimate individual stock exposure to market sentiment and find that, in periods of low market sentiment, stocks in the highest sentiment beta quintile generate a 0.74% higher ex-post monthly return than stocks in the lowest sentiment beta quintile. However, this return spread is not significant in medium- or high-sentiment periods. This finding is consistent with the argument that overpricing in high-sentiment periods is more prevalent than underpricing in low-sentiment periods due to short-sale constraints. In the second essay, we use Yelp restaurant customer reviews to construct a novel consumption-based sentiment index. Our weekly index is based on the ratio of positive to negative user ratings to capture an embedded element of sentiment associated with consumption. To validate that our measure captures consumption sentiment, we show that it is correlated with aggregate market risk aversion. Furthermore, consistent with a flight to safety, our index predicts mutual fund flows from bond to equity funds. We find that consumption sentiment predicts stock return reversals, an effect that is particularly strong for difficult-to-arbitrage stocks. The evidence suggests that our consumption sentiment index captures sentiment-induced mispricing in the stock market. When we decompose our index into components of optimism and pessimism, we find that pessimism drives the predictive power of the index, a result that gives direct evidence for the negativity bias in our context. The third essay examines the role of market disagreement in explaining the cross-section of hedge fund performance. In a market where disagreement fluctuates, skilled arbitrageurs may employ different trading strategies to exploit the mispricing caused by disagreement and short-sale constraints. Skilled hedge funds with high sensitivity to disagreement can take advantage of mispricing in high-disagreement periods to improve their performance. We show that hedge funds with a high disagreement beta tend to have a disagreement exploitation skill and thus they can earn higher cross-sectional returns relative to other hedge funds that do not have this skill. Experienced hedge funds (using size and age as proxies) and hedge funds that charge a high incentive fee are likely to have high disagreement betas.