Chapter 7: Behavioural Finance

Question 1

h. iiIi)main steps involved in financial planning

Explain the what Capital budgeting decision is and party responsible for it.

Outline why it may be complicted to carry our in practice.

Answer 1

It is the choise of capital projects and thus real assets to invest in.
it is the remit of the controller, or CFO.
Complicated in pratice due to:
- may be more than one apparently profitable project which to choose
- it is very difficult to estimate future profitability of a project

Question 2

h. ii)main steps involved in financial planning

Explain the what Financing decision is and parties responsible for it.

Answer 2

Decision on how to best raise finance for capital projects.

Responsibilities:

• This the roles of the treasurer
• In a small organisation, it could be the role of the CFO
• Will be tied into plans for product development, production and marketing and so involve managers from these areas
• will ultimately (by law or custom) rests with BoDs

Question 3

h. ii)main steps involved in financial planning

List the roles of the treasurer

Answer 3

• Look after cash
• Raise new capital
• Maintain relationship with
  Bank
  o Shareholders
  o Investors

Question 4

h. ii)main steps involved in financial planning

1. Define working capital
2. Outline what is meant by ST financial planning (& Assessment of on going liquidity)

Answer 4

1. Working Capital:

• current (ST) A - current (ST) L

2. ST financial planning (& assessment of ongoing liquidity):
   * Concerned with managment of…:
   - …working capital requirements (Current A and current L)
   - trade credit
   - stock (inventory) policy
   * Takes the form of a 12-month ‘rolling’ plan
   - will involve projecting current A & L forward in time using assumptions based on long-term business plans (production and sales) and current market conditions
   - allow for settlement policies adopted in respect of accounts payable and receivable.
   - perform stress tests on assumptions used.
   - Make allowance for tax, dividends and interest payments, liquidity gap analysis.

Question 5

h. ii)main steps involved in financial planning

List the main classes of current A and current L

Answer 5

Current A:

• Inventories (stocks of raw materials, finished and partly finished goods)
• trade receivables (debtors)
• cash and short-term securities held

Current L

• trade payables (creditors)
• outstanding dividends and tax payments
• short-term loans and borrowings

Question 6

h. ii)main steps involved in financial planning

1. Define fixed capital
2. Outline what is meant by LT financial planning

Answer 6

1. Fixed capital
   LT assets (usually tangible) use to produce goods and services on an ongoing basis, e.g., machinery, plant etc.
2. LT financial planning:

• Concerned with LT investment decisions and capital requirements
• Looks several years ahead and develops financial plans based on firm’s business plans - its anticipated prduct development and sales objectives
• Uses sensitivity analysis to explore business plans under a range of scenarios
• Once business plans have developed, they be converted in financial plans starting with forecasts of future cashflows.
• Considers no-operational issues e.., financial covenants and credit ratings.

Question 7

h. ii)main steps involved in financial planning

Outline what is meant by financial analysis and how it can be useful.

Answer 7

Financial analysis:

• Analysis of the financial implication of different possible actions
• requires input from different disciplines
• Must be objective, impartial and real (use specialist finance function)
• Includes…
• …Description of risks
• …Mitigation techniques
• …Uncertain factors

Uses:

• delineate the risks involved in the project
• highlight salient factors
• suggest methods by which risks might be reduced

Question 8

*h. i)Motives for mergers and divestitures *

What is the main danger of mergers and acquisitions?

Answer 8

Can often provide greatest scope for principal agent problems and destruction of shareholder value ( e.g., Overpayment for Target Company, Integration Costs, Loss of Focus) e.g., done as an exercise in empire building

Important to assess motives for mergers

Question 9

*Motives for mergers and divestitures *

List three types of mergers

Answer 9

1. Horizontal mergers
2. Vertical mergers
3. Conglomerate mergers

Question 10

*Motives for mergers and divestitures *

What is a Horizontal merger and are the motives for it:

Answer 10

Horizontal merger:
Involves firms engaged in similar activities

Motives:

