Chapter 6: Theory of finance Flashcards
1
Q
Outline the ideas behind
- Framing
- Overconfidence
A
Framing
- Suggests taht the way in wwhich choicce is presented or ‘framed’ can have an enormous impact on answer given or deciion made
- Equally, response to quesiton can be influenced by way its worded
Overconfidence
- People tend to overestimate own knowledge and skills. Discrepancy between accuracy and overconfidence increases with knowledge
May result from
- Hindsight bias - events that happen/dont happen will be thought of as having been preditable/unlikly prior to event
- Confirmation bias - people tend to look for evidence that confirms their point of view (and dismiss evidence that does not justify it)
2
Q
What is meant by anchoring and adjustment
A
- People’s perceptions are anchored by past experience or ‘exper’ opinon, and fall to adjust fuly to reflext current conditions
- Effect grows with size of difference between anchor value - original estimate provided - and pre-anchor estimate - mean estimate people make before eposed to explict anchor
- Effects of anchoring difficult ot ignore, even when people aware of effect and away that anchor is ridculous
3
Q
Explain what
- Is meant by the term estimating probilities
- myopic loss aversion suggests
*
A
Estimating probabilities
- Invesetors edstimates of prbabilities may be influenced by
- Dislike of negative events
- Representative heristics - as amount of detail describing circumstance or outcome increases, its apparent likelihood may increase (althought true probability can only decrease)
- Availability - suggests more generally that people tend to over-estimate probility of events they can esily imagine, and vice versa
Myopic loss aversion
- People take short term view in assessing gains and losses, which leads them to overcautious, even when investing for long term
- Also, invetors are less risk - averse when faced with repeated series of gambles than when faced with single gamble
4
Q
Explain what is suggested by
- Prospect theory
- mental accounting
A
Prospect theory
- Suggests that whilst investors are typically risk averse when considering gains relative to some benchmark, they are likely to be risk -loving when considering losses - ie they would prefer to take chance on gamble with higher expected losses than to incur certain loss
Mental accouting
- Suggests people show tendency to seperate related events and decisions and find it difficult to aggregate events and decisions and find it difficult to aggregate events
- Rather than netting out all gains and losses, people set up series of mental accounts and view individual decisions as relating to one or another of these accounts
5
Q
Describe how the order of a range of choices may influence choice
give four other influences of the range of options choice
A
How order of range of choices may influence choice
- Primary effect suggests people are more likely to choose first option presented
- recency effect suggests that final option may be preferred
- other research suggests people are more likely to choose an intermediate option than one at either end
Other influences of range or options on choice
- Greater range of options discourages decision making
- satus quo bias - people have marked preference for keeping things as they are
- regret acersion - by retaining existing arrangements, people minimise possibility of regret (pain assoicated with feeling responisble for loss)
- ambiguilty aversion - people dislike uncertainty and are preapred to pay a premium for rules
6
Q
List of six asset classes that one would expect to give high future returns, starting from a time point when market sentiment is low
A
- Small stocks
- highly volatile stocks
- the stocks of unprofitable companies
- non-dividend paying stocks
- extrememly high growth stocks
- distressed stocks
7
Q
List four ways to measure investor sentiment at any point in time
A
- The average discount on closed end funds (should be low when sentiment is high)
- Share turnover (should be high when sentiment is high)
- The level of activity in the IPO market and the level of issue of new equity (should be high when sentiment is high)
- The level of the dividend premium, which is a proxy fo rthe relative demand for dividend payers among investors (demand for high dividend shares should be low when sentiment is high)
8
Q
Describe four examples of where investor mood can affect markets returns
A
- Calender effects - blue mondays and good returns preholidays
- Sunshine - daily market returns in world markets have been found to be strongly correlated with the amount of morning sunshire in the city fo th ecountry’s leading stock exchange
- sports results
- aviation disasters have been shown to leaad to losses of stock market value which are a large mutiple of the estimated actual economic losses
9
Q
Outline what is meant by long term financial planning
A
- Concerned with long tem investment decisions and capital requirements
- looks several years ahead and develops financial plans vased on firm’s business plans - its anticipated product development and sales objectives
- uses sensitivity analysis to explore impact of different scenaios
- once business plans have been developed, they can be convereted into financial plans starting with forecasts of future cashflows
- considers non - operational issues, e.g. financial covenants and credit ratings
10
Q
Outline what is meant by short term financial planning
A
- Concerned with management of
- Working capital requriemets (current assets and liabilities)
- Trade credit
- stock (inventory) policy
- Often takes the form of a 12 month rolling plan
11
Q
List the main classes of current assets and current liabilities
A
- Current assets included
- Inventories
- Trade receivables
- cash and short term securities held
- Current liabilities include
- Trade payables
- outstanding dividend and tax payments
- short term borrowings and loans
