Behavioral Finance
Unit II
Unit II
Course objectives:
• To understand the cognitive psychology
• To understand arbitrageur
• To understand the fundamental of risk
• To understand Expected utility
• To understand theories based on expected utility
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• Course Outcome
• Building block of Behavioural Finance,
• Demand by arbitrageurs
• Transaction costs and short-selling costs
• Professional arbitrage
• Destabilizing informed trading
Cognitive psychology
Cognitive psychology is the study of
mental processes such as "attention,
language use, memory, perception, problem
solving, creativity, and thinking."
Attention
• The psychological definition of attention is
"A state of focused awareness on a subset of
the available perceptual information".
• The key function of attention is to
discriminate between irrelevant data and
filter it out, enabling the desired data to be
distributed to the other mental processes.
Perception
Perception involves both the physical
senses (sight, smell, hearing, taste, touch) as
well as the cognitive processes involved in
interpreting those senses. Essentially, it is
how people come to understand the world
around them through interpretation of
stimuli.
Language
• Cognitive psychologists study how
language use is involved in mood,or
numerous other related areas.
Metacognition
• Metcognition, in a broad sense, is the thoughts
that a person has about their own thoughts.
More specifically, it includes things like:
• How effective a person is at monitoring their own
performance on a given task (self-regulation).
• A person's understanding of their capabilities on
particular mental tasks.
• The ability to apply cognitive strategies.
Definition of 'Arbitrageura
• A type of investor who attempts to profit
from price inefficiencies in the market by
making simultaneous trades that offset each
other and capturing risk-free profits.
The limits to arbitrage
• Misvaluations of financial assets are
common, but it is not easy to reliably make
abnormal This is called The limits to
arbitrage
Transaction Cost
• In economics and related disciplines,
a transaction cost is a cost incurred in
making an economic exchange
Short Selling Cost
• In finance, short selling (also known
as shorting or going short) is the practice of
selling securities or other financial
instruments that are not currently owned,
and subsequently repurchasing them
("covering"). losses, and any
Definition of 'Noise Trader Risk'
• A form of market risk associated with the
investment decisions of noise traders. The
higher the volatility in market price for a
particular security, the greater the
associated noise trader risk
DEFINITION OF 'EXPECTED
UTILITY'
An economic term summarizing the utility
that an entity or aggregate economy is
expected to reach under any number of
circumstances.
expected utility hypothesis
Expected utility is based on the expected
utility hypothesis. This hypothesis is related
with the people’s preference with regard to
their choice that have uncertain outcomes
This hypothesis states that if certain axioms
are satisfied, the subjective value associated
with a gamble by an individual is the statistical
expectation of that individual's valuations of
the outcomes of that gamble.
Expected utility models
• Expected utility of income and initial
wealth model
• Expected utility of income model
• Expected utility of terminal wealth model
Expected utility of income and initial
wealth model
• This model assumes that gains are ordered
pairs of amounts of initial wealth and
income.
Expected utility of income model
• This model assumes that gains are amount
of income.
Expected utility of terminal wealth
model
This model assumes that gains are amount of
terminal wealth
Decision making process
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Formulation of objective
Identifying the criteria for decision making
Identifying alternatives
Comparing various available alternatives
Making final decision
Expected utility as a basis of
decision making
• Expected utility theory states that at the
time of decision making, the decision maker
choose among various risky or uncertain
option by comparing their expected utilities
with respect to their needs.
Criticism
• Expected Utility Theory is a normative theory about
how to make optimal decisions under risk. It does not
say anything about how people actually take decisions in
practice.
• A related idea, the Expected Utility Hypothesis, states
that people do in fact behave as rational agents and this
is controversial within behavioral science.
• Like any mathematical model, expected utility theory is
an abstraction and simplification of reality. The
mathematical correctness of expected utility theory do
not guarantee that expected utility theory is a reliable
guide to human behavior or optimal practice.
Fundamental Risk
• Exposure to loss from a situation affecting a
large group of people or firms, and caused
by (a) natural phenomenon such as
earthquake, flood, or (b) social
phenomenon, such as inflation,
unemployment, war. Fundamental risks
may or may not be insurable.
Professional Arbitrage
In stack markets, larger volume involving
arbitrage transactions are performed by a
relatively small number of professionally
trained investors (wealth managers), who
take larger positions with their client’s
money.
Informed Trading
• Trading when based on certain information
is known as “Informed trading”
• Informed Traders are those who trade on the
basis of some information available or
provided to them.
Types of Informed Traders
(1) Fundamental Traders:Those who believe
that market will react to the events in
acertain ways which can predict the future
market prices based on these events.
(2) Technical traders
Those who use various types of charts, trends
and other trading information like prices
and trading volumes for analysis.
(3) High Frequency Traders
• Those who use and analyse complex
alogrithms to execute orders in stock
markets.
Destabilizing Informed trading
• Some activities can be attributed to
destablising of informed trading as follows:
(1) Trading in future:
Positive feedback
• Positive feedback investors buy stock when