• Economies of scale…
• …such as sharing core services common to both organisations (negotiation power, logistics, advertising, admin)
• …spreading fixed costs
  -… specialisation in production process
• …ability to obtain finance cheaply
• Expolit complementary resources
• Access to otherwise unavailable opportunities
• Eliminate inefficient resources (e.g., underperforming management)

Question 11

*Motives for mergers and divestitures *

What is a Vertical merger and are the motives for it:

Answer 11

Vertical merger:
Involve companies engaged in different stages of a production process (super market chain and a food production company)

Motives:

• Improve co-orditation and admin
• …by spanning and controlling greater part of the process (e.g., super market better supply food to its stores)
• exploit complementary resources

Question 12

*Motives for mergers and divestitures

What is a Conglomerate merger and are the motives for it:

Answer 12

Conglomerate mergers:
Involve firms in unrelated lines of business.

Motives:
* Lower finacing costs
* Economies of scale (if it allows sharing of functions such as general management, accounting and marketing)
* Takover threat protection (by increasing size)
* Share earnings enhancement (i.e., EPS)
* Benefit from unused tax benefits
* Utilise surplus funds
* Diversification to reduce exposure to fortunes of either sector

Question 13

h. ii) application of the key findings in behavioural finance

Define behavioural finance

Answer 13

The field of behavioural finance looks at how a variety of mental biases and decision making errors can affect financial decisions. it relates to a psychology that may underlie and drive financial decision-making behaviour.

Question 14

h. ii) application of the key findings in behavioural finance

Outline three practical situation where key findings in behavioural finance are applied.

Answer 14

1. Contrarian investment funds:

• run on the basis of taking advantage of perceived errors made by other investors
• tends to take the opposite view to the rest of the market, e.g., selling shares when market is high or rising on basis that market tends to overreact to positive news and so likely overvalued

2. Those responsible for investment policy are subject to types of mental bias –> so recommended investment management structure should be chosen to reflect those biases.
3. If markets are influenced by behavioural factors –> investors recognise this may be able to exploit it

Question 15

h. ii) application of the key findings in behavioural finance

List the 16 Main behavioural biases

Answer 15

1. Status quo bias
2. Anchoring
3. Dislike of negative events
4. Prospect theory
5. Representative bias
6. Options
7. Overconfidence
8. Familiarity
9. Framing
10. Loss aversion
11. Availiability bias
12. Self-serving bias
13. Herd behaviour
14. Mental Accounting
15. Optimism
16. Belief preservation

SAD PROOF FLASH MOB

Question 16

h. ii) application of the key findings in behavioural finance

Outline the ideas behind:
* Framing
* Overconfidence

Answer 16

Framing:

• Suggests that the way in which a choice (in particular a question in terms of gains and losses) is presented or ‘framed’ can have an enormous influence on the answer given or decision made.
• Equally, a response to a question can be influenced by its wording
• In particular, a ‘structure response’ question will convey an implicit range of acceptable answers

Overconfidence:

• People tend to be overconfident when making estimates both regarding the confidence intervals around their estimates and the probability of particular events occuring

this may result from:

• hindsight bias - events that happen//don’t happen will be thought as having being predictable/unlikely to have prior to event
• confirmation bias - people tend to look for evidence that firms their point of view (and dismiss evidence that does not justify it).

Question 17

h. ii) application of the key findings in behavioural finance

Explain what is meant by anchoring.

Answer 17

• When forming estimates people tend to start at an initial value (an ‘anchor’), which may be more or less arbitrary.
• To arrive at a final estimate, they will adjust away from this value.
• Experimental evidence suggests the adjustments are too small and so people are said to be anchored heavily on the initial value.

Question 18

h. ii) application of the key findings in behavioural finance

Explain what is meant by the term loss aversion.

Answer 18

• A person may be more sensitive to losses that to gains of the same magnitude
• A related behaviour is myopic loss aversion which considers repeated choices rather than a single gamble

Question 19

h. ii) application of the key findings in behavioural finance

Explain what is meant by the term myopic loss aversion.

