Chapter 2 Flashcards
- What are the differences between Expect Value, Expected Utility Theory and Prospect Theory?
Expected value is only taking into consideration probability of the events.
EUT calculates based on individual preferences and riskiness of the outcomes. People can either be risk averse, risk neutral or risk seeking.
Prospect theory takes into account reference point for the loss and gain. They have a four fold risk taking behaviour ( Kahneman and Tversky). It states that people are risk averse in gains when it is more probable or higher stakes and also more loss averse and become risk seeking as potential losses increase.
LossGain
Medium P risk seeking: as already lost so Risk averse: gained a lot don’t wanna lose
Want to make up gambling losssafe investments
Low Prisk averse: avoid potential losses risk seeking as stakes are lower lotteries
insurance
Expected Value=probability of that outcomeoutcome
Expected Utility Theory= Ev with a utility function
- Probability of outcomeutility(outcome)
- Give an example of framing effect. Why is framing effect considered irrational? How does prospect theory help to explain framing effect?
When surveyed after a potential resuce methof to save number of people. People were provided with two choices with different reference points.
Gain frame:
If A is done then 200 saved
If b is done then 1/3 probability that 600 will be saved and 2/3 that no will be saved
People chose A>B even if the Expected outcome of both options is 200 saved and 400 die
Loss Frame:
If C done then 400 Die
If D done then 1/3 probability that none will die and 2/3 that 600 will die
Same thing 400 die and 200 save
But D>C as there’s a probability for no one dying. This is inconcistent to EUT as if we are violating dominance effect. But Kahneman and Tversky use Pt to explain that we have changed the reference point for these choices hence the individuals are inconsistent with EUT.
- What is St Petersburg paradox? Why is it a paradox? How can expected utility theory help to explain it?
St petersberg paradox is that coin is tossed until first head occurs. If it occurs after n times then the investor receives 2^n Euros. Now a risk neutral and rational investor will be willing to be EV of the game to participate in this game. The answer is infinity.
But people don’t want to pay more than 2 to play this game even if the EV can be more than 2 and hence they can earn from this. That’s why this is a paradox
Expected utility theory introduces the utility function into this equation and says that investors have diminishing marginal utility as the chances to get heads increases hence they would only be willing to pay 2ln(2) which is their Expected Utility for playing this game.
- Allas paradox describes the following preference pattern: The same person prefer 1 million over [2.5 million, 10%; 1 million, 89%; 0, 1%], but prefer [2.5 million, 10%] over [1 million, 11%]. Why is this a paradox? Can you use prospect theory to explain it?
Since in the first choice 1 million is 100% certain and in the second option it is only 89% certain hence people prefer A over B
Since the probabilities in the second choice are small 10% vs 11% hence people prefer 2.5 million 10% over other option. But if they were affected by certainty then they should have chosen 1 million 11% as it has a higher probability but they don’t so it is a paradox.
Prospect theory says that people tend to overweight small probabilities event so in the second choice the probabilities were small so they took more chance as compared to before.
- We often observe the same person buy insurance (risk averse) and play lotteries (risk seeking). Can you use prospect theory to explain this preference pattern?
People buy insurances because they are loss averse when it comes to smaller probability losses hence they are in the steep zone in the S curve. The same people are risk seeking in small probabilities in gain frame too hence play lotteries. It also depends on reference dependence as individuals see the low chance of winning the lottery a big shift from their reference point.
- What is sunk cost fallacy? What are the potential explanations?
Sunk cost fallacy is the tendency for people to continue an activity even if abandoning it will be more beneficial.
Example, project managers invested a lot of money but now the project is not as important.
Will they abandon?
Depends on the utility they would get from continuing versus avoiding
It depends on
i. Convexity of value function in losses
The value of doing is the activity is more than the value of not doing it so it is convex. So on x axis loss. Y axis utility/pain from loss. So as the loss increases the pain decreases hence as the cost of attending the event is more you need to go to save the money and not waste it.
ii. Overestimate probability of winning: even if we know the project isn’t worthwhile we are over estimating the probability of this event
iii. Self justification: over confident to justifiy their so much money spent
iv. Responbility(escalation of commitment)
If high responsibility managers had a disappointing previous investment they tend to invest even more in the same thing.
