The concept of competence hypothesis identified by Heath and Tversky (1991) proposes that ambiguity aversion is affected by the subjective competence level of participants. When people feel knowledgeable or skillful in a field, they would rather bet on their own judgment even with uncertainty. However, when participants do not feel knowledgeable or skillful, they prefer betting on the unambiguous chance event. Therefore, the bias of ambiguity aversion is conditional on the subjective competence level of the participants. Our study selects managers of open and domestic stock type mutual funds to be study objects. There are 12 months during the study period, starting from April 2004 and ending in March 2005. In the first part of this paper, we investigate whether the competence effect influences professional managers¡¦ behaviors. We explore the relation between manager competence and mutual fund holding bias by conducting multiple regression analysis. Our study finds competence effect in the behaviors of mutual fund managers. A positive relation exists between manager competence and mutual fund holding electronic stocks bias. When manager competence is high, the mutual fund holdings in electronics stocks will be either more or less than the market. That is, weighting of holding electronics categorized stocks in mutual fund clearly deviate from the weighting of electronics categorized stocks in the market. However, when manager competence is not high, weighting of holding electronics categorized stocks in mutual fund follows that in the market. The other hypothesis proposes that manager competence is not relevant to the £] of mutual fund portfolio. Secondly, we explore the factors that affect manager competence by conducting logistic regression analysis. Among the five variables which may affect mutual fund manager competence, we find ¡§fund size¡¨ the only factor that is positively relevant to mutual fund manager competence. In other words, the larger the mutual funds, the more likely that managers will perceive themselves as skillful and knowledgeable. The other four variables are the manager¡¦s previous fund management experience, educational level, gender, and performance of mutual fund in the past year. They are not related to competence.

Theoretical models predict that ambiguity is an asset pricing factor in addition to risk, however few of them have been tested in the real market. This thesis tests one of the hypotheses that, investors’ propensity to invest in stocks is reduced when ambiguity in the marketplace increases. The hypothesis is tested by using equity fund flows and households’ equity holding as measurements of the market participation, and using dispersion in analysts’ forecasts about aggregate returns as measurement of ambiguity. The results confirm this hypothesis, since the increases in ambiguity are significantly and negatively related to equity fund flows, as well as the likelihood that the average household invests in equities. Moreover, the results also find that the fund flows in non-dividend paying stocks are more sensitive to the changes in ambiguity, and investors transfer capital from the equity market into more liquid asset classes during high-ambiguity periods. In addition, this thesis also tests whether there is heterogeneity in individuals’ ambiguity aversion, and examines the psychological roots of ambiguity aversion. FNE theory explains ambiguity aversion as the result of fearing negative evaluation from others. It predicts that married households are more ambiguity averse; while households with higher income and education, or households that are more mature, are less ambiguity averse. On the other hand, self-evaluation theory explains ambiguity aversion as the result of minimizing anticipated regret. It predicts that households that are more optimistic, or have less income, are less ambiguity averse; while households that have negative market experience, or have higher income, are more ambiguity averse. The results show that married households, or households with high income / negative market experience, are more ambiguity averse; and households that are more optimistic / more mature, are less ambiguity averse. Therefore, both theories have successful predictions, suggesting that the ambiguity aversion is the combined result of the two motivations.

We examine risk taking when the bank's preferences exhibit smooth ambiguity aversion. Ambiguity is modeled by a second-order probability distribution that captures the bank's uncertainty about which of the subjective beliefs govern the financial asset return risk. Ambiguity preferences are modeled by the (second-order) expectation of a concave transformation of the (first-order) expected utility of profit conditional on each plausible subjective distribution of the return risk. Within this framework, the banking firm finds it less attractive to take risk in the presence than in the absence of ambiguity. This result extends to the case of greater ambiguity aversion. Given that the competitive bank's smooth ambiguity preferences exhibit non-increasing absolute ambiguity aversion, imposing a more stringent capital requirement to the bank reduces the optimal amount of loans, if the bank's coefficient of relative risk aversion does not exceed unity. Ambiguity and ambiguity aversion as such have adverse effect on the bank's risk taking.