Answer 19

Relevant when considering investment choices, e.g., if an investor reviews and possibly changes their investment strategy on an annual basis, then investment strategy can be thought of as a series of repeated one-year gambles.

relates to investor’s aversion to short term losses. e.g., less risk averse if investment strategy is a series of repeated short-term gambles and can take long-term view than when it is immediate short-term gamble.

length of reporting period influencial, eg., pension scheme reports annually –> more risk averse to short term investments –> forced to invest in less volatile assets to reduce risk of reporting poor returns –> invest less in equities and long-term bonds.

Question 20

h. ii) application of the key findings in behavioural finance

Explain what is suggested by Prospect theory

Answer 20

Prospect theory:

• Its a theory of how people make decisions when faced with risk and uncertainy
• it is an alternative to risk averse/risk seeking decreasing marginal utility
• Assumes asymmetrical response to losses versus gain from a particular starting point
• This asymmetry generate utility curves with a point of inflextion at the chosen starting point
• rather than being risk averse people will be risk seeking when faced with a loss
• Suggest decisions depends on whether problem framed as a gain or loss
• Curve convave when faced with a gainst and convex when faced with a loss

Question 21

Explain what is suggested by Mental Accounting

Answer 21

Mental accounting:

• Suggests that people show a tendency to seperate related events and decisions and find it difficult to aggregate events.
• Rather than netting out gains and losses, people to to set up a series of ‘mental accounts’ and view individual decisions s relating to one or another of these accounts.
• e.g., all profitable trades group in one ‘mental ccount’ and losses in another and value of gains easier to remember

Question 22

h. ii) application of the key findings in behavioural finance

Describe how the order of a range of choices may influence choice.

Give four influences of the range of options on choice.

Answer 22

Range choices:

• *Primary effect *suggest that people are more likely to choose first option presented (if decision made sooner)
• Recency effect suggests that final option may be preferred
• Other research suggests that people are more likely to choose an intermediate option other than either end.

other Influences of range:

1. Greater range of choices discourages decision-making
2. status quo bias - people have marked preference for keeping things as they are
   3.* regret aversion* - by retaining existing arrangements, people minimise possibility of regret(pain associted with feeling reponsible for a loss)
3. ambiquity aversion - people dislike uncertainty and are prepared to pay a premium for rules

Question 23

h. ii) application of the key findings in behavioural finance

Outline 8 other behaviours associated with behavioural finance.

Answer 23

1.Optimism - People tend to overestimate their own abilities
2. Representative bias - People often put too emphasis on particular features of a sample as opposed to likely features of whole population
3. Belief presevation - once people have formed a belief they tend to be reluctant to change it even when faced with strong contrary evidence
4. Availability bias - when making estimating probabilities people tend to focus excessively on more recent and salient events
5. Familiarity - process by which people prefer/favour situations/options which are familiar over new ones
6. Dislike of negative events - valence of an outcome hass an enormous influence on probability of its likely occurence.
7. self-serving bias - tendency of individuals to take credit for positive outcomes (like successful investments) and blame external factors for negative outcomes (like investment losses).
8. Herd behaviour - following the crowd/fear of missing out (explain stock market bubbles)

Question 24

h. ii) application of the key findings in behavioural finance

‘Modern financial economics’ based on premise that ‘agents’ are rational

Outline characteristics of rationality

Answer 24

• basing every decision on max wealth
• trading extra return with extra risk –> risk is volatility of returns
• fully informed on all potential investments
• able to spread pf over a large # of investments without incurring excessive costs
• continuously reviewing all existing investments as well as reviewing potential new investments.

