Finance Webcast 7A

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5 Terms

1
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What is the behavioural critique?

Investors are not rational, or cannot act as if they were rational, therefore mispricing can survive even in efficient markets.

2
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What are the 3 limits to rationality?

  1. Information processing

  2. Behavioural biases

  3. Limits to arbitrage


3
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One of the limits to rationality is information processing. Give the 4 parts that information processing is made up of.

  1. Limited Attention - individuals have a limited amount of time and attention to procss information and as a result often resort to heuristics procedures for decisionmaking.

  2. Overconfidence - Individuals tend to overestimate the precision of their estimates, because of cultural and psychological reasons.

  3. Conservatism - Agents are too slow in updating their beliefs, and as a result tend to underreact to news.

  4. Extrapolation - Individuals have the tendency to identify patterns in the data (even when they are not there) and to believe that a pattern generalizes to the entire population (representative bias)


4
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What are the five behavioural biases?

  1. Framing: the decisions made by individuals depend on how the choice is framed

  2. Mental Accounting: individuals segregate decisions (in time and space) and as a result investors make incoherent choices.

  3. Regret Avoidance: individuals who make poor decisions have more regret when the decision was unconventional.

  4. Affection: investors attach feelings to stocks and assets.

  5. Prospect theory: agents derive utility not from the actual level of wealth but from changes in the level of wealth.


5
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What are the 3 limits to arbitrage?

  1. Fundamental Risk “the market may remain irrational longer than you can remain solvent” - Keynes

  2. Transaction Costs - investors cannot trade as much as they would need to exploit mispricing. Examples: short-selling is expensive, investors may not lever up as much as they want, misprices stocks may be illiquid.

  3. Model Risk - Mispricing crucially depends on the model used to estimate the “correct” price. If investors do not know if the model they use is correct, they may find it rational not to exploit the apparent mispricing.