While new agricultural technologies may lead to substantial yield improvements, the take-up rates in developing countries have frequently been low. There are many possible reasons why a farmer might refrain from adopting a new technology, and literature has pointed to several possible reasons in different settings. A key area for research is to understand what policies could encourage higher adoption rates. This thesis studies the research question by using a case study of fertiliser adoption in cocoa farming in Ghana. Chapter I investigates whether returns to fertiliser in cocoa farming are high and whether farmers' adoption decisions can be explained by comparative advantage. Chapter I uses data from Ghana to measure the returns to fertiliser using a correlated random model and static and dynamic panel models of homogeneous returns to fertiliser. The estimated returns in different models are positive, high and strongly significant statistically. The chapter also presents a correlated random effects model of heterogeneous technology, which allows for farmer-specific comparative advantage. The effect of the comparative advantage is found not to be statistically significant. Chapter II explores the fertiliser investment decisions and risk preferences of Ghanaian cocoa farmers in a framed field experiment. The experimental subjects decided whether to invest in fertiliser, and the fertiliser return depended on a stochastic weather realisation. An inexpensive index insurance scheme with a positive level of basis risk was found to have a minor positive effect on the fertiliser take-up, but this effect was statistically insignificant. An expensive index insurance scheme with no basis risk was found to have a substantial positive effect, and this effect was strongly significant. The experimental findings suggest that farmers are willing to pay for an index insurance if it successfully shields them from income variability. Chapter III investigates the effect of trust and of an ambiguous environment on fertiliser investments under index insurance. These two behavioural factors were studied by means of a framed field experiment conducted with Ghanaian cocoa farmers. The subjects had an option to invest in a package of fertiliser bundled with index insurance with a positive level of basis risk. The returns depended both on the subjects ́ investment choices and a stochastic weather realization. The key ingredient of the study was that for different subjects, the nature of the basis risk was framed differently. Substantially fewer subjects adopted fertiliser when possible losses of fertiliser investment were framed as resulting from the insurer ́s failure to meet its contract obligations, compared with an alternative in which the losses were framed as resulting from a mismatch between their own weather realizations and those on which the index insurance was based. A large negative effect on fertiliser investments was also found in treatments with either a small or large ambiguity regarding the exact level of basis risk. Both negative treatment effects were strongly significant. This may suggest that technologies with which farmers are relatively more experienced are more likely to be adopted under index insurance schemes. The overall experimental findings provide evidence that trust and ambiguity may be significant factors other than basis risk, limiting the effectiveness of index insurance in promoting agricultural innovation.

<p>The thesis consists of three self-contained essays on public policy in the macroeconomy.</p><p>“Government Policy in the Formal and Informal Sectors” quantitatively investigates the interaction between the firms' choice to operate in the formal or the informal sector and government policy on taxation and enforcement. Taxes, enforcement, and regulation are incorporated in a general equilibrium model of firms differing in their productivities. The model quantitatively accounts for the keys aspects in the data and allows me to back out country-specific enforcement levels. Some policy reforms are analyzed and the welfare gains can be fairly large.</p><p>“Determinants of Capital Intensive and R&D Intensive Foreign Direct Investment” studies the determinants of capital intensity and technology content of FDI. Using industry data on U.S. FDI abroad and data on many different host countries' institutional characteristics, we show that there is a differential response of FDI flows to investment climate according to the capital intensity of the industries receiving the investments. We find that better protection of property rights has a significant positive effect on R&D intensive capital flows. We find evidence that an increase in workers' bargaining power results in a reduction of both kinds of FDI. </p><p>“Ambiguity Aversion, the Equity Premium, and the Welfare Costs of Business Cycles” examines the relevance of consumers’ ambiguity aversion for asset prices and how consumption fluctuations influence consumer welfare. First, in a Mehra-Prescott-style endowment economy, we calibrate ambiguity aversion so that asset prices are consistent with data: a high return on equity and a low return on risk-free bonds. We then use this calibration to investigate how much consumers would be willing to pay to reduce endowment fluctuations to zero, thus delivering a Lucas-style welfare cost of fluctuations. These costs turn out to be very large: consumers are willing to pay over 10% of consumption in permanent terms.</p>

