Stochastic Risk Aversion, Behavioral Over-Reaction, and the Role of Informed Investors

49 Pages Posted: 22 Jun 2009

See all articles by Steven G. Sapra

Steven G. Sapra

Analytic Investors, Inc.; Claremont Graduate University

Date Written: June 19, 2009

Abstract

A subset of investors, termed “behavioral investors”, are subject to random risk aversion shocks, the distribution of which is assumed to be beta. A second investor cohort, termed “arbitrageurs”, attempts to exploit the risk aversion shocks of behavioral investors. Arbitrageur presence is shown to have a stabilizing effect on the distribution of prices, not only in terms of variance but also skewness. Specifically, prices become less negatively skewed as the proportion of the market comprised of arbitrageurs increases. Finally, arbitrageur entry is endogenized under a fixed cost of entry assumption. It is shown that arbitrageurs are more likely to enter the market in response to large price declines compared to large price increases, and that the extent of entry is inversely related to entry costs.

Keywords: behavioral finance, risk aversion, asset pricing, overreaction

JEL Classification: G14

Suggested Citation

Sapra, Steven, Stochastic Risk Aversion, Behavioral Over-Reaction, and the Role of Informed Investors (June 19, 2009). Available at SSRN: https://ssrn.com/abstract=1422688 or http://dx.doi.org/10.2139/ssrn.1422688

Steven Sapra (Contact Author)

Analytic Investors, Inc. ( email )

555 W. 5th St.
50th Floor
Los Angeles, CA 90013
United States
213-688-3015 (Phone)
213-688-8856 (Fax)

HOME PAGE: http://www.analyticinvestors.com

Claremont Graduate University ( email )

150 E. Tenth Street
Claremont, CA 91711
United States

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