Question 25

h. ii) application of the key findings in behavioural finance

Ouline other features rationality and fetures of noise traders

Answer 25

Rationality

1. Means that when agents receive new information update their beliefs correctly in line with Bayes’ law and they act to max their subjective expected utility over time.
2. if agents rational –> price of security = fundamental value –> incorporates new information –> market prices taken as a measure of fair value
3. if prices deviate from ‘correct’ value –> informed agents make money from this –> prices move back to appropriate levels

noise traders

1. heavily influenced by short-term noise (such as a news article or another trader’s opinion) and ignores other information and fundamentals –> they create herd behaviour and push prices further away from theoretical ‘rational’ price.
2. Behavioural finance is not a certain route to profits –> rational investor may not always take advantage of market price anomalies as irrational agents can make prices even more irrational in the short-term.

Question 26

h. ii) application of the key findings in behavioural finance

Question 27

h. ii) application of the key findings in behavioural finance

List six asset classes that one would expect to give high future returns, starting from a time point where market sentiment is low.

4.2 Market behaviour at a macro level

Answer 27

1. Small stocks
2. Distressed stocks
3. stocks of unprofitable companies
4. non-dividend paying stocks
5. extremely high growth stocks
6. highly volatile stocks

Question 28

h. ii) application of the key findings in behavioural finance

List four ways to measure market sentiment

4.2 Market behaviour at a macro level

Answer 28

1. the average discount on closed-end funds (should be low when sentiment is high)
2. Share turnover (# of shares traded/average # of shares outstanding) - should be high when sentiment is high
3. the level of activity in the IPO market and the level of issue of new equity (should be high when sentiment is high)
4. the level of dividend premium, which is a proxy for the relative demand for dividend payers amoung investors(demand for high dividend shares should be low when sentiment is high)

Question 29

h. ii) application of the key findings in behavioural finance

Outline herding, reasons for itand evidence of it.

4.2 Maket behaviour at a macro level

Answer 29

• when investors make decisions based on what they observe other investors doing
• distinguish this from spurious herding when investors do the same thing without reference to one another, e.g as result of a major adverse economic announcement causing many to rationally sell equities.

is potentially bad for markets –> may increase volatility –> possibly threaten the integrity of the whole system if markets are driven to the extremes.

Reasons:
- following experts
- incentives facing fund managers –> keeping close to peer group or unlikely to be to be sacked if all perform badly
- fear of missing out
- intrinsic desire to conform

Evidence of herding pronounced:
- in times of economic stress
- in less developed markets

Question 30

h. ii) application of the key findings in behavioural finance

Describe cross-sectional and time-series momentum.

4.3 The cross-sectional behaviour of stocks and other securities

Answer 30

Cross sectional momentum:

• An influencial study by Jegadeesh and Titman (1993) shows that what is termed cross-sectional momentum may be an important factor in predicting stock market returns.
• The grouped all stocks traded on the NYSE by return and showed that the decile worst performing stocks over the last six months performed worse than the best performers over the next six months
• Thus, there was a cross-sectional momentum effect with relatively poor performing stocks continuing to perform poorly and well-performing stocks continuing to perform well

Time series momentum:

• what is termed time series momentum effect has also been well documented where the past peformance of many financial instruments, such as equity indexes, currencies, commodities, sovereign bonds is considered in isolation rather than to other instruments.
• The past 12 -month execess return of many instruments has been found to be a positive predictor of their future return over roughly the next year.

Question 31

h. ii) application of the key findings in behavioural finance

Describe four examples where investor mood can affect market returns.

4.4 Particular mood-based anomalies

Answer 31

1.Calendar effects - ‘Blue Mondays’ and Good returns Pre-holidays
2. sunshine - daily market returns in the world markets have been found to be correlated with the amount of morning sunshine in the city of the country’s leading stock exchange
3.Sport results - loss –> poor returns
4. Aviation disasters have shown to lead to losses of stock market value which is a large multiple of the actual economic losses.

Question 32

h. ii) application of the key findings in behavioural finance

Outline direct investigation of individual’s trades and portfolios

Answer 32

• individuals trade too much, falsely believing they can pick winners, whereas they are actually losing money because of trading costs and poor trades –> consistent with overconfidence
• men trade more than women
• individuals are prone to realise the profits of winning as opposed to losing trades (disposition effect)
• individuals tend to hold pfs that may be far from optimum and use inefficient means of diversification