Transcript Diapositiva 1

BEHAVIOURAL FINANCE
INTERNATIONAL FINANCIAL INSTITUTIONS AND
MARKETS
Prof. Federica Ielasi
Academic Year 2010-2011
Bersini Diego
Gourba Dana
Khayrullina Ekaterina
Maragno Giovanni
Marturano Giulio
Rizzo Debora
Serina Annamaria
1 - What B.F is
2 - Prospect Theory
3 - Cognitive Biases
4 - Limits To Arbitrage
5 - Applications (Inflation & Stock Market
Undepricing of IPOs)
6 - Countries and cultures in B.F
• Equity markets : increasing volatility and fluctuations
• Market participants have for a long time relied on the
notion of efficient markets and rational behavior when
making financial decisions.
• Idea of fully rational who always maximize their utility
and demonstrate perfect self-control is become
inadequate.
• Examples of market inefficiency in the form of anomalies
and irrational investor behavior
• Behavioral finance is a new paradigm of finance theory ,
which seeks to understand and predict systematic
financial market implications of psychological decisionmaking.
• By understand the human behavior and psychological
mechanisms involved in financial decision-making,
standard finance models may be improved to better
reflect and explain the reality in today’s evolving markets.
• Behavioral finance helps to explain why and how markets
might be inefficient.
• Behavioral finance focuses upon how investors interpret
and act on information to make informed investment
decisions. Investors do not always behave in a rational,
predictable and an unbiased manner indicated by the
quantitative models.
History
• Adam Smith wrote an important text describing
psychological principles of individual behavior, The
Theory of Moral Sentiments and Jeremy Bentham wrote
extensively on the psychological underpinnings of utility.
• Economic psychology emerged in the 20th century in the
works of different economists : Gabriel Tarde, George
Katona and Laszlo Garai.
• Psychologists in this field such as Ward Edwards, Amos
Tversky and Daniel Kahneman began to benchmark
their cognitive models of decision making under risk and
uncertainty against economic models of rational
behavior.
• The most important paper was written by Kahneman and
Tversky in 1979:'Prospect theory: Decision Making
Under Risk', used cognitive psychological techniques to
explain a number of documented anomalies in rational
economic decision making
INTRODUCTION
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Prospect Theory is a mathematical alternative theory
elaborated by Kahneman and Tversky to explain the human
behavior under uncertainty.
Expected utility theory offers a representation (investors
are always risk averse) of truly rational behavior under
certainty.
Groups of individuals have been subjected to questions in
the form of choice between two combinations of
outcomes and probabilities.
By these empirical experiments have been observed
certain behaviors constituting violations of the classical
theory of expected utility.
VIOLATIONS OF EXPECTED UTILITY
•
The certainty effect (preference for certain outcomes): subjects
between choices with positive results give greater weight to
certain results compared to those uncertain that however have an
expected value higher than the certain value. Therefore in a
positive demain there’s risk aversion.
•
The reflection effect:in a negative domain (situation in which the
results of all possible alternatives are negative) there’s the
tendency to take up risks. (risk seeking and love for losses)
•
The effect of isolation: tendency of the agents to ignore common
elements between more options and to focus the attention and
the decision only on differential elements . Unlike the expected
utility theory, choices between alternatives aren’t determined only
by the final states of wealth.
FRAME DEPENDENCY
• One of the main assumptions of the Prospect Theory is the “Frame
dependency” (the decision is determined by how the choices are
represented).
• According to this approach agents evaluate lotteries through a two-level
process:
• 1. Phase of editing: the aim of this phase is to organize the options in order to
make the subsequent phases of assessment and choice easier. In this phase is
crucial the way in which problems are placed (the frame )because,unlike
expected utility, the order of preference between various options isn’t
invariable. Different contexts of reference lead to various ways of information
processing.
• 2. Phase of evaluation which uses a value function
•
- The value function confirms that the utility of an economic agent depends
on the gains or losses that can be achieved with respect to a certain level of
wealth that is the reference point determined by the subjective impression of
individuals of the decision context.
