[This paper examines whether investor sentiment about the stock market affects prices of the S&P 500 options. The findings reveal that the index option volatility smile is steeper (flatter) and the risk-neutral skewness of monthly index return is more (less) negative when market sentiment becomes more bearish (bullish). These significant relations are robust and become stronger when there are more impediments to arbitrage in index options. They cannot be explained by rational perfect-market-based option pricing models. Changes in investor sentiment help explain time variation in the slope of index option smile and risk-neutral skewness beyond factors suggested by the current models.]

Using mutual fund flows, we evaluate prospect theory with choice outcomes in the market. We provide strong support for prospect theory: under a standard set of parameters, funds whose past returns generate higher prospect theory value attract significantly larger future flows; we also find corroborative evidence using account-level data. Taking a revealed preference approach, we estimate the prospect theory parameters through a discrete choice model and find that our field-based estimates align well with previous experiment-based estimates. Moreover, we show that prospect theory offers a new framework for understanding flows, as it has explanatory power beyond existing drivers.

This paper examines whether investor sentiment about the stock market affects prices of the S&P 500 options. The findings reveal that the index option volatility smile is steeper (flatter) and the risk-neutral skewness of monthly index return is more (less) negative when market sentiment becomes more bearish (bullish). These significant relations are robust and become stronger when there are more impediments to arbitrage in index options. They cannot be explained by rational perfect-market-based option pricing models. Changes in investor sentiment help explain time variation in the slope of index option smile and risk-neutral skewness beyond factors suggested by the current models. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: [email protected], Oxford University Press.

[We analyze capital allocation in a conglomerate where divisional managers with uncertain abilities compete for promotion to CEO. A manager can sometimes gain by unobservably adding variance to divisional performance. Capital rationing can limit this distortion, increase productive efficiency, and allow the owner to make more accurate promotion decisions. Firms for which CEO talent is more important for firm performance are more likely to ration capital. A rationed manager is more likely to be promoted even though all managers are identical ex ante. When the tournament payoff is relatively small, offering an incentive wage can be more efficient than rationing capital; however, when tournament incentives are paramount, rationing is more efficient.]

ABSTRACT I develop an interest rate model with separate factors driving innovations in bond yields and their covariances. It features a flexible and tractable affine structure for bond covariances. Maximum likelihood estimation of the model with panel data on swaptions and discount bonds implies pricing errors for swaptions that are almost always lower than half of the bid–ask spread. Furthermore, market prices of interest rate caps do not deviate significantly from their no‐arbitrage values implied by the swaptions under the model. These findings support the conjectures of Collin‐Dufresne and Goldstein (2003) , Dai and Singleton (2003) , and Jagnnathan, Kaplin, and Sun (2003) .

Abstract We show theoretically and empirically that the cross-section of stock return idiosyncratic volatilities contains useful information about the ICAPM. We construct a proxy cross-sectional bivariate idiosyncratic volatility (CBIV) for the covariance risk between the market and the unobserved hedge portfolio under the ICAPM. Consistent with the ICAPM pricing relation, CBIV is a robust and significant predictor of the equity risk premium. We further show that the return predictability of the tail index in Kelly and Jiang (2014) can be explained by the ICAPM covariance risk.

Abstract This paper examines the characteristics and pricing of stocks that are actively traded by speculative retail investors. We find that stocks with high retail trading proportion (RTP) have strong lottery features and they attract retail investors with strong gambling propensity. Furthermore, these stocks tend to be overpriced and earn significantly negative alpha. The average monthly return differential between the extreme RTP quintiles is −0.60%. This negative RTP premium is stronger among stocks that have lottery features or arelocated in regions where people exhibit stronger gambling propensity. Collectively, these results indicate that speculative retail trading affects stock prices.

This paper presents a robust new finding that delta-hedged equity option return decreases monotonically with an increase in the idiosyncratic volatility of the underlying stock. This result cannot be explained by standard risk factors. It is distinct from existing anomalies in the stock market or volatility-related option mispricing. It is consistent with market imperfections and constrained financial intermediaries. Dealers charge a higher premium for options on high idiosyncratic volatility stocks due to their higher arbitrage costs. Controlling for limits to arbitrage proxies reduces the strength of the negative relation between delta-hedged option return and idiosyncratic volatility by about 40%.

The tendency of some investors to hold on to their losing stocks, driven by prospect theory and mental accounting, creates a spread between a stock's fundamental value and its equilibrium price, as well as price underreaction to information. Spread convergence, arising from the random evolution of fundamental values and the updating of reference prices, generates predictable equilibrium prices interpretable as possessing momentum. Empirically, a variable proxying for aggregate unrealized capital gains appears to be the key variable that generates the profitability of a momentum strategy. Controlling for this variable, past returns have no predictability for the cross-section of returns.

We test a new cross-sectional relation between expected stock return and idiosyncratic risk implied by the theory of costly arbitrage. If arbitrageurs find it more difficult to correct the mispricing of stocks with high idiosyncratic risk, there should be a positive (negative) relation between expected return and idiosyncratic risk for undervalued (overvalued) stocks. We combine several well-known anomalies to measure stock mispricing and proxy stock idiosyncratic risk using an exponential GARCH model for stock returns. We confirm that average stock returns monotonically increase (decrease) with idiosyncratic risk for undervalued (overvalued) stocks. Overall, our results support the importance of idiosyncratic risk as an arbitrage cost.