Three essays in behavioral finance

Abstract

This dissertation consists of three related topics in behavioral finance that examines the relationship between managers' behavioral biases and firms' performance. We begin by examining the relationship between managers' optimism and the stock price performance of non-financial firms. Optimism as it is used in this paper is that same as managerial overconfidence where managers overestimate their firms' future performance. Next, we investigate the role that managerial overconfidence plays in financial institutions' contribution to the financial system's systemic risk. Both of these papers extend the research on the "dark" side of managerial overconfidence which associates it with bad outcomes. Finally, in the third paper, we examine the "bright" side of managerial overconfidence in a study that looks at the positive role that ability plays in tempering the consequences of managerial overconfidence.

In the first chapter, using a large panel dataset from 1994 to 2011, we investigate the relationship between CEO and CFO optimism and firms' stock price crash risk. We find that although CEO and CFO optimism is positively related to firms' future stock price crash risk, CEO optimism is actually more important than CFO optimism. We also find that optimism exists in a continuum and excessively optimistic executives are more detrimental to firms that those with only slightly elevated level of optimism.

In the third paper, we investigate the possibility that overconfident managers differ along ability lines. That is, we believe that an overconfident manager's marginal contribution to his firm is a function of his overconfidence as well as his abilities. We test this possibility using firms' debt issues, investments and acquisitions. We find that the higher the ability of overconfident managers, the lower their debt issues, investments and acquisitions. We also find that the financial markets react positively to the acquisitions of these high-ability overconfident managers reflecting the general quality of their acquisitions.

In the second chapter, we look at the implications that managerial overconfidence has for financial institutions' contribution to systemic risk. In particular, we investigate the role that CEO and CFO overconfidence plays in explaining financial institutions' contributions. Using a sample of firms from 1995 to 2011, we find that institutions with overconfident executives, on average, contribute more to systemic risk than institutions with non-overconfident executives. This contribution is driven entirely by banks as opposed to insurance companies, brokers and other financial institutions. We also find that CFO overconfidence is more important than CEO overconfidence for systemic risk contribution, reflecting the impact that CFOs have on the day to day financial decisions of these financial institutions.