Publication Type

PhD Dissertation

Version

publishedVersion

Publication Date

3-2021

Abstract

This dissertation consists of three studies in the areas of empirical asset pricing, market microstructure, and behavioral finance. I study the trading behavior and portfolio choices of institutions and retail investors in the equity and derivatives markets. Examining the ways in which different market participants make investment decisions allows us to understand their role in shaping financial market dynamics. This is important in order to know how to structure markets for enhanced market efficiency, and to protect less sophisticated investors through better policies and regulations. Although there is a considerable amount of literature disputing the ability of retail investors and different types of institutions to make informed investment decisions, their trading patterns and the various effects they have on the markets are not fully understood. My dissertation aims to explore this broad issue from several different angles.

Chapter I examines retail investor activity in the extreme portfolios of well-known cross-sectional anomalies. This study is co-authored with Prof. Ekkehart Boehmer. We show that retail investors tend to trade in the opposite direction of anomalies (buying stocks in the short portfolios and selling stocks in the long portfolios), both before and after the anomaly variables become public information. However, we do not find evidence that retail trading is the cause of mispricing and subsequent return predictability. Stocks with high retail participation do not appear to be more mispriced after controlling for confounding factors. Instead of pushing prices away from fundamentals, contrarian retail trades are likely to provide liquidity to arbitrageurs after firm announcements. In addition, we show that retail short sellers exploit anomaly information and help to correct mispricing of overvalued stocks in the short portfolios of value-versus-growth anomalies. Overall, the goal of this study is to show that retail participation in equity markets is not detrimental to market efficiency and in certain settings can even be helpful in correcting anomalies.

Chapter II investigates trading styles and profitability of institutional and retail investors in a leading derivatives market. This study is co-authored with Prof. Jianfeng Hu, Prof. Seongkyu Gilbert Park, and Prof. Doojin Ryu. Using comprehensive account-level transaction data, we provide a detailed description of the options market and the different types of investors. We find that retail investors tend to stick to one trading style. About 70% of retail investors predominantly hold simple positions such as long calls or long puts. Institutional investors are more likely to use multiple strategies with various levels of complexity. We use trading style complexity as an ex-ante measure of trading skills and show that it significantly affects investment performance. Specifically, retail investors using simple strategies lose to the rest of the market. For both retail and institutional investors, volatility trading is the most profitable strategy, although subject to large downside risk. After adjusting for risk, Greek neutral strategies outperform. These style effects are persistent and cannot be explained by systematic risk exposure or known behavioral biases.

Chapter III is about rational regulation and irrational investors. It is co-authored with Prof. Jianfeng Hu. We show that irrational response to regulatory reforms aimed at investor protection can lead to these reforms having the opposite effect and hurting investors. After the August 2011 crisis in the Korean equity market, regulators increase the contract size of equity index options fivefold, hoping to limit retail participation and excessive speculation in the market. Contradicting the purpose of the reform, we find that investors’ propensity to exit the market decreases after the reform. The dollar risk exposure of remaining investors significantly increases after the reform, consistent with investor inattention to the reform. Our estimation shows that it takes six months for risk taking activity to return to the pre-reform level but there is no significant decrease afterward. Heightened risk taking also leads to worse performance in the post-reform period. Although these effects are always stronger on retail investors, institutional investors are not spared either. In addition, we find that investors who are adversely affected by the reform exhibit self-attribution bias which causes them to extrapolate their performance into the future. They tend to outperform their peers before the crisis and their trading activity becomes more responsive to past performance after the crisis. However, limited attention to the market reform exacerbates their losses when their performance reverts to the mean. These results highlight the importance of considering behavioral biases in policy research and setting to avoid unintended consequences.

Keywords

investment decisions, portfolio choices, trading behavior, institutional investors, retail investors, equity markets, derivatives markets

Degree Awarded

PhD in Business (Finance)

Discipline

Corporate Finance | Finance and Financial Management

Supervisor(s)

BOEHMER, Ekkehart

First Page

1

Last Page

166

Publisher

Singapore Management University

City or Country

Singapore

Copyright Owner and License

Author

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