FRAME DEPENDENCY
• - Due to the effect certainty, economic agents don’t behave in a mirror
way in front of gains and losses:
•
* Their attitude has a convex function in the losses (for wealth
levels under the reference point investors are risk seekers to stay above
the reference point).
•
* Their attitude has a concave function in gains (for wealth levels
after the reference point investors are risk averse to stay at the
perceived current level of utility)
•
- The slope of the function in losses exceeds that in gains because
the “suffering” produced by losses is higher than the “enjoyment”
determined by gains
•
- On the contrary, in expected utility theory the utility function:
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* doesn’t have a reference point
•
* is focused on final wealth
•
* is concave downward for all levels of wealth because investors
are always considered risk averse.
VALUE FUNCTION KAHNEMAN D. AND TVERSKY
A, “PROSPECT THEORY”: AN ANALYSIS OF
DECISION UNDER RISK.
Psychology and Beliefs
Emotion and Psychology
There are many instances where emotion and
psychology influence our decisions, causing us to behave
in unpredictable or irrational ways.
Cognitive psychologists have documented many
patterns regarding how people behave.
Some of these patterns are as follows :
Key Concepts
1) Heuristic and Anchoring
2) Mental Accounting
3) Hindsight Biases
Heuristic and Anchoring
-People often make decisions based on
approximate rules of thumb, not strict logic.
In particular the concept of anchoring draws on
the tendency to attach or "anchor" our
thoughts to a reference point and then make
adjustments to it to reach their estimate.
.
-Psychologists have documented that when
people make estimates may be heavily
influenced by previous values of the item.
Car salesman
For example…
Investment anchoring
For example, some investors invest in the stocks of companies
that have fallen considerably in a very short amount of time. In
this case, the investor is anchoring on a recent "high" that the
stock has achieved and consequently believes that the drop in
price provides an opportunity to buy the stock at a discount.
-Successful investors evaluate each company
from a variety of perspectives in order to
derive the truest picture of the investment
landscape.
MENTAL ACCOUNTING
Mental accounting refers to the tendency for people to separate their
money into separate accounts based on a variety of subjective criteria,
like the source of the money and intent for each account.
.
The Different Accounts Dilemma
Different Source, Different Purpose
The different accounts dilemma
We have a weekly lunch budget and are going to
purchase a $6 sandwich for lunch. As we are waiting in
line, one of the following things occurs:
We find that we have a hole in our pocket and have lost
$6;
We buy the sandwich but we stumble and our delicious
sandwich ends up on the floor
In either case would you buy another
 sandwich?
The different accounts dilemma
Because of the mental accounting bias, most people in
the first scenario wouldn't consider the lost money to be
part of their lunch budget because the money had not
yet been spent, consequently they'd be more likely to buy
another sandwich, whereas in the second scenario,
because the money had already been spent!
Different source,Different purpose
People tend to spend a lot more "found" money, such
as tax returns and work bonuses and gifts, compared
to a similar amount of money that is normally
expected, such as from their paychecks. This
represents another instance of how mental accounting
can cause illogical use of money.
Money should be interchangeable !!!
HINDSIGHT BIAS
•
Hindsight Bias tends to occur in situations where a
person believes some past event was predictable and
completely obvious.
•
Psychologists attribute hindsight bias to our innate
need to find order in the world by creating explanations
that allow us to believe that events are predictable
TECHNOLOGY BUBBLE
• For example…
HINDSIGHT BIAS
• For investors and other participants in the financial
world, the hindsight bias is a cause for one of the most
potentially dangerous mindsets that an investor or trader
can have: Overconfidence. In this case, overconfidence
refers to investors' or traders' unfounded belief that they
possess superior stock-picking abilities!
Limits To Arbitrage
What does arbitrage mean?
Arbitrage is the simultaneus purchase and sale of an asset in
order to profit from a difference in the price.
Arbitrage exists as a result of market inefficiences; it
provides a mechanism to ensure prices do not deviate
substantially from fair value for long periods of time.
Limits to arbitrage is a theory that, due to restrictions that
are placed on funds that would ordinarily be used by rational
traders to arbitrage away pricing inefficiencies, prices may
remain in a non-equilibrium state for protracted periods of
time.