The thesis consists of three self-contained essays on public policy in the macroeconomy. “Government Policy in the Formal and Informal Sectors” quantitatively investigates the interaction between the firms' choice to operate in the formal or the informal sector and government policy on taxation and enforcement. Taxes, enforcement, and regulation are incorporated in a general equilibrium model of firms differing in their productivities. The model quantitatively accounts for the keys aspects in the data and allows me to back out country-specific enforcement levels. Some policy reforms are analyzed and the welfare gains can be fairly large. “Determinants of Capital Intensive and R&amp;D Intensive Foreign Direct Investment” studies the determinants of capital intensity and technology content of FDI. Using industry data on U.S. FDI abroad and data on many different host countries' institutional characteristics, we show that there is a differential response of FDI flows to investment climate according to the capital intensity of the industries receiving the investments. We find that better protection of property rights has a significant positive effect on R&amp;D intensive capital flows. We find evidence that an increase in workers' bargaining power results in a reduction of both kinds of FDI. “Ambiguity Aversion, the Equity Premium, and the Welfare Costs of Business Cycles” examines the relevance of consumers’ ambiguity aversion for asset prices and how consumption fluctuations influence consumer welfare. First, in a Mehra-Prescott-style endowment economy, we calibrate ambiguity aversion so that asset prices are consistent with data: a high return on equity and a low return on risk-free bonds. We then use this calibration to investigate how much consumers would be willing to pay to reduce endowment fluctuations to zero, thus delivering a Lucas-style welfare cost of fluctuations. These costs turn out to be very large: consumers are willing to pay over 10% of consumption in permanent terms.

This paper examines the optimal production and export decisions of an international firm facing exchange rate uncertainty when the firm's preferences exhibit smooth ambiguity aversion. Ambiguity is modeled by a second-order probability distribution that captures the firm's uncertainty about which of the subjective beliefs govern the exchange rate risk. Ambiguity preferences are modeled by the (second-order) expectation of a concave transformation of the (first-order) expected utility of profit conditional on each plausible subjective distribution of the exchange rate risk. Within this framework, we show that ambiguity has no impact on the firm's propensity to export to a foreign country. Ambiguity and ambiguity aversion, however, are shown to have adverse effect on the firm's incentive to export to the foreign country.

This thesis improves our understanding of asset prices and returns as it documents a regime shift risk premium in currencies, corrects the estimation bias in the term premium of bond yields, and shows the impact of ambiguity aversion towards parameter uncertainty on equities. The thesis consists of three essays. The first essay "The Yen Risk Premiums: A Story of Regime Shifts in Bond Markets" documents a new monetary mechanism, namely the shift of monetary policies, to account for the forward premium puzzle in the USD-JPY currency pair. The shift of monetary policy regimes is modelled by a regime switching dynamic term structure model where the risk of regime shifts is priced. Our model estimation characterises two policy regimes in the Japanese bond market---a conventional monetary policy regime and an unconventional policy regime of quantitative easing. Using foreign exchange data from 1985 to 2009, we find that the shift of monetary policies generates currency risk: the yen excess return is predicted by the Japanese regime shift premium, and the emergence of the yen carry trade in the mid 1990s is associated with the transition from the conventional to the unconventional monetary policy in Japan. The second essay "Correcting Estimation Bias in Regime Switching Dynamic Term Structure Models" examines the small sample bias in the estimation of a regime switching dynamic term structure model. Using US data from 1971 to 2009, we document two regimes driven by the conditional volatility of bond yields and risk factors. In both regimes, the process of bond yields is highly persistent, which is the source of estimation bias when the sample size is small. After bias correction, the inference about expectations of future policy rates and long-maturity term premia changes dramatically in two high-volatility episodes: the 1979--1982 monetary experiment and the recent financial crisis. Empirical findings are supported by Monte Carlo simulation, which shows that correcting small sample bias leads to more accurate inference about expectations of future policy rates and term premia compared to before bias correction. The third essay "Learning about the Persistence of Recessions under Ambiguity Aversion" incorporates ambiguity aversion into the process of parameter learning and assess the asset pricing implications of the model. Ambiguity is characterised by the unknown parameter that governs the persistence of recessions, and the representative investor learns about this parameter while being ambiguity averse towards parameter uncertainty. We examine model-implied conditional moments and simulated moments of asset prices and returns, and document an uncertainty effect that characterises the difference between learning under ambiguity aversion and learning under standard recursive utility. This uncertainty effect is asymmetric across economic expansions and recessions, and this asymmetry generates in simulation a sharp increase in the equity premium at the onset of recessions, as in the recent financial crisis.

