essay plans

Question 1

div policy intro

Answer 1

standard finance = MM irrelevance, perfect capital mkts, symmetric info and no agency probs. baker and wurgler irrational mgrs/rational invs vs.

irrational invs influence securities, mgrs smart in distinguishing mkt prices + fundamental val. VS mgrs beh departing from rational expectations/utility maximisations of mgr

Question 2

div policy (1)

Answer 2

irrational mgrs, rational inv

main research on mgOC and div policy.
+ve relationship: Wu and Liu, Bouwman, say div incs signal OC in future cashflows, higher FV in expanding economy. div announcements higher for OC mgrs.
-ve relationship: Corderia + Deshmukh et al., OC mgrs believe securities undervalued, so don’t issue equity and pay lower divs, so can invest in more projects. empirical evidence exists to support

Question 3

div policy (2)

Answer 3

rational mgrs, irrational invs

leads to mgrs catering to irrational investor demand, which exists because: money not seen as fungible, CG should = divs bc all just money but invs prefer CG. divs seen as dull and steady, CG more exciting - different mental accounts used.

div catering - div cuts are refused by mgrs. Cohen and Yagil’s new agency cost of divs. miss good NPV projects bc pressure to keep investors who are beh conditioned to see div cuts as bad. makes share prices drop. primacy effect: invs see div cuts in report, read further to find out why, but first info holds biggest sway

Question 4

div policy conclusion

Answer 4

good for firm value: OC and more divs = higher fundamental value in expanding economy.

bad for firm value: lower divs, catering meaning missing +ve NPV projects.

policy implications: failsafe where +ve NPV projects>div payouts, published company policy. place this higher in fin reports to avoid primacy effect. if CG more exciting, shareholders should understand this policy because should lead to share price increases.

Question 5

OC and myopia intro

Answer 5

OC more likely when task risky, outcomes uncertain, task complex, committed to task. also with higher education/experience. this essentially describes everyday business

Question 6

OC and myopia (1) - inv appraisal

Answer 6

traditional - mgrs take bad projects bc agency probs, which can be corrected through incentives and stock options.

behavioural - mgrs overestimate cash flow forecasts and ability, and underestimate risk. gives double upward bias to NPV and leads to truly -ve projects being taken. can however offset natural risk aversion

Question 7

OC and myopia (2) - cap structure

Answer 7

trad - MM irrelevance, capital structure not factor in firm value, assumes perfect mkt conditions

beh - OC increases debt (Shefrin), but OC mgrs put more effort in to deliver promises, therefore perceived optimal level of risk higher. limit at fin distress, repayments no longer feasible

Question 8

OC and myopia (3) - div policy

Answer 8

trad - MM irrelevance, CG=Divs

beh - research divided into confidence abt future earnings vs belief securities undervalued, empirical evidence for latter however may lead to -ve projects so could be stuck in a loop given inv app.

Question 9

OC and myopia (4)

Answer 9

shareholders

moderation is key. -ve NPV projects at one end, but can also offset risk aversion. debt is inc, but effort inc too. divs mixed but if moderated could break loop

Question 10

OC and myopia (5)

Answer 10

including myopia

inv app - kang et al can offset but optimal = no debt/myopia

cap structure - myopic mgrs may lower debt for more cash on hand so could offset.

for both - besharov second best

Question 11

OC and myopia conclusion

Answer 11

mixed effects across the corp finance decisions. if moderated, could be okay, and myopia may be able to offset in inv app and cap structure. 2nd best states ambiguous implications for welfare, so should be used w caution as a solution

Question 12

Heuristics intro

Answer 12

trad fin - invs fully rational, unlimited mental processing. due to ease of info and globalisation, more and more decisions need to be made in avg business heuristics = cog shortcuts so can help w this

Question 13

heuristics (1)

Answer 13

background

heuristics = simplified decision rule. can be conscious or unconscious. simon’s BR 1992, unreasonable to assume people capable of complex optimisation in real world settings. heuristics help w cog dissonance. type 1 autonomic quick/uncomplicated. type 2 cognitive slower and systemic. can lead to biases

Question 14

heuristics (2)

Answer 14

classes

familiarity - heath and tversky experiment, more likely to accept gamble with understanding of context. ambiguity aversion - ellsberg paradox, prefer risk to uncertainty and inherent uncertainty of paradox makes uncomfy.

representativeness - conjunction fallacy, base rate neglect, availability (recency, primary, salience).

anchoring - insufficient adjustment from initial value

Question 15

heuristics (3)

Answer 15

in fin mkts

home bias investing - overseas potential ignored despite lower correlations. could be explained by transaction costs and currency risks

1/n heuristics - results in inefficient portfolio, variety reduces appearance of choice

anchoring - framing probs for forecasting

Question 16

heuristics (4)

Answer 16

good or bad?

gig F&F, says combat to BR, only way to deal w constant info overload. also may save you costs, if stopped and rationally considered everything, end up frozen in indecision

Question 17

heuristics conclusion

Answer 17

while heuristics are v simplified and lead to biases, may provide some value in helping to deal w info overload invs deal w daily, stops them freezing. czakon et al’s myopia scale shows how to use it to advantage, could implement this by having teams of investors with range of heuristics to help consider all options and avoid systemic biases.

Question 18

Emotions intro

Answer 18

trad fin - homo economicus. only risk aversion looked at in terms of emotion. changes in risk attitude important, affects how you value an asset. cog biases like PT big focus until recently, w inc of pride/regret. recent research looks into effect on fin mkts and even more recently unconscious emotions

Question 19

emotions (1)

Answer 19

emotions = transitory, aimed at object, involve physiological arousal, result in tendency to act - Elster (98). mood = long lasting, not directed, e.g. inv sentiment = collective mood. may be periodic/cyclic and link to herding beh in mkts. affect = how person experiences a feeling, affective assessment = experience someone has in response to stimulus. reflects evaluation and doesn’t require cog response. can be infectious, powerful social force

Question 20

emotions (2)

Answer 20

good or bad?

AIM - +ve mood is inc in risk tolerance, Grable and Roszowski evidence for this.
vs
MMM - +ve mood leads to greater caution to stay in good spirits.

A&D say invs faced w so much info, deliberate calculation can leave you paralysed. emotions help spur into action.

Fenton + ocreevy say incidental and integral, control and accentuate

Hinvest et al 2021 - optimal medium level of risk aversion where returns highest, but for emotions better to be all or nothing

ultimately, emotions mean prices diverge from fundamentals

Question 21

emotions (3)

Answer 21

emotional finance

taffler and tucket, eshragi and taffler

took ideas from Freud and applied to mkts. looked at theory of phantastic objects, applied to stock mkts to explain bubbles/crashes. new toy, love to hate. interesting explanation but not forward looking - do emotions lead price path or lag behind?

Question 22

emotions conclusion

Answer 22

opinions are divided on how emotions affect decision making and performance in terms of good vs bad. however can help spur to action. should be moderated and kept in check, as hinvest et al found. no reason to think can’t be emotional and act calmly/rationally, as long as considering right emotions (F&OC). emotional finance needs further dev before can help invs mge beh and decisions