Summary and exam questions - Behavioral finance (D0o82a) part 2
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Course
Behavioral finance (D0O82A)
Institution
Katholieke Universiteit Leuven (KU Leuven)
In the following document, you will find a summary of the second part of the course 'behavioral finance'. The document will contain sample exam questions as well as a summary of the subject matter given by the prof.
Behavioural Finance Part 2
Part 1
What is a fair game: a game where neither the player not the casino has an advantage over each other
(this is not true in real life), this means that the expected value of pay-off for both parties is 0.
St Petersburg Paradox: a game where a coin is flipped and every time it’s not heads up they flip again
,you receive 2^n euro’s with n the #of tries before it hits heads up. How much would you be willing to
pay to play this game? When we estimate the pay-off this would imply infinity so you would be willing
to pay any amount to play this game, but in real life players do not enter the game for high prices even
if this is theoretically irrational.
➔ Marginal utility: money should be valued in proportion of marginal utility to the wealth you
have. In the St. Petersburg game “Decreasing marginal utility” can be seen, they compare the
utility of the loss in wealth (certain) to the utility in the gain in wealth (uncertain)
➔ This leads to an Expected Utility function which is a summation of the utility of the outcome
with the probability the outcome will happen (so the utility of paying the entrance fee should
be outweighed by the expected utility of the game)
The theory of rationality: rational individuals make choices coherently with their preferences and with
the constraints of them, this could come with some extra problems emerging from the limits of the
human ability in calculating the probabilities.
Utility theory comes with four substantive assumptions:
1. Comparability (completeness): you should always prefer on over the other or you are
indifferent. But you can always make a choice
2. Transitivity: see part 1
3. Strong independence: you’re preferences cannot change upon change in setting (decoy effect)
4. Measurability: X > Y > Z → Y = α·X + (1−α)·Z
➔ If all this axioms are satisfied, the individual is set to be rational (maximizes expected utility
instead of expected value)
The concept of expected utility is influenced by the appetited of risk a person is willing to take: most
people are Risk Averse = makes the less risky decisions.
You have three different kinds of risk attitudes profiles:
- Risk-averse
- Risk neutral: indifferent between the certain and the gamble (utility is 0)
- Risk-loving
So people suffer from cognitive restrictions making it impossible to comply to the different axioms
mentioned above, this leads to quasi rationality what leads to suboptimal decision-making via:
- Problem decomposition: where we break down the problem in different small parts and that
they’re solved sequentially (not always optimal)
- Framing: the way how something (a choice) is presented to use when making a decision about
it
, - Mental accounting: we take all other things into account when making a decision (sunken cost
fallacy)
So normative theories are not always able to explain behaviour and decision making under uncertainty,
this leads to a new theory:
Prospect Theory: in this theory we account for things as loss aversion, we make a distinction between
a our value when in the department of gains and when we are losing (framing).
Exam question: compare utility theory with prospect theory:
Utility theory: we weighted a outcome to commit a decision based upon you’re utility when deriving
the outcome weighted with the probability of the outcome. This decision is influenced by the different
characteristics of people (risk loving, risk neutral and risk averse). With risk loving the utility from the
gamble will be higher than for it’s certainty equivalent and visa versa for the risk averse person.
But people suffer from cognitive restrictions making it impossible to comply to the different axioms
mentioned above, this leads to quasi rationality what leads to suboptimal decision-making via:
- Problem decomposition
- Framing
- Mental accounting
This leads to a new concept of Prospect theory what is mainly based upon the framing of the decisions.
People are more loss averse, this is when we lose 2 euro’s it hurts us more than when we win 2 euro’s
we are happy. So decisions can be framed to computed different outcomes based on in which area of
the curve we are in when reading/making the decision. All decisions made are based upon our
reference point we are in.
Part 2
Mergers and acquisitions are on average not profitable for shareholders so why do they do this?
Overtime we see different types of M&A waves suggesting different ideas why M&A’s should be done
and are profitable, we have two main theories who explain why M&A’s happen in waves:
- Neo-classical explanation: takeover waves are associated with shocks that occur in the business
environment
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