Three Essays on Market Efficiency and Corporate Diversification

In my first essay, I use additions to the S&P 500 index as a laboratory to investigate how the interaction between arbitrageurs and arbitrage risk affects security prices. I find that the price effect is strong when there is high arbitrage risk (as measured by the lack of close substitutes) and low presence of arbitrageurs (as measured by low ownership by active institutions). Furthermore, a strong presence of arbitrageurs moderates the effect of arbitrage risk on the post-addition price reaction of added stocks. I also find a significant decrease in arbitrageurs\u27 ownership in the added stocks post addition. More importantly, this decrease is accompanied by a significant increase in arbitrageurs\u27 ownership in the added stocks\u27 close substitutes. My second essay examines the sensitivity of investments to changes in investment opportunities for diversified and for single-segment firms. Because many concerns have been raised about existing proxies of investment opportunities, I introduce and examine the empirical performance of a new proxy based on financial analysts\u27 earnings forecasts. The findings are consistent with the idea that firms respond efficiently to changes in investment opportunities. I find that firms increase (decrease) their capital expenditures when there is a favorable (unfavorable) change in opportunities. In addition, I find that diversified firms are more sensitive to changes in investment opportunities than are single-segment firms and that much of the difference in investment behavior between the two types of firms is explained by changes in investment opportunities. My findings are consistent with the idea that, when compared to single-segment firms, diversified firms use their larger internal capital markets and enjoy a less constrained response to changes in investment opportunities. The overall findings are in contrast to existing evidence that diversified firms allocate resources inefficiently. In my third essay, I investigate how the diversification discount depends on internal and external governance control mechanisms. The study uses CEO power to measure internal control and institutional ownership to measure external control. I find that CEO power has a negative effect on firm value and that this effect is greater for diversified firms. I also find that while institutional ownership is positively related to the value of single-segment firms it is not significantly related to the value of multi-segment firms. The overall findings that the diversification discount is more pronounced for firms with weaker internal and external governance control mechanisms support the hypothesis that governance control mechanisms are less effective in diversified firms than in single-segment firms