Essays On Behavioral Finance And Market Microstructure

Author : Bradley J. Cannon
Publisher :
ISBN 13 :
Total Pages : 311 pages
Book Rating : 4.:/5 (129 download)

DOWNLOAD NOW!

Download or read book Essays in Behavioral Finance and Corporate Finance written by Bradley J. Cannon and published by . This book was released on 2020 with total page 311 pages. Available in PDF, EPUB and Kindle. Book excerpt: This dissertation consists of three chapters that study how psychology impacts stock prices and how stock prices then impact corporate decisions. In the first chapter, I study whether a firm’s investment responds to the stock valuations of other firms headquartered nearby. I document a positive relation between a firm’s investment and the valuation of neighboring firms. This relation is stronger among financially constrained firms and is robust to controlling for the actual investment of other firms in the region. These findings are difficult to reconcile with traditional theories that link investment opportunities to firm valuations, but instead suggest that the ability of firms to raise external finance rises and falls with the stock valuations of other firms located nearby. Consistent with this explanation, I document that financially constrained firms issue more debt and receive more trade credit when neighboring firms have high stock valuations. In the second chapter, I test models of return extrapolation in the cross-section of stock returns. Return extrapolation is a biased belief structure that has received considerable attention because of its ability to generate prominent empirical findings in the asset pricing literature, while also being able to match investor beliefs. I document that return extrapolation is not uniform across firms but is instead more prevalent among firms that do not pay dividends (capital-gain firms). Specifically, analyst return expectations are positively related to past annual returns for capital-gain firms but show no relation among dividend-paying firms. I exploit this difference in extrapolative expectations to test asset pricing predictions stemming from models of return extrapolation. Consistent with return extrapolation models, I show that the value premium and long-term reversal are stronger among capital-gain firms. Momentum, however, is stronger among dividend-paying firms and, consequently, does not appear to be a result of return extrapolation. In the third chapter, co-authored with Hannes Mohrschladt, we test whether reference prices impact how investors respond to news. When current prices are farther from a reference price, investors react more strongly to news. We first document that individual investors are more (less) likely to sell a stock following bad (good) news when the stock's trading price is farther from the investor's purchase price. Motivated by this micro-level evidence, we construct a stock-level measure to capture the distance between a stock's trading price and its purchase price for the average investor. We provide evidence that this distance from purchase price produces a substantial amount of cross-sectional variation in the degree to which stocks over- or underreact to news. Stocks trading farthest from their purchase price react more strongly to news than stocks trading near their purchase price. Consistent with relative overreaction, stocks trading farthest from their purchase price also exhibit greater return reversal following news days. We document that a cross-sectional strategy exploiting these return patterns earns a monthly alpha of 0.93%. These findings are distinct from alternative explanations related to size, illiquidity, and volatility. Our evidence instead suggests that reference prices have a meaningful impact on how investors respond to news.