intro

Question 1

what are two examples of social forces?

Answer 1

herding behaviour

groupthink

Question 2

what is behavioural finance?

Answer 2

looks at effects of investors’ psychological biases in corporate decisions.

Question 3

what are the main focus areas of behavioural corporate finance?

Answer 3

investment appraisal
capital structure
dividend policy
mergers and acquisitions

Question 4

how does standard finance view managers and investors vs behavioural finance?

Answer 4

standard finance - managers and investors are fully rational, unbiased, emotionless, self-interested maximisers of expected utility with stable preferences (AKA homo economicus)

behavioural finance - considers real world - agents are boundedly rational, biased, emotional, not full self-interested, not expected utility maximisers with unstable preferences

Question 5

what broad part of behavioural finance shows people are not expected utility maximisers, and have unstable preferences?

Answer 5

prospect theory

Question 6

what does behavioural finance claim stops people being self interested?

Answer 6

fairness, trust, empathy

Question 7

what is a bias/what are some examples?

Answer 7

a predisposition towards error. examples:

excessive optimism
overconfidence
confirmation bias
illusion of control

Question 8

what is are heuristics and what are some examples?

Answer 8

rules of thumb used to make a decision. examples:

representativeness
availability
anchoring
affect

Question 9

what are framing effects?

Answer 9

occur when a person’s decisions are influences by many things in which setting for decision is described. very important in prospect theory in terms of loss aversion

Question 10

what is prospect theory?

Answer 10

a general psychological approach that describes how people make choices among risky alternatives.

Question 11

what does prospect theory say about people attitude to risk when faced with gains and losses?

Answer 11

risk seeking w gains, risk averse with losses, hate losses more than you love gains.

Question 12

what is disposition effect?

Answer 12

when investors winning, they were selling quickly. losing possible future gains. they also hold onto losing stocks too long, and making further losses.

Question 13

what is integrating/segregating in terms of prospect theory?

Answer 13

integrating - considering multiple gains or losses together.

segregating - taking first gain or loss and using it as your reference point

Question 14

what are the two key assumptions about preferences in neoclassical economics?

Answer 14

completeness and transivity

Question 15

what is expected utility theory?

Answer 15

says individuals should act when confronted with decision making under uncertainty in a certain way. theory is really set up to deal with risk, not uncertainty.

Question 16

what is a prospect?

Answer 16

series of wealth or income levels and associated probabilities. expected utility theory comes from series of assumption (axioms) on these prospects.

assumptions of transivity and completeness of preferences over prospects.

when such choices over risky prospects are to be made, people should act as if they are maximising expected utility.

Question 17

what is the risk aversion assumption?

Answer 17

comes from frequent observation that most people most of the time are not willing to accept a fair gamble, implying concavity.

Question 18

what are the problems with expected utility theory?

Answer 18

number of violations have been discovered, most famous being Allais paradox. alternative theories have been developed which seek to account for these violations. best known is prospect theory - Tversky and Kahneman.

Question 19

what is the operational definition of market efficiency?

Answer 19

financial markets efficient if no one can consistently earn excess (once risk and after costs factored in) returns.

Question 20

what are simulated trading strategies?

Answer 20

based on info that was available. if a strategy succeeds in generating excess returns, this is preliminary evidence against market efficiency. but we need: statistical evidence, consistency. beware of data mining!

Question 21

what are the three types of market efficiency and what type of information do they require?

Answer 21

weak form: historical prices and returns.

semi-strong: all public info

strong: all info, including private

Question 22

what is an agency relationship and how can it lead to agency problems?

Answer 22

agency relationship exists whenever someone contracts with someone else to take actions on behalf of principal and represent principal’s interests.

in an agency relationship, agent has authority to make decisions for the principal. an angency problem arises when agent’s and principals incentives not aligned.

Question 23

what are agency costs?

Answer 23

incurred because managers’ incentives are not consistent with maximising value of firm.

direct costs: monitoring managers, hiring outside auditors etc

indirect costs: mgrs of firm that is an acquisition target could resist takeover over job security concern even if shareholders would benefit.

Question 24

are EU theory and prospect theory normative or positive?

Answer 24

expected utility theory normative (what people should do), prospect theory positive (what people do).

Question 25

what is the common ratio effect?

Answer 25

people choosing options out of prospect pairs in a way that contradicts linear transformation rule. nonlinear weighting can explain the choices.

Question 26

what is the lottery/insurance effect?

Answer 26

people overweight low prov event

Question 27

what is the certainty effect?

Answer 27

certainty accorded high weight relative to near certainty

Question 28

what is the principle of invariance?

Answer 28

essential condition for a theory of choice is principle of invariance - different representations of same problem should yield same preference. doesn’t always work in practice. people have diff perspectives and come up with different decisions depending on how a problem is framed.

Question 29

what is mental accounting?

Answer 29

related to prospect theory and frames. accounting = process of categorising money, spending and financial events.

mental accounting = description of way people intuitively do these things and how it impacts financial decision-making. often leads to odd and sub-optimal decisions

Question 30

what happens if you integrate after a win vs after a loss?

Answer 30

after a win, you move up the value function

after a loss, you move down

Question 31

what happens if you segregate on the value function?

Answer 31

you always go back to reference point

Question 32

what is disposition effect?

Answer 32

people avoid closing accounts at a loss. e.g. selling stocks at losses is painful so they don’t dispose of them.

Question 33

do small capital portfolios or large win out?

Answer 33

small

Question 34

in the theoretical foundations of efficient markets, of what three conditions does at least one need to hold?

Answer 34

universal rationality

uncorrelated errors

unlimited arbitrage

Question 35

what does EMH say about arbitrage?

Answer 35

EMH condition of no arbitrage. if there are pricing errors (caused by irrational investors) smart-money traders arbitrage them away. no free lunch

Question 36

what three things hamper arbitrage exploitation?

Answer 36

fundamental risk
noise-trader risk
implementation costs

Question 37

what two things are needed for mispricing to exist?

Answer 37

irrational investors
limits to arbitrage

Question 38

what is fundamental risk?

Answer 38

if think stock is underpriced, you can buy it but: might be sideswiped by market or industry, there is idiosyncratic risk

pure arbitrage seeks to eliminate all of these.

problem = finding perfect substitutes. what are they? if, e.g., ford is too cheap, you buy ford but market or auto industry may drop. so you buy ford and short GM, but ford itself may falter without industry or market dropping.

Question 39

what is noise trader risk?

Answer 39

spread may widen as investors get things more wrong.

noise - opinion on value unrelated to fundamental information.

sentiment - correlated noise, has potential power to move markets. implies price movements can be driven by misinformation rather than information.

NTrisk = risk that mispricing being exploited by arbitrageur may worsen. has been showed NTrisk systematic (undiversifiable). real world arbitrageurs cannot wait it out because as professional money managers they don’t have long horizons.

Question 40

what are implementation costs?

Answer 40

in some cases, horizon is short but short-selling is expensive (commissions, spreads, price impact and fees for shorting stock), difficult or even impossible (lack of availability regardless of fees, legal factors).

cost of finding arbitrage opportunities.