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theses

This dissertation consists of two essays on the effects of legal frictions on asset prices. The first essay comprises the derivation of a theoretical valuation of tax deductions with fixed upper bounds. There are numerous examples in practice where the taxpayer, corporations, or individuals are constrained by tax laws that disallow tax deductions beyond a fixed limit. Typical examples would be the upper bound on State and Local Tax deductions for individuals introduced recently in 2018, and Section 382 of the Internal Revenue Code that imposes a ceiling on tax deductions stemming from the losses of acquired corporations. Despite the ubiquity of such tax frictions, there is very little in the academic literature on the impact of these on the consumption-investment decisions and asset prices. We develop a Consumption Capital Asset Pricing Model (CCAPM) where a risk averse investor makes consumption investment decisions in the presence of taxes, but faces fixed legal limits on tax deductions, and show the modifications required of the traditional CCAPM model without frictions, including the well-known Hansen-Jagannathan bound. Interestingly, it turns out that under certain conditions, increasing the tax deduction limit actually reduces investment in risky assets.

In the second essay, we investigate the stock and option market reactions to events in the United States Supreme Court (SC) relating to cases where at least one party involved is a public firm. Typically, cases that reach the SC level would have passed through multiple lower courts. Consequently, much of the information content of these cases would be publicly known and priced by the financial markets. If the market has perfectly anticipated that the SC would grant (a rare event) the writ of certiorari (accept a case), the tone of the subsequent legal arguments, and the final decision, then there should be no reaction to any of these events, as and when they unfold. Using a comprehensive dataset of more than 500 cases, we find that the stock market reacts to both the grant of certiorari and to the announcement of the final decision, suggesting that the stock market could not predict the SC actions. We also find that specific case characteristics, such as parties involved, the type of legal issue, and press coverage explain some of the cross-sectional variations in the stock returns across cases. Our tests also indicate that there is no information leakage prior to the events, and no stock price drift after the events. However, we find that the option market anticipates the final decision as early as the date certiorari is granted, reinforcing the theory that smart money comes early to the option market.

ETD_10666

doi:10.7282/t3-qpmc-8827

Ph.D.

Includes bibliographical references

ETD doctoral

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