Behavior Finance

Question 1

Behavior Finance

Answer 1

Attempts to understand and explain observed investor and market behaviors. At its core, behavior finance is about understanding how investors and market behave

Question 2

Traditional Finance

Answer 2

Based on hypotheses about how investors and markets should behave

Question 3

Utility Theory

Answer 3

In utility theory, people maximize the present value of utility subject to a present budget contraint.

Question 4

Utility

Answer 4

thought of as the level of relative satisfaction received from the consumption of goods and services

Question 5

Axioms of Utility Theory

Answer 5

Assumes that a rational decision maker follows rules of preference consistent with the axioms and the utility function of a rational decision maker reflects the axioms

Question 6

The basic axioms of Utitlity Theory are?

Answer 6

1. Completeness
2. Transitivity
3. independence
4. Continuity

Question 7

Completeness

Answer 7

Assumes that an individual has well-defined preferences and can decide between any two alternatives

Question 8

Axiom (Completeness)

Answer 8

Given choices A and B, the individual either prefers A to B, prefers B to A, or is indifferent between A and B

Question 9

Transitivity

Answer 9

Assumes that, as an individual decides according to the completeness axiom, an individual decides consistently

Question 10

Axiom (Transitivity)

Answer 10

Transitivity is illustrated by the following examples: Given choices A, B, and C, if an individual prefers A to B and prefers B to C., then the individual prefers A to C; if an individual prefers A to B and is indifferent between B and C, then the individual prefers A to C; or if an individual is indifferent between A and B and prefers A to C, then the individual prefers B to C

Question 11

Independence

Answer 11

Also pertains to well-defined preferences and assumes that the preference order of two choices combined in the same proportion with a third choice maintains the same preference order as the original preference order of the two choices

Question 12

Axiom (Independence)

Answer 12

Let A and B be two mutually exclusive choices, and let C be a third choice that can be combined with A or B. If A is preferred to B and some amount, x, of C is added to A and B, then A plus xC is preferred to B plus xC. This assumption allows for additive utilities. If the utility of A is dependent on how much of C is available, the utilities are not additive.

Question 13

Continuity

Answer 13

Assumes there are continuous (unbroken) indifference curves such that an individual is indifferent between all points, representing combinations of choices, on a single difference curve

Question 14

Axiom (Continuity)

Answer 14

When there are three lotteries (A, B, and C) and the individual prefers A to B and B to C, then there should be a possible combination of A and C such that the individual is indifferent between this combination and the lottery B. The end result is continuous indifference curves.

Question 15

Bayes’ Formula

Answer 15

A mathematical rule explaining how existing probability beliefs should be changed given new information
Bayes’ Formula shows how one conditional probability is inversely related to the probability of another mutually exclusive outcome.

The formula is
P(A|B) = [P(B|A)/P(B)] P(A)
where
P(A|B) = conditional probability of event A given B. It is the updated probability of A given the new information B
P(B|A) = conditional probability of B given A. It is the probability of the new information B given event A
P(B) = prior (unconditional) probability of information B
P(A) = prior probability of event A, without new information B. This is the base rate or base probability of event A.

Question 16

Example of Bayes’ Formula
You have two identical urns, U1 and U2. U1 has 2 red balls (R) and 3 white balls (W). U2 has 4 red balls and 1 white ball. You randomly choose one of the urns to pick out a ball. A red ball is pulled out first. What is the probability that you picked U1, based on the fact that a red ball was pulled out first, P(U1|R)?

Answer 16

Solution:
P(R|U1) is the conditional probability of a red ball being pulled out, given U1 is picked:
2 red balls/5 balls = 40%

P(U1) is the probability of picking U1:

1 urn/2 urns = 50%
P(R) is the probability of a red ball being picked regardless of which urn is picked:

2 red balls in U1 + 4 red balls in U2 = 6 red balls
6 red balls/10 balls = 60%

P(U1|R) is the objective of the exercise. Based on the above formula, we calculate:

P(U1|R) = [P(R|U1)/P(R)] P(U1) = [40%/60%]50% = 33.3%

This solution can also be shown using a probability tree. In Exhibit 1, we can see that the probability of U1 being picked and a red ball being chosen is P(U1) × P(R|U1) = (0.5 × 0.4) = 0.20. The probability of picking a red ball if either urn is picked is P(R) = (0.20 + 0.40) = 0.60. Therefore, because we know that a red ball was picked, we can find the probability of having chosen U1 by dividing the probability of choosing both U1 and a red ball by the probability of choosing ared ball. This gives us 0.333 or 33.3% [= 0.20/0.60].