Efficient Market Hypothesis (EMH)
In a traditional framework where agents are rational and
there are no frictions, a security's price equals its
“fundamental value”
the discounted sum of expected future cash
flows, where in forming expectations, investors
correctly process all available information, and
where the discount rate is consistent with a
normatively
acceptable
preference
specification.
Behavioural Finance Vs. EMH
Behavioral finance argues that some features of asset prices are
most plausibly interpreted as deviations from fundamental
value, and that these deviations are brought
about by the presence of traders who are not fully rational.
Friedman's objection: rational traders will quickly undo any
dislocations caused by irrational traders.
Behavioural Finance Vs. EMH
Friedman's objection is based on two assertions:
1)as soon as there is a mispricing – an attractive investment
opportunity is created;
2)rational traders will immediately snap up the opportunity,
thereby correcting the mispricing
Behavioural Finance disputes the first step: even when an
asset is wildly mispriced, strategies designed to correct the
mispricing can be both risky and costly, rendering them
unattractive. As a result, the mispricing can remain
unchallenged.
Actors
Irrational traders
“noise traders”
Rational traders
“arbitrageurs”
KIND OF MISPRICING
Misvaluations are of two types:
1)recurrent or arbitrageable
the market is pretty efficient for these assets, at
least on a relative basis.
2)non-repeating and long-term in nature.
it is impossible in real time to identify the peaks
and troughs until they have passed.
Risks and Costs
Fundamental Risk;
Noise Trader Risk;
Implementation Costs.
Risks and Costs
Fundamental risk:
impersonal both in origin and consequence;
the losses are not normally caused by one individual
and their impact generally falls on a wide range of people.
Arbitrageurs are well aware of this risk, which is why they
short a substitute security (substitute securities are rarely
perfect, and often highly imperfect, making it impossible
to remove all the fundamental risk).
Risks and Costs
Noise trader risk: is the risk that the mispricing being
exploited by the arbitrageur worsens in the short run.
pessimistic investors that become more pessimistic
cause an additional lowering of securitity's price
agency feauture
arbitrageurs aggresiveness
Risks and Costs
Implementation costs: anything that makes it
less attractive to establish a short position than a long
one.
commissions;
bid–ask spreads;
price impact;
short-sale constraints (the fee charged for borrowing a
stock, legal constraints, the cost of finding and learning
about mispricing).
Applications
FIRST APPLICATION
Inflation and the stock market
ASSUMPTIONS
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inflation rate is 6%
equity risk premium is zero
nominal cost of capital is 10% (a real cost of capital is
4%)
Real value of debt unchanged (nominal amount of debt
increases by 6% each year)
no real growth
all free cash flow (if any) is paid out in dividends
How much the equity of this firm worth?
DATA
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Revenue $1,200,000
Cost of Goods Sold $600,000
Administrative Expenses $400,000
Interest Expense $200,000
Taxes $0
After-tax profits $0
Debt $2,000,000
Book Equity $1,500,000
Shares outstanding 10,000
Interest rate on debt 10%
CALCULATION
With inflation at 6% and $2 million in debt, the firm must issue
$120,000 more debt next year to keep the real value of its
debt constant. This cash can be used to pay dividends. This is
$12 per share, and using the growing perpetuity formula
P = Div1/(r – g)
with r = 10% and g = 6%,
P = $12/(0.10 – 0.06) = $300 per share.
So the equity is worth $3 million, or $300 per share.
CONCLUSION
• The true economic earnings are higher than the accounting
earnings, because accountants measure the cost, but not
the benefit to equity-holders, of debt financing when there
is inflation.
• Nominal interest expense appears on the income statement.
The decrease in the real value of nominal liabilities due to
inflation does not appear on the income statement.
• That why investors don’t take it into account, and hence
undervalue equities when inflation is high.
CONCLUSION
If the market makes this mistake, then stocks become riskier,
because they fall more than they should when inflation
increases, and they rise more than they should when inflation
decreases. Over a full inflation cycle, these two effects balance
out, which is why stocks are less risky in the long run than they
are in the short run.
