Three essays on the psychology of investment and financial markets

Préface My thesis consists of three essays where I consider equilibrium asset prices and investment strategies when the market is likely to experience crashes and possibly sharp windfalls. Although each part is written as an independent and self contained article, the papers share a common behavioral approach in representing investors preferences regarding to extremal returns. Investors utility is defined over their relative performance rather than over their final wealth position, a method first proposed by Markowitz (1952b) and by Kahneman and Tversky (1979), that I extend to incorporate preferences over extremal outcomes. With the failure of the traditional expected utility models in reproducing the observed stylized features of financial markets, the Prospect theory of Kahneman and Tversky (1979) offered the first significant alternative to the expected utility paradigm by considering that people focus on gains and losses rather than on final positions. Under this setting, Barberis, Huang, and Santos (2000) and McQueen and Vorkink (2004) were able to build a representative agent optimization model which solution reproduced some of the observed risk premium and excess volatility. The research in behavioral finance is relatively new and its potential still to explore. The three essays composing my thesis propose to use and extend this setting to study investors behavior and investment strategies in a market where crashes and sharp windfalls are likely to occur. In the first paper, the preferences of a representative agent, relative to time varying positive and negative extremal thresholds are modelled and estimated. A new utility function that conciliates between expected utility maximization and tail-related performance measures is proposed. The model estimation shows that the representative agent preferences reveals a significant level of crash aversion and lottery-pursuit. Assuming a single risky asset economy the proposed specification is able to reproduce some of the distributional features exhibited by financial return series. The second part proposes and illustrates a preference-based asset allocation model taking into account investors crash aversion. Using the skewed t distribution, optimal allocations are characterized as a resulting tradeoff between the distribution four moments. The specification highlights the preference for odd moments and the aversion for even moments. Qualitatively, optimal portfolios are analyzed in terms of firm characteristics and in a setting that reflects real-time asset allocation, a systematic over-performance is obtained compared to the aggregate stock market. Finally, in my third article, dynamic option-based investment strategies are derived and illustrated for investors presenting downside loss aversion. The problem is solved in closed form when the stock market exhibits stochastic volatility and jumps. The specification of downside loss averse utility functions allows corresponding terminal wealth profiles to be expressed as options on the stochastic discount factor contingent on the loss aversion level. Therefore dynamic strategies reduce to the replicating portfolio using exchange traded and well selected options, and the risky stock.

On the applicability of mathematics : philosophical and historical perspectives

The present thesis is a contribution to the debate on the applicability of mathematics; it examines the interplay between mathematics and the world, using historical case studies. The first part of the thesis consists of four small case studies. In chapter 1, I criticize "ante rem structuralism", proposed by Stewart Shapiro, by showing that his so-called "finite cardinal structures" are in conflict with mathematical practice. In chapter 2, I discuss Leonhard Euler's solution to the Königsberg bridges problem. I propose interpreting Euler's solution both as an explanation within mathematics and as a scientific explanation. I put the insights from the historical case to work against recent philosophical accounts of the Königsberg case. In chapter 3, I analyze the predator-prey model, proposed by Lotka and Volterra. I extract some interesting philosophical lessons from Volterra's original account of the model, such as: Volterra's remarks on mathematical methodology; the relation between mathematics and idealization in the construction of the model; some relevant details in the derivation of the Third Law, and; notions of intervention that are motivated by one of Volterra's main mathematical tools, phase spaces. In chapter 4, I discuss scientific and mathematical attempts to explain the structure of the bee's honeycomb. In the first part, I discuss a candidate explanation, based on the mathematical Honeycomb Conjecture, presented in Lyon and Colyvan (2008). I argue that this explanation is not scientifically adequate. In the second part, I discuss other mathematical, physical and biological studies that could contribute to an explanation of the bee's honeycomb. The upshot is that most of the relevant mathematics is not yet sufficiently understood, and there is also an ongoing debate as to the biological details of the construction of the bee's honeycomb. The second part of the thesis is a bigger case study from physics: the genesis of GR. Chapter 5 is a short introduction to the history, physics and mathematics that is relevant to the genesis of general relativity (GR). Chapter 6 discusses the historical question as to what Marcel Grossmann contributed to the genesis of GR. I will examine the so-called "Entwurf" paper, an important joint publication by Einstein and Grossmann, containing the first tensorial formulation of GR. By comparing Grossmann's part with the mathematical theories he used, we can gain a better understanding of what is involved in the first steps of assimilating a mathematical theory to a physical question. In chapter 7, I introduce, and discuss, a recent account of the applicability of mathematics to the world, the Inferential Conception (IC), proposed by Bueno and Colyvan (2011). I give a short exposition of the IC, offer some critical remarks on the account, discuss potential philosophical objections, and I propose some extensions of the IC. In chapter 8, I put the Inferential Conception (IC) to work in the historical case study: the genesis of GR. I analyze three historical episodes, using the conceptual apparatus provided by the IC. In episode one, I investigate how the starting point of the application process, the "assumed structure", is chosen. Then I analyze two small application cycles that led to revisions of the initial assumed structure. In episode two, I examine how the application of "new" mathematics - the application of the Absolute Differential Calculus (ADC) to gravitational theory - meshes with the IC. In episode three, I take a closer look at two of Einstein's failed attempts to find a suitable differential operator for the field equations, and apply the conceptual tools provided by the IC so as to better understand why he erroneously rejected both the Ricci tensor and the November tensor in the Zurich Notebook.