Summary: Lecture 1: Introduction To Behavioral Finance

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• Traditional vs Behavioral finance: Rational expectations hypothesis. what are 3 assumptions here?

  1.Investors are generally rational.
  2.Managers are generally rational.
  3.Efficient market hypothesis - asset prices incorporate all available information.

• Behavioral finance; what are 3 assumptions here?

  Some agents are not fully rational.
  Asset prices systematically deviate from fundamental values.
  Impact on corporate finance decisions, investments and asset prices.

• What are 3 Main areas of behavioral finance application

  1 Asset princing: - Aggregate stock market, bond market, real estate. - Performance of various stock market strategies. - Bubbles.
  2 Investor behavior: - Portfolios that investors hold. - Trading activity over time.
  3 Corporate finance: - Security issuance. - Capital structure. - Investment decisions. - M&A activity.

• Rational choice meets four criteria:

  1 It is based on decision maker’s current assets.
  2 Based on the possible consequences of the choice (no effect of framing).
  3 Agents make choices consistent with the expected utility framework. Consider different possible future outcomes. Decide how good or bad each outcome will make him feel. Weight each outcome by its probability and sum up.
  4 When agents receive new information, they update their expectations correctly, as described by Bayes law.

• Forms of market efficiency:

  Strong form - prices incorporate all public and private information.
  Semi-strong form - prices incorporate all public information.
  Weak form - prices incorporate only past public information

• Some agents are not fully rational: 2 things stand out here:

  - Fail to update beliefs correctly (fail to incorporate all available information).
  - Make choices that are normatively unacceptable.

• Limits to arbitrage: 2 things stand out here

  - Rational agents cannot always correct the irrationality of other investors.
  - Irrationality (mispricing) can have substantial and long impact.

• Behavioral biases (psychology): name 6 biases:

  - The irrational decisions are not random.
  - Systematic form of irrationality that creates a mispricing.
  - Belief formation
  - how agents form expectations.
  - Decision-making (preferences)
  - how agents evaluate risky decisions.

• Limit to arbitrage: Even when an asset is wildly mispriced, strategies designed to correct the mispricing can be both risky and costly, rendering them unattractive.What are 3 risks. Name 2 Risks and 1 costs(name and explain these costs) allowing the mispricing to survive:

  1 Fundamental risk: - The risk that the asset held by an investor loses value. - Finding a perfect hedge (substitute) is usually impossible.
  
  2 Noise trader risk: - Mispricing worsens further in the short run due to investor sentiment. - Can force arbitrageurs to liquidate their positions prematurely.
  
  3 Implementation costs: - All costs that make it less attractive to exploit the mispricing. - Transaction costs, short-sale constrains, and information costs. - Horizon risk. - Synchronization risk.

• what are Sufficient conditions to limit the arbitrage: Name 2

  Arbitrageurs are risk averse and have short horizons.
  - Arbitrageurs cannot afford to be patient. - Creditors and investors evaluate the arbitrageur based on his returns. - Forced closure of a short position.
  Noise trader risk is systematic.
  - Whatever investor sentiment is causing one asset to be undervalued relative to the other, it could also cause the mispricing to increase in the short term.