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Abstract:
The tendency of some investors to hold on to their losing stocks, driven by prospect theory and mental accounting, creates a spread between a stock's fundamental value and its equilibrium price, as well as price underreaction to information. Spread convergence, arising from the random evolution of fundamental values and updating of reference prices, generates predictable equilibrium prices that will be interpreted as possessing momentum. Cross-sectional empirical tests are consistent with the model. A variable proxying for aggregate unrealized capital gains appears to be the key variable that generates the profitability of a momentum strategy. Past returns have no predictability for the cross-section of returns once this variable is controlled for.

prospect theory, mental accounting, disposition effect, momentum

Abstract:
This paper examines whether investor sentiment about the stock market affects prices of the S&P 500 options. The findings reveal that the index option volatility smile is steeper (flatter) and the risk-neutral skewness of monthly index return is more (less) negative when market sentiment becomes more bearish (bullish). These significant relations are robust and become stronger when there are more impediments to arbitrage in index options. They cannot be explained by rational perfect-market-based option pricing models. Changes in investor sentiment help explain time variation in the slope of index option smile and risk-neutral skewness beyond factors suggested by the current models.

G12, G13, G14

Abstract:
This paper examines whether investor sentiment about the stock market affects prices of the S&P 500 options. I find that the index option volatility smile is steeper (flatter) and the risk-neutral
skewness of monthly index return is more (less) negative when market sentiment becomes more bearish (bullish). These significant relations are robust and become stronger when there are more
impediments to arbitrage in index options. They can not be explained by rational perfect-market based option-pricing models. Changes in sentiment help explain time variation in the slope of index option smile and risk-neutral skewness beyond factors suggested by the current models.

sentiment, pricing kernel, skewness, limits to arbitrage, index option smile

Abstract:
This paper offers an explanation for the forward discount puzzle in foreign exchange markets based upon investor overconfidence. In our model, overconfident individuals overreact to their information about future inflation differential. The spot and the forward exchange rates differentially reflect such overreaction; as a result, the forward discount forecasts reversal in the spot rate. With plausible parameter values, the model explains the magnitude of the forward discount puzzle and stylized facts about how the forward discount bias varies with time horizon and time-series versus cross-sectional test method. Furthermore, the model generates new empirical predictions about the relation between the forward discount bias to foreign exchange trading volume, exchange rate volatility and predictability, as well as the degree of violation of the relative Purchasing Power Parity.

investor overconfidence, forward discount puzzle, inflation differential, exchange rate overshooting, market efficiency, Purchasing Power Parity

Abstract:
Real estate investment trust (REIT) provides a unique laboratory to study the relation between insider ownership and firm value. One, a REIT has to satisfy special regulations which weaken alternative mechanisms to control agency problems. Empirically, I find a significant and robust nonlinear relation between Tobin's Q and REIT insider ownership that is consistent with the trade-off between the incentive alignment and the entrenchment effect of insider ownership. Two, many REITs are Umbrella Partnership REITs (UPREITs) which have dual ownership structure. They have both common shares and Operating Partnership Units (OP units). Property owners can contribute their properties to the UPREIT in exchange for OP units. Their capital gains taxes remain deferred as long as they hold onto their OP units and the UPREIT does not sell the properties they contributed. OP units owners are locked in with the firm and have incentive to monitor firm management, but their interests diverge from the common shareholders because their tax bases are much lower. Consistent with the trade-off between positive monitoring effect of OP units and tax-induced agency costs, I find that UPREIT's firm value increases with the fraction of OP units, but the effect is significantly weaker for the UPREITs where insiders hold OP units.

REITs, UPREITs, ownership structure, firm value, tax, conflict of interests

Abstract:
Real estate investment trust (REIT) provides a unique laboratory to study the relation between insider ownership and firm value. One, A REIT has to satisfy special regulations which weaken alternative mechanisms to control agency problems. Empirically, I find a significant and robust nonlinear relation between Tobin's $Q$ and REIT insider ownership that is consistent with the trade-off between the incentive alignment and the entrenchment effect of insider ownership. Two, many REITs are Umbrella Partnership REITs (UPREITs) which have dual ownership structure. They have both common shares and Operating Partnership Units (OP units). Property owners can contribute their properties to the UPREIT in exchange for OP units. Their capital gains taxes remain deferred as long as they hold onto their OP units and the UPREIT does not sell the properties they contributed. OP units owners are locked in with the firm and have incentive to monitor firm management, but their interests diverge from the common shareholders because their tax bases are much lower. Consistent with the trade-off between positive monitoring effect of OP units and tax-induced agency costs, I find that UPREIT's firm value increases with the fraction of OP units, but the effect is significantly weaker for the UPREITs where insiders hold OP units.

