This thesis contains two essays: both are on tail events. The first essay is on probability weighting which suggests that people tend to overweight the probability of tail events; the second essay documents that investors have a misperception that they think lower priced stocks have more upside potential, namely that the perceived probability of extreme positive tails is higher than the real probability.

Chapter II: Probability Weighting and Asset Prices: Evidence from Mergers and Acquisitions

For mergers and acquisitions with a small failure probability, the average decline in target stock price if the deal fails is much larger than any increase that accompanies deal success. Probability weighting implies that the deal failure probability of such target stocks will be overwei...[ Read more ]

This thesis contains two essays: both are on tail events. The first essay is on probability weighting which suggests that people tend to overweight the probability of tail events; the second essay documents that investors have a misperception that they think lower priced stocks have more upside potential, namely that the perceived probability of extreme positive tails is higher than the real probability.

Chapter II: Probability Weighting and Asset Prices: Evidence from Mergers and Acquisitions

For mergers and acquisitions with a small failure probability, the average decline in target stock price if the deal fails is much larger than any increase that accompanies deal success. Probability weighting implies that the deal failure probability of such target stocks will be overweighted, leading them to be undervalued. I test whether investors are averse to holding such stocks and find strong supporting evidence. Target stocks with lower ex-ante failure probability yield positive abnormal returns, but other targets do not generate significant abnormal returns. A trading strategy that buys target stocks with low ex-ante failure probability and sells short target stocks with high ex-ante failure probability delivers around 1% abnormal return per month. These abnormal returns are not subsumed by a preference for positive skewness under traditional (expected) utility models; in fact, target stocks with lower ex-ante failure probability have lower betas, lower volatilities, and lower downside risk. I also find that profits from the strategy are significantly higher when arbitrage is more difficult.

Chapter III: Nominal Price Illusion

We explore the psychology of stock price levels and provide evidence that investors suffer from a nominal price illusion in which they overestimate the “room to grow” for low-priced stocks relative to high-priced stocks. While it has become increasingly clear that nominal price levels influence investor behavior, why prices matter to investors is a question that as of yet has gone unanswered. We find widespread evidence that investors systematically overestimate the skewness of low-priced stocks. Investor expectations of future skewness increase drastically on days that a stock undergoes a split to a lower nominal price. Empirically, however, future physical skewness actually decreases following splits. In the broad cross-section of stocks, we find that investors substantially overweight the importance of price when forming skewness expectations. Asset pricing implications of our findings are borne out in the options market. A zero-cost option portfolio strategy that exploits investor overestimation of skewness for low-priced stocks relative to high-priced stocks generates significant abnormal returns.