Lecture 5 - Revision lecture

Topic 1: Introduction to Behavioral Finance and Traditional Finance Theories

[Part One – Introduction to Behavioral Finance]

• Overview of neoclassical economics
  • (1) Preference Relation
  • (2) Utility Function and Expected Utility Theory
  • (3) Brief Introduction to Behavioural Finance

Normative model

• In a perfect world, what should be expected

[Part Two – Foundations of Finance]

• Foundations of Finance II: Asset Pricing, Market Efficiency and Agency Relationships
  • (1) Risk and Return Relationship
  • (2) CAPM model and Fama and French
  • (3) Market Efficiency (brief introduction = > more details in Topic 3)
  • (4) Agency Relationships and Corporate Governance

Part One

• Neocalssical economics (normative theory)

1. Rational preferences

• Completeness
• Trainstivity

2. Maximise utility

• The Expected Utility Theory of Prospect
• Properties of Utility Functions
• Certainty Equivalents

3. Independent decisions based on all “relevant” information

• Introduction to Behavioural Finance
  • Loss Aversion
  • Representative
  • Mental Accounting
  • Fear of Regret

Three assumptions

• Should be rational
  • 'In a perfect world' we say so that we can make predictions about the future

We should make decisions that maximise utility

• It should be an always upper sloping curve
• shape of utility will depend on preference
  • Calculate expected utility
• Certainty equivalent, what prospects will give the same utility
• Risk averse, what should be the amount you are happy to get

Four common types of biases

• Mental accounting related to efficient market hypothesis

Part two

• Foundations of Finance

1. Portfolio Risk & Return

• Portfolio Expected Return & Standard Deviations
• Efficient Frontier & CML

2. CAPM Model
3. Market Efficiency (more discussed in Lecture 3)
4. Agency Relationships & Corporate Governance

• Agency Costs (Direct vs Indirect)

• traditional finance concepts
• Market efficiency
• Agency - direct and indirect costs

Everything related to traditional finance is in appendix

• go through appendix

Lecture 2

[Part One – Prospect Theory]

• Overview about Prospect Theory
  • (1) Risk Aversion vs. Risk Seeking
  • (2) Development of Prospect Theory
• Prospect Theory Value Function
• The Weighting Function

[Part Two – Mental Accounting]

• Mental Accounting
  • (1) Integration vs. Segregation
  • (2) Theater Ticker Problems
  • (3) Opening and Closing Accounts

• Value function, how we deal with probability
• Mental accounting, how it affects how we make decisions

1. Risk aversion vs Risk seeking vs Loss aversion
2. Value Function

• Reference dependent
• Risk averse in positive domain
• Risk seeking in negative domain
  • Loss aversion

3. Weighting Function

• Overweighting low probabilities
• Underweighting medium-high probabilities
• Certainty effect

4. Framing & Mental Accounting Effect

• Segregation vs Integration (reference point)
• Silver lining effect & House money effect

• With prospect theory, they are reference dependent
• reference point, status quo
• gaining or losing money will change how you deal with it
  • Identify risk aversion versus loss aversion
• The reason why we make decisions are based on different reasons
  • Risk aversion - minimise uncertainty
  • Loss aversion - don't like the loss, avoid the potential of losing in the future
    • may increase your risk taking

Value function

• which one is adding to loss aversion

Weighting function

• don't look at probabilities rationally
• psychological bias
  • tend to overweight low probabilities
  • medium to high probabilities, overweight it
• When something is certain, the weighting function is not biased - will always be one (and zero is zero)

Framing

• other biases affect
• Mental accounting with prospect theory - segregation vs integration
  • People tend to integrate when you are winning money
  • losing money, tend to segregate
• silver lining
  • tend to segregate losses
  • firms do that as well (taking the bath)
  • do not tend to have lots of small losses - push to small positive earnings
    • have a major losses announcement - higher chances of positive increase in next financial period

WILL NOT ASK HOW THE EQUATIONS ARE FORMED

• need to know how to calculate it
• prospect versus utility

Topic 3: Challenges to Market Efficiency

[Part One – Efficient Market Hypothesis]

• Overview of Efficient Market Hypothesis
• Theoretical foundations and assumptions

[Part Two – Challenges to Market Efficiency]

• Rationales supporting the Efficient Market Hypothesis
• Theoretical Challenges and Empirical challenges

Market Efficiency

1. 3 levels of efficiency
2. Implications: Better off do passive investing
3. Random Walk vs. EMH

• “Prices are right” vs “No free lunch”

4. Theoretical Foundations

• Universal Rationality
• Uncorrelated Errors
• Unlimited Arbitrage

5. Rationales Supporting Efficiency vs Effective Trading Rules (Anomalies?)

EMH

• Only new information will affect the market
• People who are supporting market efficiency should only participate in pasive investing
  • cannot beat the market, cannot do active investment

Random walk vs EMH

• Two scholars
  • Random walk - no one can beat the market, then the price should be efficient
  • Can't make the link - doesn't necessarily mean the price is correct

If was have a bunch of noise traders

• if they are correlated and forms a sentiment, can move the market
  • not based on information (needs to add value) tradings on errors
  • pushing the price away from the fundamental (cannot predict it)
• Cannot reject or support EMH

Theoretical foundations

• don't need all three
  • universal rationality, can achieve EMH
    • based on all relevant information
  • If irrational investors decisions are uncorrelated, they will cancel out each other
    • price moved by rational investors
  • If we have unlimited arbitrage, opportunities to have risk free profit

Rationals supporting efficiencies

• all the anomalies, momentums,
• Should be at least semi-strong, should not be able to use past information
• Equal likely chance of spotting under/overreactions
• all the anomalies found could be due to methodologies
  • Have to rely on asset pricing - man made models
  • many adjustments, what is a universally affected method?

Arbitrage

1. Triangular Arbitrage
2. Limits to Arbitrage

• Fundamental Risk
• Noise-trader Risk
• Implementation Costs

• not unlimited
• triangular arbitrage (three trades)

Fundamental risk

• idiosyncratic risk
• capture fundamental risk

Noise trader risk

• systematic risk, before it gets better it can get worse
• try to push the price back, noise traders may form a sentiment
• cannot be eliminated or controlled

Implementation Costs

• costs, fees, spread, risk
• can be controlled but not eliminated
• even if you can get it, after the cost