SECOND APPLICATION
Underpricing of IPOs
Prospect theory is a descriptive theory of choice under
uncertainty
Prospect theory focuses on changes in wealth
Prospect theory also assumes loss aversion
Prospect theory also incorporates framing—if two related
events occur, an individual has a choice of treating them as
separate events (segregation) or as one (integration).
WE USE PROSPECT THEORY TO EXPLAIN THE
SEVERE UNDERPRICING OF SOME IPOS.
• If an IPO is underpriced
• pre-issue stockholders are worse off because their wealth has
been diluted.
• if an entrepreneur receives the good news that he or she is
wealthy because of a higher than expected IPO price
• the entrepreneur doesn't bargain as hard for a higher offer price
• because the person integrates the good
• news of a wealth increase with the bad news of excessive
dilution
Underwriters take advantage of this mental accounting
and severely underprice these deals.
offer price has been raised (a little)
the market price goes up a lot
that leave a lot of money on the table
COUNTRIES AND CULTURE IN
BEHAVIORAL FINANCE
HOW DO THE CULTURAL DIFFERENCES MAY
INFLUENCE ON INVESTORS' BEHAVIOR?
In “Does Culture Affect Economic Outcomes?” (Guiso,
Sapienza, and Zingales, 2006) defined culture as “those
customary beliefs and values that ethnic, religious, and social
groups transmit fairly unchanged from generation to
generation.”
Culture matters, and it is persistent.
THE CASE
Paul Bond is a lawyer at the Brown & Long law firm. One
day he overheard John Grand, another lawyer, talking with an
associate about his work on a proposed purchase of the Pillow
company by the Down company for $120 per share. Paul Bond
had no role in the work on the proposed purchase of Pillow
and Brown & Long represented only Down, not Pillow. Paul
Bond bought 1,000 shares of Pillow for $70 per share. Please
rate Paul’s behavior as:
Completely Fair, Acceptable, Unfair, or Very Unfair.
PERCEPTIONS OF THE FAIRNESS OF INSIDER
TRADING BY FINANCE PROFESSIONALS IN
EIGHT COUNTRIES
Country and percentage of who rated Bond’s behavior
Completely Fair or Acceptable:
Turkey
56%
India
49%
Italy
43%
Tunisia
41%
Australia
16%
Israel
16%
Netherlands
5%
United States
5%
THE SURVEY FOCUSED ON THE PROPENSITY
FOR RISK
• Suppose you are the only income earner in the family, and
you have a good job guaranteed to give you and your family
income every year for life. Now you are given an
opportunity to take a new and equally good job.
• The new job has a 50/50 chance to increase by 50% OR to
reduce by X percent your standard of living each year during
your lifetime (circle the maximum X percent reduction you
are willing to accept).
RELATIONS BETWEEN THE VARIABLES
- China and Vietnam were the most willing to take risk
- Germany and Switzerland were the least willing
- Men are more willing than women to take risk with their
income and portfolio
- People who are ready to take risks with their income are
generally also more willing to take risks in their portfolio (except
Tunisia)
TRUST IS THE ASPECT OF A CULTURE
The other variable that is consistently related in a significant
way to the propensity to take income and portfolio risk is trust:
- Trusting people are more willing to invest in stocks and to take
risk.
- Women are less trusting than men.
- China ranked the highest in agreeing that most people can be
trusted.
CONCLUSION
The ideas of behavioral portfolio theory explain the difference
in the responses:
Investors tend to think about their money in layers, and job
income makes up the basic layer (the safe money),
wealth is in a layer above job income.
portfolio
People in low-income countries have high aspirations relative
to their current income. But it is not that they like risk. Rather,
they pay with risk for a chance to move up in life.
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Another difference among
individualism-collectivism line:
cultures
occurs
along
the
People in collectivistic countries can afford to take more risk
because their in-groups provide downside protection.
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In individualistic societies, ties among individuals are loose
and all are expected to look after themselves and people have a
lower propensity for risk.
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AN AWARENESS OF THE CULTURE THAT CLIENTS COME FROM
IS IMPORTANT, AND THAT INSIGHT WILL ALLOW ADVISERS TO
SERVE THEIR CLIENTS WELL.
CULTURES VARY, AND CULTURE MATTERS.