Essays on institutional investors, central banks and asset pricing

The objective of this dissertation is to investigate the impact of important market participants such as Mutual Funds, Hedge Funds and the Federal Reserve Bank on the equilibrium equity premium, risk free rate and asset volatility and to analyze the effect of these institutions on risk shifting, portfolio allocation and financial stability. Specific features of institutional investors and central banks as well as their role in financial markets are reviewed and analyzed in Chapter 1. In Chapter 2, it is shown that the competitive pressure to beat a benchmark may induce institutional trading behavior that exposes retail investors to tail risk. In our model, institutional investors are different from a retail investor because they derive higher utility when they outperform the benchmark. This forces institutions to take on leverage to over-invest in the benchmark. Institutions execute fire sales when the benchmark asset experiences negative shocks. This behavior increases market volatility, raising the tail risk exposure of the retail investor. Nevertheless, ex-post, tail risk is only short lived, all investors survive in the long run under standard conditions, and the most patient investor dominates in the sense that she has the highest con-