BF-2: Behavioral Factors in Valuation: Theory
Choosing to Disagree
1INSEAD, France; 2UCSD; 3UNC Chapel Hill
The rational expectations paradigm restricts the subjective beliefs of investors to align with the objective distribution. We relax this constraint and analyze how investors optimally choose their subjective beliefs about the information contained in their private signals and in prices. We show that investors systematically choose to deviate from rational expectations. In any symmetric equilibrium, investors optimally exhibit overconfidence in their private information but under-react to the information in prices. However, when aggregate risk aversion is sufficiently low, such symmetric equilibria do not exist.Instead, there exists an asymmetric equilibrium in which investors endogenously separate into (i) fundamental investors, who also ignore the information in prices, and (ii) "technical" traders, who overweight the information in prices when forming beliefs. Relative to the corresponding rational expectations equilibrium, these equilibria feature higher (i) return predictability, (ii) price informativeness, (iii) trading volume and (iv) return volatility. Finally, we show that such deviations by informed investors improve the welfare of liquidity traders under the objective distribution.
Trading Complex Risks
University of Melbourne, Department of Finance, Australia
This paper studies how complexity impacts markets’ ability to aggregate information and distribute risks. I amend fundamental asset pricing theory (Debreu, 1959; Arrow, 1964) to reflect agents’ imperfect knowledge (Knight, 1921) about complex dividend distributions and test its clear-cut predictions in the laboratory. Market equilibria corroborate complexity aversion-implied trading behavior. Complexity reduces the price elasticity of trading strategies associated with lower consumption risk. However, complex risks are overpriced. Absent of aggregate risk, the reduction in price sensitivity overcomes the variation in subjective beliefs, allowing for efficient risk sharing. While complexity induces noise in individual trading decisions, market outcomes remain theory-consistent. This striking feature reconciles with a random choice model, where bounds on rationality are reinforced by complexity. Markets’ effectiveness in aggregating beliefs about complex risks depends on the trade-off between reduced price sensitivity and reinforced bounded rationality. My findings show how individual heterogeneity creates aggregate stability, contrasting representative singular behavior.
Stock Return Extrapolation, Option Prices, and Variance Risk Premium
Purdue University, United States of America
This paper presents a model of stock return extrapolation in the presence of stochastic volatility. In the model, consistent with survey evidence, following positive stock returns, in addition to expecting future stock returns to be higher, the investor also expects future returns to be less volatile. The model is highly tractable, leading to closed-form solutions for the stock price, its dynamics, variance risk premium as well as providing analytic option pricing formulas that nest the Heston stochastic volatility formulation. The key novel predictions of the model are as follows. The magnitude of the stock price variance elasticity and the negative correlation between the stock return and its variance are both increasing in the extrapolation degree. A more bearish investor sentiment, due to extrapolating bad recent stock performance, leads to a more negative variance risk premium and a higher option prices with the price increases being more pronounced for out-of-the-money options as in data. The variance risk premium predicts future stock market returns negatively even after controlling for the realized variance, consistent with empirical evidence.