WK 5 Flashcards
Behavioural finance
What does behavioural finance agree on regarding prices and arbitrage opportunities?
Behavioural finance agrees that right prices imply there are no arbitrage opportunities.
How does behavioural finance challenge the relationship between no free lunch and right prices?
Behavioural finance challenges the notion that no free lunch necessarily implies that prices are right. It suggests that arbitrage opportunities may persistently remain unexploited despite the absence of a free lunch.
What are the limits to arbitrage according to behavioural finance?
According to behavioural finance, limits to arbitrage exist because carrying out arbitrage is not always costless. These limits include the costs associated with acquiring information, trading, and the reality that obvious profits may be risky, as seen in financial crises.
How does behavioural finance view investor rationality in relation to exploiting price patterns?
Behavioural finance suggests that investors are not always rational, meaning they may not maximize profits by exploiting price patterns.
What is the relationship between “prices are right” and “no free lunch” according to behavioural finance?
“prices are right” = “no free lunch,”
“no free lunch,”/=”prices are right”
Why might mispricing persist despite the availability of correction strategies?
Mispricing may persist because the portfolios designed to correct mispricing are often very risky, making risk-averse rational investors unwilling to implement such strategies, thereby allowing the mispricing to survive.
What factor might explain the lack of short selling, leading to overpriced stocks according to behavioural finance?
Behavioural finance suggests that loss aversion might explain the lack of short selling, which can lead to overpriced stocks.
How does the value function u(x) behave with respect to x?
The value function u(x) is increasing in x.
What is the behavior of the value function u(x) for gains and losses?
The value function u(x) is concave for gains (i.e., for x > 0) and convex for losses (i.e., for x < 0).
What does the kink at the origin represent in the value function u(x)?
The kink at the origin in the value function u(x) represents a point where there is a change in the curvature from concave to convex (or vice versa).
What does the factor λ represent in the value function u(x)?
The factor λ represents loss aversion, indicating the degree to which individuals are averse to losses compared to equivalent gains.
How does loss aversion manifest in the value function?
Loss aversion is reflected in the value function by the segment of the curve representing losses being steeper than that representing gains
What does the steeper segment of the curve for losses indicate?
The steeper segment of the curve for losses indicates that losses hurt much more than commensurate gains help for the representative individual.
Can you provide an example illustrating loss aversion?
Consider a gamble where you have a 50% chance of winning £150 and a 50% chance of losing £100.
Why do most people find the lottery described unappealing despite its positive expected value?
Most people find the lottery unappealing because the psychological cost of losing £100 is greater than the psychological gain of earning £150, illustrating the concept of loss aversion.