insiderer ownersip, firm value, REIT, UPREIT, tax, conflicts of interests , capital gains tax lock-in

Abstract:
I develop an interest rate model with separate factors driving innovations in bond yields and their covariances. My model features flexible and tractable affine structure for the covariances of bond yields. Maximum likelihood estimation of the model with panel data on swaptions and discount bonds implies pricing errors for swaptions that are almost always lower than half of the bid-ask spread. Further, market prices of interest rate caps do not deviate significantly from their no-arbitrage values implied by the swaptions under my model. These findings confirm the conjectures by Collin-Dufresne and Goldstein (2003), Dai and Singleton (2003), and Jagannathan, Kaplin and Sun (2003).

Stochastic volatility, stochastic correlation, unspanned volatility, string model, relative valuation of swaptions and caps

Abstract:
Evidence indicates that people fear change and the unknown. We offer a model of familiarity bias in which individuals focus on adverse scenarios in evaluating defections from the status quo. The model explains the endowment effect, portfolio underdiversification, home and local biases. Equilibrium stock prices reflect an unfamiliarity premium. In an international setting, our model implies that the absolute pricing error of the standard CAPM is positively correlated with the amount of home bias. It also predicts that a modified CAPM holds wherein the market portfolio is replaced with a portfolio of the stock holdings of investors not subject to familiarity bias.

familiarity, model uncertainty, status quo, home bias, diversification, inertia

Abstract:
We demonstrate that stock price momentum and earnings momentum can result from uncertainty surrounding the accuracy of cashflow forecasts. Our model has multiple information sources issuing cashflow forecasts for a stock. The investor combines these forecasts into an aggregate cashflow estimate that has minimal mean-squared forecast error. This aggregate estimate weights each cashflow forecast by the estimated accuracy of its issuer, which is obtained from their past forecast errors. Momentum arises from the investor gradually learning about the relative accuracy of the information sources and updating their weights. Empirical tests validate the model's prediction of stronger momentum in stocks with large information weight fluctuations and high forecast dispersion. We also identify return predictability attributable to changes in the information weights.

Forecast Accuracy, Uncertainty, Momentum, Bounded Rationality, Appearance of Behavioral Biases

Abstract:
Institution investors face investment constraints that may limit their ability to fully utilize their information. Consistent with this idea, we find that institutions buy significantly less of the stocks that they already overweight, even when they have positive information about the stocks. They refrain from selling the stocks that they already underweight, even when they receive negative signals. Such demand distortion may lead to price underreaction to news and cross-sectional return predictability: Stocks with good news that institutions overweight are undervalued and subsequently have abnormal high returns; stocks with bad news that institutions underweight are overvalued and have abnormal low subsequent returns. Our tests strongly support this hypothesis. We find that stocks with higher institutional investment constraints have stronger price momentum and larger post earnings announcement drift.

Institutional investors, investment constraints, market efficiency, momentum, tracking-error constraints, relative performance evaluation

Abstract:
We analyze capital allocation in a conglomerate where divisional managers with uncertain abilities compete for promotion to CEO. A manager can sometimes gain by unobservably adding variance to divisional output. Capital rationing can limit this distortion, increase productive efficiency, and allow the owner to make more accurate promotion decisions. Firms in which the CEO has a greater span of control are more likely to use capital rationing. A rationed manager is more likely to be promoted even though all managers are identical ex ante. Overconfidence can increase a manager's likelihood of promotion and can even benefit the (fully rational) owner.

promotion, tournaments, capital rationing, conglomerate, career concerns, managerial overconfidence

Abstract:
This paper studies the cross-sectional determinants of delta-hedged stock option returns with an emphasis on the pricing of volatility risk. We find that the average delta-hedged option returns are significantly negative for most stocks, and they decrease monotonically with both total and idiosyncratic volatility of the underlying stock. Writing covered calls on high volatility stocks on average earns about 2% more per month than selling covered calls on low volatility stocks. Our results are robust and can not be explained by the Fama-French factors, market volatility risk, stock jump risk, or the effects of past stock returns and volatility-related option mispricing. Our results suggest that the market prices of volatility risks at the individual stocks level are negative and their magnitudes increase with the volatility level.

