This paper documents that riskier firms with higher idiosyncratic volatility grant more stock options to nonexecutive employees. Standard models in the literature cannot easily explain this pattern; a model in which a risk-neutral firm and an employee with prospect theory preferences bargain over the employee's pay package can. The key feature which makes stock options attractive is probability weighting. The model fits the data on option grants well when calibrated using standard parameters from the experimental literature. The results are the first evidence that risky firms can profitably use stock options to cater to an employee demand for long-shot bets.

[We analyze the efficiency of indexing executive pay by calibrating the standard compensation model to a large sample of U.S. CEOs. The benefits from indexing the strike price of options are small, and fully indexing all options would increase compensation costs by 50% for most firms. Indexing has several effects with overall ambiguous outcome; the quantitatively most important effect is to reduce incentives, because indexed options pay off when CEOs' marginal utility is low. The results also hold if CEOs can extract rents and extend to the case of indexing shares. Our findings may justify the common practice of "pay-for-luck."]

We show that name-induced stereotypes affect the investment choices of U.S. mutual fund investors. Managers with foreign-sounding names have about 10% lower annual fund flows, and this effect is stronger among funds with investor clienteles more likely to be suspicious of foreigners. Foreign-named managers experience lower appreciation (greater decline) in flows following good (bad) performance. Following 9/11, flows to funds with managers with Middle-Eastern-sounding names declined abnormally. In an experimental setting in which skill differences are absent, individuals allocate 11% less money to an index fund managed by a foreign-named manager. This gap widens following the Boston marathon bombings.

We show that name-induced stereotypes affect the investment choices of U.S. mutual fund investors. Managers with foreign-sounding names have about 10% lower annual fund flows, and this effect is stronger among funds with investor clienteles more likely to be suspicious of foreigners. Foreign-named managers experience lower appreciation (greater decline) in flows following good (bad) performance. Following 9/11, flows to funds with managers with Middle-Eastern-sounding names declined abnormally. In an experimental setting in which skill differences are absent, individuals allocate 11% less money to an index fund managed by a foreign-named manager. This gap widens following the Boston marathon bombings.

We examine whether the trading activities of retail and institutional investors cause comovements in stock returns. Around stock splits, retail trading correlations (RTCs) decrease with stocks in the presplit price range and increase with stocks in the post-split price range. These shifts in RTCs induce changes in return comovements. In the cross section, return comovements among low-priced stocks are amplified when retail trades are more correlated and when aggregate uncertainty amplifies behavioral biases. We find similar patterns among local stocks and when firms change their corporate headquarters. In contrast to retail trading, institutional trading attenuates return comovements.

This study shows that correlated trading by gambling-motivated investors generates excess return comovement among stocks with lottery features. Lottery-like stocks comove strongly with one another, and this return comovement is strongest among lottery stocks located in regions where investors exhibit stronger gambling propensity. Looking directly at investor trades, we find that investors with a greater propensity to gamble trade lottery-like stocks more actively and that those trades are more strongly correlated. Finally, we demonstrate that time variation in general gambling enthusiasm and income shocks from fluctuating economic conditions induce a systematic component in investors’ demand for lottery-like stocks.

This study investigates whether geographic variation in religion-induced gambling norms affects aggregate market outcomes. We conjecture that gambling propensity would be stronger in regions with higher concentrations of Catholics relative to Protestants. Consistent with our conjecture, we show that in regions with higher Catholic–Protestant ratios, investors exhibit a stronger propensity to hold lottery-type stocks, broad-based employee stock option plans are more popular, the initial day return following an initial public offering is higher, and the magnitude of the negative lottery-stock premium is larger. Collectively, these results indicate that religion-induced gambling attitudes impact investors' portfolio choices, corporate decisions, and stock returns.

We develop a tractable equilibrium asset pricing model with cumulative prospect theory (CPT) preferences. Using GMM on a sample of U.S. equity index option returns, we show that by introducing a single common probability weighting parameter for both tails of the return distribution, the CPT model can simultaneously generate the otherwise puzzlingly low returns on both out-of-the-money put and out-of-the-money call options as well as the high observed variance premium. In a dynamic setting, probability weighting and time-varying equity return volatility combine to match the observed time-series pattern of the variance premium. Received May 30, 2017; editorial decision August 10, 2018 by Editor Andrew Karolyi.