Essays in Financial Economics

This dissertation comprises three self-contained essays that examine the relationship between the financial sector and the business cycle. It investigates the link between these two concepts by focusing on three vital elements of the financial sector, including the banking system, the hedge fund industry, and the term structure of interest rates. The overarching implication of the essays is that the business cycle yields a material influence on the behaviour of financial market participants through several transmission channels, establishing a foundation between financial markets and the macroeconomy.

The first essay studies the transmission of international monetary policy shocks through a mechanism entitled the bank lending channel. Exploiting a rich panel of data on Australian Authorised Deposit-Taking Institutions (ADIs) reveals that the domestic credit supply is vulnerable to an international pass-through of monetary policy emanating from offshore central banks. Contingent on the lending activity, commercial banks respond heterogeneously to conventional and unconventional policy measures, with banks headquartered in Asia demonstrating the highest degree of lending elasticity. Household and non-financial corporate loans are found to be the most susceptible channels to policy shocks, while higher-margin lending, non-core assets, and reservable liabilities are insensitive. Unconventional policies have a muted effect compared to traditional measures. Overall, the first essay reports robust evidence of a foreign influence on Australia’s credit supply, implying that offshore central banks can affect the domestic business cycle through their impact on commercial banks’ balance sheets.

The second essay examines the relationship between the business cycle, sentiment, and performance of U.S. hedge funds. Using Natural Language Processing (NLP) methods, fund-level sentiment scores that map to portfolio managers’ written commentaries are used to construct a unique measure of hedge fund sentiment. A substantial contribution of the essay is the construction of a novel dataset that reflects the manual collation of unstructured textual reports, serving as the basis for textual mining. The empirical analysis reveals that business cycle fluctuations asymmetrically shape hedge fund sentiment the most, dominating geopolitical, trade, and climate policy risks. Furthermore, hedge fund sentiment significantly influences the cross-section of contemporaneous returns, whereby a one-unit improvement in sentiment (from neutral to positive) increases average returns by around 2.3 per cent annually, even when controlling for standard risk factors and using alternative specifications of sentiment. In all, the second essay exhibits the merits of examining sentiment at the hedge fund level to understand how changes in economic conditions affect investor beliefs.

The final essay investigates the dynamics of U.S. Treasury term premia by applying and extending the nonparametric framework of Boudoukh, Richardson, Smith, and Whitelaw (1999) into a time-varying test of monotonicity. The framework exploits instrumental variables with economic relevance to the business cycle, which a priori predict non-monotonic Treasury returns to permit a formal test of the Liquidity Preference Hypothesis (LPH). Conditioning ex-ante returns against inversion in the yield curve, restrictive monetary policy rates, and negative investor sentiment reveals a non-monotonic term premium on Treasury bills. In contrast, term premia on portfolios comprising longer-term Treasury notes are primarily monotonic but exhibit non-monotonicity that coincides with unexpected macroeconomic shocks. When interest rates reach the zero lower bound, term premia are universally monotonic, demonstrating the Federal Reserve’s ability to normalise the yield curve. Ultimately, the work in this final essay conveys the importance of accounting for the time-varying behaviour of the term premium, especially as changes in the business cycle influence the term structure of interest rates.