CFA 3 - final formulas and lists (1)
LOS 4 asset manager code of conduct
Differences between Code and Standards and AMC
0:26
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0:54
6 Ways to Show Appreciation for Your Child's Teacher
six components of asset manager code of conduct
1. Loyalty to clients
2. Investment process and actions
3. Trading
4. Risk management, compliance and support
5. Performance and valuation
6. Disclosures
LOS 5 behavioral finance
4 axioms of traditional finance (utility)
1. Completeness: assumes individuals know their preferences and use them to choose between
any two mutually exclusive alternatives.
2. Transitivity assumes individuals consistently apply their completeness rankings.
3. Independence assumes rankings are also additive and proportional.
4. Continuity assumes utility indifference curves are continuous, meaning that unlimited
combinations of weightings are possible.
Contrast Utility theory and prospect theory?
a. utility theory....
associated with TF
,- 1) Function is concave; as more wealth/value is added, the utility (satisfaction) increases at a
diminishing rate.
- 2) Leads to convex indifference curves due to diminishing marginal rate of substitution.
Problems with utility curve..
Ignore that individuals don't think like this...
Also ignore events like recession when jobs scarce
Prospect theory....(2 phases)
- Prospect theory: Framing decisions as gains or losses and weighting outcomes
Utility theory = assume risk aversion
Prospect theory = assume loss aversion
- 2 phases of prospect theory
1) editing phase
2) evaluation phase
Editing phase (CCSCSD)
1) editing phase:
Frame proposal using decision rules to simplify the number of choices before making the final
choice. Also called isolation effect:
Codification: codes the proposal as a gain or loss of value and assigns probability to each
outcome
Combination: simplifies outcome by combining those with identical values
Segregation: used to separate expected return into both risk free and risky component of return.
Next 3 apply when comparing two or more proposals
- Cancellation: remove outcomes common to two proposals. Overlapping not affect decisions
- Simplification: apply to small differences in probabilities or highly unlikely outcomes.
- Detection of dominance: would discard from consideration any proposal that is dominated. EG
50/50 chance of $500/$700 reward vs 50/50 chance $400/$600 reward
Evaluation phase
evaluation phase:
focus on loss aversion vs risk aversion....loss aversion more concerned with change in wealth
than level of wealth.
,Investors place values on alternatives in terms of weighted probability outcome to determine
expected utility.
Bounded rationality
- Bounded rationality
Assumes knowledge capacity limits and removes assumptions of perfect information, rational
decision making and consistent utility maximization
Instead - only outcomes that offer sufficient satisfaction but not optimal utility
Summary of TF versus BR and prospect theory
Utility Theory VS Prospect Theory
4 alternate models to TF theory....
1. CS
2. BAPM
3. BPT
4. AMH
1. Consumption and savings
2. Behavioral asset pricing model
3. Behavioral portfolio theory
4. Adaptive markets hypothesis
Consumption and savings
1. Consumption and savings
a. TF assumes being able to save and invest early in life to fund retirement. Requires self
control. C&S proposes alternative live cycle that questions self control and mental biases
framing wealth as current income/assets owned/
b. TF assumes all forms of wealth are interchangeable. BH presumes people less likely to
spend from current assets and expected future wages
Behavioral asset pricing model
2. Behavioral asset pricing model
a. Adds a sentiment premium to traditional asset pricing (like CAPM) to the discount rate
i. Rr = Rf rate + fundamental risk premium + sentiment risk premium
ii. Sentiment premium also = stochastic discount factor (SDF)
, Behavioral portfolio theory
3. Behavioral portfolio theory
a. Investors construct portfolio by layers
b. BPT says investors concentrate in either risk free or very risky assets
c. Allocation depends on...
i. Goal of investor
ii. Asset selection done by layer and goal for each
iii. # of assets
iv. If investor believes they have an information advantage
v. If an investor is loss averse - may need liquidity
Adaptive markets hypothesis (AMH)
4. Adaptive markets hypothesis (AMH)
a. Success evolutionary...evolve process through trial and error
b. AMH based on BF...satisfaction vs utility
5 conclusions from AMH?
5 conclusions of AMH
i. Relationship of risk/return shouldn't be stable. Market risk premium changes over time
ii. Active management can find opportunities and add value
iii. No strategy should work all the time
iv. Adaptation / innovation essential to process
v. Survivors change/adapt
Los 6 behavioral biases individuals
Cognitive errors:
Belief perseverance (5)
(C-C-R-IOC-H)
1. conservatism
2. confirmation
3. representativeness
4. illusion of control
5. hindsight
1. Conservatism bias
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