Behavorial finance

1. BUILDING BLOCKS
OF BEHAVORIAL
FINANCE
PRESENTED BY
SIMRAN KAUR
MBA 2NDYEAR

2. COGNITIVE PSYCHOLOGY
■ Meditational process
■ Informational process
■ Introspection or observation
■ Studies the group
■ Schema

3. PROCESS OF COGNITIVE
PSYCHOLOGY
■ Thoughts
■ Feelings
■ Behaviour
■ Retrieval
■ Memory

4. ADVANTAGES OF COGNITIVE
PSYCHOLOGY
■ Scientific
■ Highly applicable
■ Combines easily with approaches
■ Many empirical studies to support theories

5. DISADVANTAGES OF COGNITIVE
PSYCHOLOGY
■ Ignores biology
■ Experiments
■ Behaviourism
■ Humanism

6. LIMITSTO ARBITRAGE
■ Theory which assumes that restrictions placed upon funds, that would ordinarily be
used by relational traders to arbitrage away pricing inefficiencies
■ Always costly
■ Can’t perfectly move on inflated prices
■ Increase market efficiency

7. DEFINITION OF ARBITRAGEUR
■ Simultaneous buying and selling of same or substitute securities in different markets
to benefit from mispricing
■ Very experienced investors
■ Long position in cheaper or underpriced securities and short the expensive or the
overpriced one

8. LONG-TERMTRADES
■ Distant cashflows
■ Mispricing of claims to long-term investment projects take longer to disappear
■ Focus on long-term assets
■ Not automatic
■ Long-term assets are stocks and foreign exchange

9. SHORT-TERMTRADES
■ Mispricing must disappear in the near future
■ Faster and less risky
■ Focus on short-term assets
■ Price fluctuations are small
■ Short-term assets are options, futures, and other instruments

10. TRANSACTIONCOSTS
■ Cost of finding and learning about a mispricing, as well as cost of the resources needed
to exploit it
■ For most stocks, fees range between 10 and 15 basis points
■ Eg: commissions, bid-ask spread, premium costs,etc.

11. SHORT-SELLING COSTS
■ Source of non-trader risk
■ Securities are impossible to short
■ Lead to extreme price mismatches

12. FUNDAMENTAL RISK
■ Financial markets don’t always offer an ideal substitute whose price will react to news
■ If a stock is priced incorrectly, derivative instruments based on this stock will also be
mispriced
■ Trigger severe losses for arbitrageurs

13. NOISE-TRADER RISK
■ May cause the price of the security to deviate even further from its fundamental value
■ Can force people to take unwanted and unnecessary steep losses
■ Also called “resale risk”
■ If resale risk is high, investors will have a comparatively shorter time horizon

14. PROFESSIONALARBITRAGE
■ Conducted by relatively few professional, highly specialized investors
■ Have an incentive to avoid positions that expose professional arbitrageurs
■ Market pricing inconsistently can persist
■ Remove discrepancies in rate ofexchange

15. POSITIVE FEEDBACK
■ Investors who buy securities when prices rise and sell when prices fall
■ Liquidation of the positions of investors unable to meet margin calls
■ Rational speculation can be destabilising
■ Extrapolative expectations resulting from biases in judgement under uncertainty

16. PREDATION
■ Firms keep themselves deliberately opaque
■ Trading that induces and exploits another investor’s need to change their position
■ May even lend to others “financially fragile” because they can obtain higher profits
■ Infinite-horizon, multi-period framework , with each period a continuous-time game

17. EXPECTED UTILITYTHEORY
■ Normative approach
■ EUT states that the decision-maker chooses between risky or uncertain prospects by
comparing their expected utility values
■ Investment criteria:
1. Maximum Return Criterion(MRC)
2. Maximum Expected Return Criterion(MERC)

18. THEORIES BASED ONTHE CONCEPT
OF EXPECTED UTILITYTHEORY
■ Game theory
■ Decision theory
■ Marginal utility theory
■ Subjective expected utility theory
■ Von Neumann- Morgenstern theory

19. THANKYOU!!!