Three Essays in Finance Dissertation Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of The Ohio State University By Sehoon Kim, M.Sc. Graduate Program in Business Administration The Ohio State University 2017 Dissertation Committee: Ren´eM. Stulz, Advisor Kewei Hou Bernadette A. Minton Berk A. Sensoy c Copyright by Sehoon Kim 2017 Abstract This dissertation is comprised of three essays that study the consequences of fi- nancial frictions in the context of corporate finance and asset pricing. The first and second chapters are empirical investigations of how firms use their internal finances to make real corporate decisions, and how external forces influence the efficacy with which firms utilize their internal resources. The third chapter is an attempt to quan- tify market frictions and their impact on the cross-section of stock returns. In the first chapter, I study how corporate cash holdings impact firms’ product pricing strategies. Exploiting the Aviation Investment and Reform Act of the 21st Century as a quasi-natural experiment to identify exogenous shocks to competition in the airline industry, I find that firms with more cash than their rivals respond to intensified competition by pricing more aggressively, especially when there is less concern of rival retaliation. Financially flexible firms based on alternative measures respond similarly. Moreover, cash-rich firms experience greater market share gains and long-term profitability growth. The results highlight the importance of strategic interdependencies across firms in the effective use of flexibility provided by cash. The second chapter studies the effects of hedge fund activism on the activity and efficiency of target companies' internal capital markets. I find that firms targeted by activist hedge funds significantly increase investment cross-subsidies between divi- sions, predominantly by enhancing the efficiency of their internal resource allocations. ii Following Schedule 13D filings by activist hedge funds, segment investments of tar- geted companies become more sensitive to cash flow generated elsewhere in the firm, and this increase in cross-subsidization is primarily driven by the redirection of firm cash flows toward segments with high Tobin's Q. The increases in the activity and efficiency of internal capital markets due to hedge fund activism are unlikely to be driven by measurement errors in Tobin's Q or changes in unobserved correlations across segments. In the third chapter, co-authored with Kewei Hou and Ingrid Werner, we propose a parsimonious measure based solely on daily stock returns to characterize the sever- ity of microstructure frictions at the individual stock level and assess the impact of frictions on the cross section of stock returns. Based on our measure, stocks with the largest frictions command a value-weighted return premium as large as 10% per year on a risk-adjusted basis. The friction premium is stronger among small, low price, volatile, value, and illiquid stocks. Return spreads associated with momentum and idiosyncratic volatility are smaller and statistically less significant than previously documented after screening out stocks with high microstructure frictions. Using UK data, we show that our measure is useful in settings where the availability of quality data on trading volume, bid-ask prices, and intraday high-low prices is limited. iii Dedicated to all my beloved ones. iv Acknowledgments This dissertation could not have come to fruition without the boundless support of those who deserve much more than these few words of gratitude. First and foremost, I am deeply indebted to my advisor, Ren´eM. Stulz, who has guided, pushed, and supported me throughout the uncharted 5 years of my early academic life. I am proud to have joined a lineage of pupils who will always look up in awe and inspiration. I would also like to thank my dissertation committee, Kewei Hou, Bernadette A. Minton, and Berk A. Sensoy, for their advice and encouragement. I am particularly grateful to my co-authors of the third chapter, Kewei Hou and In- grid Werner, from whom I learned a great deal. I am also thankful to my colleagues for their comments and friendship. I also send a special thanks to Robyn Scholl, who has always gone beyond her way to ensure my academic and personal well-being. My parents have greatly shaped my values, tenacity, and work ethic, which have made the eventual completion of my PhD possible. I would like to thank them for making me who I am, and for providing their unconditional love and support (not to mention patience). Also thanks to my sister for bearing with an increasingly pedantic older brother. I thank my friends back home, Eung Kyu and Wonbin, for their unwavering friend- ship and loyalty through the