bEHAVIORAL FINANCE

Question 1

Classical and behavioral finance

Answer 1

1) Classical finance assumes that:
a. Rational expectations of market participants
b. Market efficiency

2) Behavioral finance rejects these assumptions, instead analyzing financial phenomena under the account of the behavior of market participants.

Question 2

Deviations from the assumptions of the classical finance model

Answer 2

1) Autocorrelation of rates of return – in the short term, an increase in the price of the instrument at the time of t leads to further increases in the t+k period
2) Calendar effect – instrument prices increase on weekends and in January
3) Small businesses have higher returns on their issuances than the CAPM forecasts
4) Small investors choose securities with declining rates of return
5) Financial crises

Question 3

How do investors behave?

Answer 3

1) They are not rational
2) Make decisions based on superficial information
3) Have disproportionate reactions to information
4) The illusion of control – investors are too confident in their decisions
5) Retrospective thinking – paying too much attention to past events and looking for non-existent patterns in them
6) Ownership effect – investors are not willing to change their investment portfolio
7) Decisions based on heuristics – simplified judgments, quick decisions, instinct
8) Investors receive a lot of information at once, so they have to arbitrarily choose the ones they think are important.

Question 4

When behavioral finance is useful

Answer 4

1) Modelling of financial markets
2) Prediction of exchange rates, prices of financial instruments
3) Taking into account the risk premium

Question 5

Risk premium

Answer 5

– the difference in the rate of return of a risky instrument compared to an unencumbered instrument

Question 6

Speculative bubbles

Answer 6

1) The phenomenon of rapid price rise to the point of price collapse
2) In model terms, this means faster and faster deviations of the observed values from the forecasted values.
3) If there is a speculative bubble, you cannot value instruments using classical models
4) Speculative bubbles arise through rational expectations!

Question 7

During CRISIS WHAT BEHAVIORAL phenomenon CAN APPEAR?

Answer 7

Speculative bubbles
Turbulence in financial markets
Financial modeling during the crisis

Question 8

Turbulence in financial markets

Answer 8

1) The appearance of such turbulence causes that classical models are not a suitable valuation tool
2) Threshold models then become useful

Question 9

Financial modeling during the crisis

Answer 9

1) Classic models do not cope with crises
2) Important aspects of investor behavior during the crisis
a. Greed
b. Underestimation of risk
c. Herding
d. Errors of credit rating agencies not taken into account by investors