Although Chinese and American cultures have been well-studied along dimensions such as collectivist versus individualist orientation, less is known about how culture influences individual economic decision-making. Here we examined cultural influences on decisions involving risk, characterized by unknown outcomes but known underlying probability distributions, versus ambiguity, in which both the outcome and distribution of possible outcomes are unknown. Based on previous research using self-reported survey data, we hypothesized that Chinese decision makers may be more ambiguity-averse than Americans. College students from mainland China (N = 27) and North America (N = 27) performed a standard economic decision-making task, choosing between a certain payoff and a gamble. Gambles varied in the magnitude of the payoff and in the degree of risk (13%, 25%, 38%, 50% or 75% probability of winning) or ambiguity (24%, 50% or 74% probability unknown). Using the proportion of risky and ambiguous gambles accepted, ambiguity and risk aversion coefficients were calculated separately for each participant. Following the main task, participants completed demographic surveys and personality measures including the Big Five Inventory and the Need for Cognitive Closure Scale. We found that variation in risk aversion was explained by personality factors of Neuroticism and Decisiveness, without respect to cultural group. In contrast, after controlling for differences in personality measures, for ambiguity aversion only the effect of cultural group was significant, with Chinese participants showing greater ambiguity aversion than Americans. By assessing individual decision behavior using experimental economic methods, our results provide a more complete picture of the role of culture in economic choices under risk versus ambiguity.

In this dissertation, I address a range of topics in the context of mutual fund performance and high frequency trading. The first chapter provides novel evidence on the role of ambiguity aversion in determining the response of mutual fund investors to historical fund performance information. It presents a model of ambiguity averse investors who receive multiple performance-based signals of uncertain precision about manager skill. A key implication of the model is that when investors receive multiple signals of uncertain quality, they place a greater weight on the worst signal. There is strong empirical support for this prediction in the data. Fund flows display significantly higher sensitivity to the worst performance measure even after controlling for fund performance at multiple horizons, performance volatility, flow-performance convexity, and a host of other relevant explanatory variables. This effect is particularly pronounced in the case of retail funds in contrast to institutional funds. The results suggest that fund investor behavior is best characterized as reflecting both Bayesian learning and ambiguity aversion. The second chapter combines data on high frequency trading (HFT) activities of a randomly selected sample of 120 stocks and data on institutional trades, I find that HFT increases the trading costs of traditional institutional investors. An increase of one standard deviation in the intensity of HFT activities increases institutional execution shortfall costs by a third. Further analysis suggests that HFT represents an opportunistic and extra-expensive source of liquidity when demand and supply among institutional investors are imbalanced. Moreover, the impact on institutional trading costs is most pronounced when high frequency (HF) traders engage in directional strategies (e.g., momentum ignition and order anticipation). I perform various analyses to rule out an alternative explanation that HF traders are attracted to stocks that have high trading costs. First, HFT is most prevalent in liquid stocks. Second, the results are robust to controls for stable stock liquidity characteristics and events that might jointly affect HFT and trading costs. Third, an analysis of the HFT behavior around the temporary short selling ban in September 2008 highlights the opportunistic nature of liquidity provision by HF traders. Finally, Granger causality tests show that intensive HFT activity significantly contributes to institutional trading costs, but not vice versa. The third chapter analyzes the implications of the tournament-like competition in the mutual fund industry using a framework that addresses the risk-taking incentives facing fund managers. The theoretical model presented in this chapter suggests that the increase in the \emph{activeness} of the interim loser manager's portfolio is directly related to the magnitude of the performance gap at the interim stage, and to the strength of the investor (cash flow) response to the relative performance rankings of the funds (i.e., the strength of the tournament effect). The empirical evidence based on quarterly Active Share data for a sample of domestic stock funds, is consistent with the key predictions of the model.