We present empirical evidence on the asset pricing implications of salience theory. In our model, investors overweight salient past returns when forming expectations about future returns. Consequently, investors are attracted to stocks with salient upsides, which are overvalued and earn low subsequent returns. Conversely, stocks with salient downsides are undervalued and yield high future returns. We find strong empirical support for these predictions in the cross-section of U.S. stocks. The salience effect is stronger among stocks with greater limits to arbitrage and during high-sentiment periods and not explained by common risk factors and proxies for lottery demand and investor attention.
We study the relationship between credit, stock trading and prices bubbles. The role of credit in financial bubbles is theoretically ambiguous. On the one hand, it may help rational arbitrageurs to trade against a bubble; on the other hand, it may enable naive speculators to buy overvalued assets. We construct a novel database containing every individual stock transaction in three major British companies during the 1720 South Sea Bubble. We link these transactions to daily margin loan positions and subscription lists of new share issues. We find that margin loan holders acted as extrapolators, i.e., they were more likely to buy (sell) following high (low) past returns. Loan holders also signed up to buy new shares of overvalued companies and incurred large trading losses. Our results suggest that credit provision was instrumental in fueling the bubble.
In this paper we study the pricing of betas that are hard to predict. We argue that in a world where investors cannot perfectly predict betas, the degree of beta predictability should matter for the extent to which these betas are priced. We show this is in a model with ambiguity averse investors that are uncertain about an asset’s risk exposure to an exogenous risk. By taking the perspective of an investor, we provide empirical evidence to support this model, where downside, size and book-to-market betas which are hard to predict, are also not priced when we use betas that would be available to investors when these make their decisions.
Is the stock market the natural place to hedge risks?
(with Gleb Gertsman and Bas Werker)
This paper examines the proposition that equity markets are not the natural place to hedge risk. For example, an investor who wants to hedge inflation or crash risk, faces substantially more hedging (beta) uncertainty in the stock market than in the derivatives market. This study provides theoretical evidence that such an investor, prefers assets with less uncertainty (TIPS and options) over assets with more uncertainty (long-short stock portfolios). More specifically, we show that equilibrium risk premiums for uncertain assets (stocks) decline once we allow investors with smooth ambiguity aversion preferences to trade assets with less uncertainty (TIPS and options). In line with these findings, we find that the inflation risk premium disappears after TIPS are being introduced into the market.