best and toughest times. Finally, thank you Bohyun for bringing happiness and hope to this challenging adventure. v Vita 1984 . .Born in Seoul, South Korea 2008 . .Summer Analyst, Goldman Sachs 2009 . .B.B.A. in Business Administration, Seoul National University 2012 . .M.Sc. in Economics, London School of Economics 2012 to present . Graduate Research Associate, Department of Finance, The Ohio State University Fields of Study Major Field: Business Administration Area of Specialization: Finance vi Table of Contents Page Abstract....................................... ii Dedication...................................... iv Acknowledgments..................................v Vita......................................... vi List of Tables.................................... ix List of Figures................................... xi Chapter 1. Cash, Financial Flexibility, and Product Prices - Evidence from a Natural Experiment in the Airline Industry................1 1.1 Introduction..............................1 1.2 Identification Strategy......................... 11 1.2.1 The Endogeneity Problem................... 11 1.2.2 Aviation Investment and Reform Act for the 21st Century. 13 1.3 Data and Empirical Specification................... 20 1.3.1 Data Sources and Screening.................. 20 1.3.2 Variables............................ 24 1.3.3 Empirical Specification..................... 29 1.4 Results................................. 31 1.4.1 Main Results.......................... 31 1.4.2 Subsample Analyses...................... 36 1.4.3 Do Firms Hold Cash Anticipating AIR-21 Coverage?.... 41 1.4.4 Is the AIR-21 Discontinuity Spurious?............ 43 1.4.5 Are Cash Rich Firms Constrained?.............. 45 1.4.6 Cash and Market Performance Outcomes.......... 50 vii 1.4.7 The Effects of Competition on Corporate Cash Holdings.. 53 1.5 Conclusion............................... 55 Chapter 2. Hedge Fund Activism and Internal Capital Markets........ 59 2.1 Introduction.............................. 59 2.2 Empirical Strategy........................... 65 2.2.1 Data............................... 65 2.2.2 Endogeneity........................... 68 2.2.3 Methodology.......................... 71 2.3 Key Results............................... 75 2.4 Conclusion............................... 87 Chapter 3. (Priced) Frictions........................... 90 3.1 Introduction.............................. 90 3.2 Simple Model.............................. 96 3.2.1 Basic Setup........................... 96 3.2.2 Methodology: Constructing \FRIC"............. 98 3.3 Data................................... 101 3.4 Characteristics of Friction-Sorted Portfolios............. 104 3.5 Cross-Sectional Return Predictability: Portfolio Sorts........ 111 3.5.1 Returns of FRIC Portfolios.................. 111 3.5.2 Robustness........................... 113 3.6 Cross-Sectional Return Predictability: Fama-MacBeth Regressions 116 3.7 Interactions between FRIC and Firm Characteristics........ 122 3.8 Anomalies and Frictions........................ 125 3.9 Extension: Results for the United Kingdom............. 133 3.10 Conclusion............................... 139 Bibliography.................................... 142 Appendix A. Additional Figures and Tables to Chapter 1............ 152 Appendix B. Data and Variable Descriptions to Chapter 2........... 158 B.1 Variables................................ 158 B.2 Data Screening............................. 159 Appendix C. Addendum to Chapter 3...................... 162 C.1 Adjusting FRIC for Serial Correlation in True Returns....... 162 viii List of Tables Table Page 1.1 Airline and Market Summary Statistics................. 23 1.2 Airlines and Airports........................... 26 1.3 Key Variable Statistics.......................... 28 1.4 Cash, Competition, and Multimarket Contact............. 33 1.5 Low Cost Carriers vs. Legacy Airlines................. 38 1.6 Ex-Ante Market Dominators vs. Laggards............... 40 1.7 Cash 3 to 4 Years Prior, Competition, and Multimarket Contact... 42 1.8 Placebo Tests with Alternative Treatment Thresholds......... 44 1.9 Financial Flexibility vs. Constraints................... 47 1.10 Cash and Market Performance Outcomes................ 51 2.1 Sample Statistics............................. 67 2.2 Hedge Fund Activism and Internal Capital Markets.......... 76 2.3 Internal Capital Market Efficiency: Alternative High Q Definitions.. 80 2.4 Matched Sample Difference-in-Differences Regressions......... 82 2.5 Hedge Fund Activism and Firm diversification............. 85 ix 3.1 Characteristics of Friction-Sorted Portfolios.............. 105 3.2 Microstructure Frictions and the Cross-Section of Expected Stock Re- turns: Portfolio Sorts........................... 112 3.3