Essays On Prospect Theory And Asset Pricing

The financial markets are full of puzzles. In the aggregate market, stocks earn returns that cannot be justified by individual risk aversion (the equity premium puzzle); stock prices fluctuate much more than the underlying dividend process (the excess volatility puzzle); and stock returns can be predicted by many variables, such as dividend-to-price ratios or book-to-market ratios (the predictability puzzle). In the cross-section of stock returns, when stocks are sorted into different groups according to certain economic variables, including prior returns (the momentum puzzle), book-to-market ratio (the value premium puzzle), and size (the size puzzle), one group tends to earn higher average returns than another. At the individual trading level, a large body of evidence suggests that investors are reluctant to take losses (the disposition effect), tend to hold under-diversified portfolios (the under-diversification puzzle), and trade more than can be justified on rational grounds (the excessive trading puzzle). None of these facts can be explained by the traditional consumptionbased asset pricing models; they are thus labeled as anomalies. This study explores how models incorporating prospect theory preferences can improve our understanding of asset prices at both the aggregate market and individual stock levels. Chapter 1 studies a market-selection problem in an economy populated by Epstein-Zin investors and prospect theory investors. This chapter answers the questions of whether prospect theory investors can survive and have price impact in the long run, and thus, this chapter lays down the foundation for using prospect theory preferences to understand financial markets. Chapter 2 examines the implications of prospect theory preferences for the disposition effect, the momentum effect in the cross-section of stock returns, and the correlation between returns and volumes. Chapter 3 first provides strong empirical evidence for volatility clustering in the dividend growth rate process and then incorporates this feature into an asset pricing model with prospect theory investors to explore its implications for the aggregate stock market.