Thesis on behavioural asset pricing and portfolio choice

This thesis presents three papers in the field of behavioural financial economics and financial econometrics. The first paper, entitled "Optimistic versus Pessimistic–Optimal Judgemental Bias with Reference Point" develops a model of reference-dependent assessment of subjective beliefs in which the loss-averse people optimally choose expectation as the reference point to balance the current felicity from the optimistic anticipation and the future disappointment from the realization. The choice of over-optimism or over-pessimism depends on the real chance of success and optimistic decision makers prefer receiving early information. In the portfolio choice problem, pessimistic investors tend to trade conservatively. However, they might trade aggressively if they are sophisticated enough to recognise the biases as low expectation can reduce their fear of loss. The second paper, entitled "Information and Dynamic Trading with Gambler's Fallacy", develops a multi-period stock trading model in which there are two types of investors–"rational" type and "gambler's fallacy" type, both observe the public signal about the fundamental value each period. The rational investor holds correct beliefs on the stochastic process of the signal, whereas the gambler's fallacy investor falsely believes that the sequence of signals should exhibit systematic reversals. Both types of investors trade against each other to speculate the future price changes, based on their inferences about the fundamental value. This paper explores the competitive equilibrium, in which both types of investors have model consistent expectations adjusted for the heterogeneity in their beliefs about the signal generating process. The thesis examines the dynamics of prices, returns, optimal portfolios and trading volumes in reaction to the information flow. Consistent with empirical evidence, the market in this model exhibits short-run momentum and long-run reversal. It is also demonstrated that the equilibrium price is more close to the valuation of the gambler's fallacy type. Finally, the third empirical paper entitled "Regime Switching in Financial Market and Portfolio Choice" considers a variety of regime switching models with time varying transition probabilities for the joint distribution of stocks and bonds returns. Paper results support a two-regime univariate model for stocks with ISM and P/E ratio as leading predictors for the transition probabilities and support the fixed transition probability model for univariate distribution of bond returns. Under joint distribution assumption, the model selects a three regime model with ISM, unemployment rate and P/E ratio as predictors for the time varying transition probabilities. Even though both fixed and time varying transition probability models identify three regimes in the financial market, however, the time varying transition probability model provides better out of sample predictions, based on the regime-dependent portfolio performance.