Three Papers On Behavioral Finance And Market Inefficiencies

Abstract

The three chapters in this dissertation provide new evidence on inefficiencies in the stock market, and offer some novel explanations for the cause of these inefficiencies due to the existence of investors' behavioral biases and market frictions. In the first chapter (joint with Ziyang Geng), we study the active role of rational investors in creating mispricing in the Chinese stock market. In existing behavioral finance literature on stock mispricing, rational investors largely play a passive role in tolerating mispricing due to limits to arbitrage. In this essay, we show that rational speculators sometimes proactively and intentionally create mispricing by driving up stock prices away from their fundamental values through synchronized attacks with explosive trading volumes. The inflated stock price is subsequently supported by new rounds of irrational buyers who are subject to extrapolation bias and by existing stockholders who are reluctant to sell due to the disposition effect. This paper develops a simple model to illustrate how bubble-creating attacks can succeed in equilibrium under certain limits-to-arbitrage conditions, and provides consistent empirical evidence in the Chinese stock market using investors' trading data from a large brokerage company in China. In Chapter 2 of my dissertation, motivated by existing evidence that individual investors have a preference for stocks with low nominal prices, I investigate the importance of nominal stock price in the cross-sectional pricing of stocks in the Chinese stock market. Portfolio-level analyses and firm-level cross-sectional regressions indicate a negative and significant relation between nominal prices and subsequent returns for stocks with low tradable market capitalization. Average raw and risk-adjusted return differences between the lowest and highest nominal price deciles exceed 1% per month for stocks in the lowest tercile of tradable market capitalization. The return difference between high-priced and low-priced stocks is not explained by existing predictors of expected returns, such as size, book-to-market ratio, momentum, short-term reversal, liquidity, and skewness. The magnitude of this low nominal price premium is influenced by incremental participation of new individual investors. I also provide additional evidence consistent with the hypothesis that rational speculators induce investors with a preference for low-priced stocks to trade in a way that exacerbates this anomaly. In the third chapter (joint with Peng Liu and Ke Tang), we study the economic linkage between homebuilder stock market performance and commodity futures market information on a major component of building materialslumber. The price of lumber plays a dual role in determining homebuilder prots: it represents a production input cost and serves as a future housing demand indicator. Using all US publicly listed homebuilder stocks, we show that the housing demand effect dominates the builderlumber relationship. This effect is robust even after we control for the Federal Housing Finance Association (FHFA) housing price index (HPI). Our results further indicate that the slope of the lumber futures curve serves as a cross-market signal of future housing demand and thus of homebuilder stock market performance.