stochastic volatility, volatility risk premium, option return

Abstract:
A unique data set allows us to examine trading behavior and realized returns of all participants in the Taiwan stock index options. On average individual investors lose money and foreign institutions profit from trading options, even when they use the same trading strategy and for the same type of options. Foreign institutions that trade out-of-the-money options most frequently have the highest returns, while individual investors who predominately trade short-term and out-of-the-money options have the worse performance. Option trades initiated via market orders or aggressive limit orders have a higher probability of correctly predicting the underlying stock index movements and higher realized returns. Individual investors' trading performance improves with experience and sophistication. Finally, disposition effect distracts from trading performance.

investor behavior, trading performance, index options

Abstract:
Prior experimental and empirical research documents that many investors have a lower propensity to sell those stocks on which they have a capital loss. This behavioral phenomenon, known as "the disposition effect," has implications for equilibrium prices. We investigate the temporal pattern of stock prices in an equilibrium that aggregates the demand functions of both rational and disposition investors. The disposition effect creates a spread between a stock's fundamental value - the stock price that would exist in the absence of a disposition effect - and its market price. Even when a stock's fundamental value follows a random walk, and thus is unpredictable, its equilibrium price will tend to underreact to information. Spread convergence, arising from the random evolution of fundamental values, generates predictable equilibrium prices. This convergence implies that stocks with large past price runups and stocks on which most investors experienced capital gains have higher expected returns that those that have experienced large declines and capital losses. The profitability of a momentum strategy, which makes use of this spread, depends on the path of past stock prices. Cross-sectional empirical tests of the model find that stocks with large aggregate unrealized capital gains tend to have higher expected returns than stocks with large aggregate unrealized capital losses and that this capital gains "overhang" appears to be the key variable that generates the profitability of a momentum strategy. When this capital gains variable is used as a regressor along with past returns and volume to predict future returns, the momentum effect disappears.

Abstract:
This paper studies the clientele characteristics and pricing of stocks that are heavily traded by retail investors. We find that stocks with high "retail trading proportion" (RTP) have a large concentration of speculative investors (Barberis and Huang (2008, hereafter BH)) and risk-seeking realization utility investors (Barberis and Xiong (2008, hereafter BX-RU)). Consistent with BX-RU, retail investors prefer to hold and actively trade high volatility stocks, while institutions under-weight them. Further, investors' propensity to realize gains is stronger among high RTP and high volatility stocks. In addition, consistent with BH, we find that high RTP stocks have strong speculative features and are dominated by retail investors who are known to exhibit a greater propensity to speculate and gamble in the stock market. Asset prices within this retail habitat are consistent with the predictions of the BH and BX-RU models. First, high RTP stocks earn low average returns. Second, the relation between volatility and average returns is more negative among high RTP stocks. Third, these results are stronger among more speculative stocks. We also find that the negative lottery stock premium only exists among high RTP stocks. Collectively, our results highlight the usefulness of a habitat-based approach for studying asset prices and provide support for both BH and BX-RU models within the subset of stocks whose trading is dominated by retail investors.

Abstract:
We offer a model in which sequences of individuals often converge upon poor decisions and are prone to fads, despite communication of the payoff outcomes from past choices. This reflects both direct and indirect action-based information externalities. In contrast with previous cascades literature, cascades here are spontaneously dislodged and in general have a probability less than one of lasting forever. Furthermore, the ability of individuals to communicate can reduce average decision accuracy and welfare.

information cascades, herding, conversation, imitation, information externality

Abstract:
We analyze capital allocation in a conglomerate where divisional managers with uncertain abilities compete for promotion to CEO. A manager can sometimes gain by unobservably adding variance to divisional performance. Capital rationing can limit this distortion, increase productive efficiency, and allow the owner to make more accurate promotion decisions. Firms for which CEO talent is more important for firm performance are more likely to ration capital. A rationed manager is more likely to be promoted even though all managers are identical ex ante. When the tournament payoff is relatively small, offering an incentive wage can be more efficient than rationing capital; however, when tournament incentives are paramount, rationing is more efficient.

G30, G31, G39