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Essays in asset pricing Garlappi, Lorenzo

Abstract

This dissertation consists of two essays dealing with two selected aspects of the investment decision process faced by individuals and corporations. In the first essay, I develop a model of a multiple-stage patent race between two rival firms to study the impact of technological competition on value and return dynamics of Research and Development (R&D) ventures. The model describes a firm's capital budgeting decision process in the presence of technical uncertainty, market uncertainty and preemption. I characterize the equilibrium of the race and derive optimal investment strategies. Analysis of the equilibrium firm value shows that the premium accruing to the technology "leader" is larger than the loss accruing to the technology "lagger" and that the marginal effect of success/failure is increasing in the uncertainty of cash flows. Risk premia demanded by an ownership claim to competing R&D ventures (i) increase when a rival pulls ahead in the race and (ii) are lower when rivals are "closer" to each other in the development process. Compared to the case where rival firms merge, R&D competition reduces the industry value and lowers the expected completion time for a project. The erosion in value, due to preemption, is higher when firms are "neck-and-neck" and in early stages of development. Numerical simulations show that, in later stages of development, risk premia demanded by the perfectly collusive market are generally lower than risk premia demanded by a portfolio of competing firms. The opposite is true in early stages of development, which suggests that R&D competition may actually lower the cost of early stage financing. In the second essay, I solve a portfolio allocation problem for an individual who can select between two risky assets and a riskless asset in the presence of capital gains taxes. I treat capital gains taxes as a form of endogenous transaction costs. Using this analogy, I characterize the trading strategy for the two assets, and study the effect of taxes on optimal portfolio diversification. The optimal strategy contains a "no trade" region and a dynamic tax-timing option. I find that the diversification costs due to capital gains taxes are substantial and the value of the tax deferral option is decreasing in the correlation among assets and in the volatility of the risky assets. By comparing the solution of the multiple asset portfolio problem to the one of an investor who can trade only in a mutual fund I am able to measure the value of the flexibility option of the multi-asset case as well as the cost of mutual fund turnover. Finally, I show that imposing a wash-sale constraint generates discontinuous portfolio rebalancing strategies.

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