2014 Theses Doctoral

Three Essays on Investor Behavior and Asset Pricing

An, Li

This dissertation consists of three essays on investor behavior and asset pricing.
In the first chapter, I investigate the asset pricing implications of a newly-documented refinement of the disposition effect, characterized by investors being more likely to sell a security when the magnitude of their gains or losses on it increases. Motivated by behavioral evidence found among individual traders, I focus on the pricing implications of such behavior in this chapter. I find that stocks with both large unrealized gains and large unrealized losses, aggregated across investors, outperform others in the following month (monthly alpha = 0.5-1%, Sharpe ratio = 1.6). This supports the conjecture that these stocks experience higher selling pressure, leading to lower current prices and higher future returns. This effect cannot be explained by momentum, reversal, volatility, or other known return predictors, and it also subsumes the previously-documented capital gains overhang effect. Moreover, my findings dispute the view that the disposition effect drives momentum; by isolating the disposition effect from gains versus that from losses, I find the loss side has a return prediction opposite to momentum. Overall, this study provides new evidence that investors' tendencies can aggregate to affect equilibrium price dynamics; it also challenges the current understanding of the disposition effect and sheds light on the pattern, source, and pricing implications of this behavior.
The second chapter extends the study of the V-shaped disposition effect - the tendency to sell relatively big winners and big losers - to the trading behavior of mutual fund managers. We find that a 1% increase in the magnitude of unrealized gains (losses) is associated with a 4.2% (1.6%) higher probability of selling. We link this trading behavior to equilibrium price dynamics by constructing unrealized gains and losses measures directly from mutual fund holdings. (In comparison, measures for unrealized gains and losses in chapter one are approximated by past prices and trading volumes.) We find that, consistent with the relative magnitude found in the selling behavior regressions, a 1% increase in the magnitude
of gain (loss) overhang predicts a 1.4 (.9) basis ppoints increase in future one-month returns. A trading strategy based on this effect can generate a monthly return of 0.5% controlling common return predictors, and the Sharpe ratio is around 1.4. An overhang variable capturing the V-shaped disposition effect strongly dominates the monotonic capital gains overhang measure of previous literature in predictive return regressions. Funds with higher turnover, shorter holding period, higher expense ratios, and higher management fees are significantly more likely to manifest a V-shaped disposition effect.
The third chapter studies how the recourse feature of mortgage loan has impact on borrowers' strategic default incentives and on mortgage bond market. It provides a theoretical model which builds on the structural credit risk framework by Leland (1994), and explicitly analyzes borrowers' strategic default incentives under different foreclosure laws. The key results are, while possible recourse makes the payoff in strategic default less attractive, it helps deter strategic default when house price goes down. I also examine the case when cash flow problems interact with default incentives and show that recourse can help reduce default incentives, make debt value immune to liquidity shock, and has little impact on house equity value.