- What are mental accounting and hedonic framing? Give an example of each case and use prospect theory to explain.
Mental accounting means mentally categorising money into separate accounts based on use, source of money and time frame. This will lead to different levels of expensive and cheap price range for products across categories.
Eg: you will be willing to go 20 mins extra to buy a calculator for 10 rather than 15 but not 120 for 125 jacket. Because in our mental accounting, a jacket is more expensive in general so 5 dollar saved in that respect are not worth going 20 mins.
Field Eg: Taxi drivers have a mental account of earnings per day and quit on busier days and work longer on lazy days. They should do vice versa to maximise earnings. This is an example of mental accounting as we are categorising only money earned per day and not looking at potential
Mental accounting is irrational because mental account is not a perfect substitute for money in another account. It violates principles of fungibility as it one dollar is the same as another dollar but here it isn’t.
Hedonic framing- how framing of outcomes leads to investor’s reactions to losses or gains.
So when people are receiving rewards for the same amount. If a received 50 then 100. B received 150 in total then v(50)+v(100)>v(150). So utility function is concave. As they have more utility from receiving money more than once.
When people lose the same amount their utility function is convex hence telling that they have diminishing pain to additional losses. As v(-100)+v(-50)<v(-150).
- Explain money illusion and its implication.
Money illusion means people behave differently when the same objective situation is represented in nominal terms rather than real terms. As in framing effect, it is set in nominal terms.
Implications:
- As a company during inflation it is easier to reject a salary increase by saying that it is extra cost as compared to denying that during deflation when the prices are reducing. Even if the real money of the people is reducing, they don’t seem to see it because the actual salary is not reducing.
- Inflation can help companies to adjust the salaries downward if necessary.
- Many structured products have 100% capital protection but only in nominal terms where it isn’t adjusted for inflation.
- What is equity premium puzzle? Why myopic loss aversion could be a possible reason?
Equity premium puzzle is that in the long run stocks perform better than cash or bond even if they are riskier. They perform even more than the risk associated with them as developed by economic models.
Investors are sensitive to short term losses as compared to long run losses and are scared of the long run even if stocks have performed better in the long run and add the additional risk premium to equity hence making it seem have a higher risk premium than can be explained by economic models.
- What is disposition effect? Why are the following explanations are plausible: Value function of prospect theory, mental accounting, regret theory, gambler’s fallacy and wishful thinking?
Disposition effect is holding on to loser stocks longer and selling winner easily.
Value Function of Prospect Theory- the s shaped curve can explain this by showing that when investors are gaining they are more risk averse as compared to increases losses when they are more risk seeking.
Mental Accounting: it is just a paper loss. They have created a mental account for the loss/ gain
Regret Theory: always thinking that the stocks will bounce back therefore hold on to it
Gambler’ Fallacy: thinking it will take a reversal after long run of bad runs
Wishful Thinking: Overestimating probability of it coming back up
- What is equity premium puzzle? How to explain the equity premium from behavioral preference perspective?
Equity premium puzzle tells us that the risk premium in equiy is much higher than can be explained by economic models.
Behavourial finance explains by:
- Loss aversion: investors are more sensitivite to losses hence want more premium for it
- Myopic loss aversion
- Over confidence: holding more stocks in the portfolio because they overconfident on its performance
- Herding
- What is the difference between exponential time discounting model and hyperbolic time discounting model?
Delta is the temporal discount factor
Beta is the utility discount factor
Exponential time discounting uses the discount factor which is delta. But hyperbolic time discounting uses beta*delta factor to do discounting so this makes the total less than delta which means people are more patient in the future as compared to their patience between the present and the immediate next period.
- People tend to prefer improving sequence (e.g., increasing salary profile). Why is that inconsistent with conventional time discounting model in textbooks? What are possible explanations offered from insights of behavioral preferences?
Ppl prefer an increasing sequence even if the present value of the money in the future will be less.
Explanation:
- Loss aversion:Declining seq is seen as a loss
- Adaption: ppl adapt at different levels over time and evaluate new stimuli acc to theiradaption level
- Recency effect: later periods are overweighted
- Magnitude effect: people are more patient for larger amount in the future not thinking of discount rate
- Sign effect- people discount losses less than gains so they are more impatient in receiving gains.
