Topic 9 - Behavioural Finance

• Market Efficiency

  Right prices imply no arbitrage opportunities
• No free lunch


  Does not necessarily imply prices are right
• Arbitrage opportunities may stay persistently unexploited
• Limits to arbitrage

  • Carrying out arbitrage is not always costless: information is costly, trading is costly, obvious profits are reality risky (see financial crisis)
• Investors

  Are not rational, i.e., they do not maximize profits by exploiting price patterns
• "no free lunch"

  Does not imply "prices are right"
• Mispriced assets

  • There are strategies (portfolios) that may correct the mispricing, but they are often very risky
• Risk-averse rational investors may be unwilling to put such risky strategies in place, allowing the mispricing to survive
• Lack of short selling

  May be explained by loss aversion
• Value function u(x)

  Increasing in x, concave for gains (x > 0), convex for losses (x < 0), has a kink at the origin, factor λ represents loss aversion
• Loss Aversion

  The segment of the value function curve representing losses is steeper than that representing gains, reflecting the fact that for the representative individual, losses hurt much more than commensurate gains help
• Despite the positive expected value, most people find this lottery unappealing because the psychological cost of losing £100 is greater than the psychological gain of earning £150
• Implication of loss aversion for utility theory

  Decisions in the face of uncertainty are path dependent
• If an individual gains £500 and then loses £500, traditional wealth-based utility theory would predict no change in happiness, but under prospect theory, the individual would feel an overall loss in happiness if the reference point was reset to the wealth level after the gain