SS3 - Behavioral finance Flashcards
Traditional finance assumption
Investors act rationally and markets are efficient
Behavioral vs traditional finance difference
Behavior = psychological; observed
Traditional = grounded in neoclassical economics; market prices incorporate and reflect all relevant/available info; idealized
BFMI questions?
Perfect rationality and investor decision process
BFMA questions
Efficiency of markets
Utility theory axioms
Completeness
Transitivity
Independence
Continuity
Bayes Formula
P (a|b) = p(b|a) * p(a) / p(b)
Prob of a given b
Ex: prob of black bag given US coins
(If two bags had mix of US and CAD coins)
REM
Rational economic man
Principles of perfect rationality, perfect self-interest and perfect info govern REM’s economic decisions
Assumption in traditional finance?
People are risk adverse
REM - which indifference curve?
Curve within budget constraints and furthest from origin gives the highest utility… Choices by REM will fall on this curve
Certainty Equivalent
Max sum of money someone would pay to play oppty
Or
Min sum of money someone would accept to NOT play in oppty
Risk seeking person had —- utility function?
Convex
Utility increases at an increasing rate with increases of wealth
Risk adverse person has a — utility function
Concave
Utility increases at a decreasing rate with increases of wealth
Person has diminishing marginal utility of wealth
Risk-neutral person has — utility function
Linear
He has constant marginal utility of wealth
Degree of risk aversion can be measured by
Curvature of utility function
Why is REM useful?
It is normative and helps define optimal outcome
