IOP3708_EXAM_NOTES
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IOP 3708 NOTES
Specific Outcome 1
Specific Outcome 1: Students can describe and discuss behavioural finance, neuroeconomics, firstly in terms of
background, conventional finance, prospect theory and market efficiency; secondly the behavioural science
foundation...
Specific Outcome 1: Students can describe and discuss behavioural finance, neuroeconomics, firstly in terms of
background, conventional finance, prospect theory and market efficiency; secondly the behavioural science
foundations of heuristics and biases; overconfidence, and emotional foundations and thirdly, in terms of the
history of decision making
Assessment criteria:
• Theories and definitions of behavioural finance and behavioural economics and Neuroeconomics are
researched to explain investment behaviour and the challenges to market efficiency
• Standard economic theory and behavioural economic theory are compared with examples. Prospect theory,
framing and mental accounting are defined, described and applied to explain behaviour
• Systematic biases, heuristics, overconfidence, emotional foundations and values distortion are defined. How
these cause investors to behave irrationally or contra to their espoused values are discussed with reference to
recent events
• The emerging field of Neuroeconomics, how it relates to behavioural finance and what contributions it could
make
• The outcome will be assessed by the student’s ability to demonstrate how psychological concepts, principles
and theories affect investment decisions in written assessments and an open book exam where integration
and application is assessed. Specific Outcome 1
Differentiate the following concepts (5 marks each)
Prospect Probability distribution
- Prospect in economics terms refers to a series of wealth - Statistically, probability distribution refers to the
outcomes or advancements in profits which are associated allocation of those wealth outcomes that is then linked
with a certain probability. to each outcome therefore indicating the probabilities
- To which the probability in this case is the likelihood that linked from lowest to highest expected values from
something may or may not occur. which the investor can chose from.
Risk Uncertainty
- Risk in financial terms can be described as a threat to loss. - Uncertainty simply refers to an outcome that is
- When an investor is faced with risk, it is important to know completely unknown and this is when the wealth
and select from a list of probabilities to measure their loss in a outcomes cannot be assigned to any probability.
case where the prospect responds negatively and have a plan - Here there are probabilities that can be linked to any
on how to mitigate such outcomes outcome and this can create a negative investor
- This is because the expected return might turn to be lower confidence in them wishing to buy such assets.
than the actual return promised by a particular asset.
Utility function Expected utility
- Utility function in this case refers to identification of -
preference to potential outcomes according to the expected
returns that will bring about satisfaction to the investor.
- Utility measures to size of the cash flow or wealth outcome
linked to their probabilities from least desired to the most
preferred from the distribution list or table where investors
can make their choices relative to the available probabilities.
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,- The significant function of utility is to also reveal the risk
preferences from several options of probabilities available.
Risk aversion Risk Seeking Risk neutrality
- Risk aversion refers to the type of investors - Risk seekers are investors who - These are indifferent type of
are reluctant to take risk or avoid it are always in search for investors to risk, making them to be
altogether usually in a case whereby they investments that are volatile in-between the risk averse and
have two or more options of investments. in nature or behaviour and seeking.
- These types of investors always settle for usually associated with - Their main focus is on the expected
the asset with a lower risk with rather uncertainly with the risk of value of an asset and they are not
guaranteed returns even if it means they higher gains or losses. bothered by the risk it is associated
are relatively low than choosing a high risk - In the investment world, risk with.
investment linked to uncertainty. seekers usually gambling - Their choice of investments is not
behaviour and are not determined by the level of
terrified by risk uncertainty involved.
Differentiate between the following concepts
Systematic risk Unsystematic risk
- Systematic risk, which is also referred to as “market risk” - Unsystematic risk which is also well-known to as
or “un-diversifiable risk” is the type of uncertainty that is “specific risk” or “residual risk” refers to the nature
inherited as a result of the market environment in which of uncertainty that is inherent by the environment of
they exist. the industry one invests in.
- Types of assets under this environment often have - The advantage about the unsystematic risk is that
behaviour of day-to-day fluctuations that may change the trends that are within the industrial environment in
direction of the investment to whether the expected which may exist can be mitigated, for example;
return it will exceed or fall short. interruptions like boycotts that bring uncertainty into
- Uncontrollable factors such as interest rates, changes in companies one has invested in pose a risk to assets
the economy will always impact on the stock market.
Beta Standard deviation
- Beta in terms of the financial market is a tool that - On the other hand, the standard deviation is a tool
measures risk of the market as a whole. that is used to measure the risk for individual or a
- In other words the beta measure the unpredictability specific stock in the market.
referred to as “volatility” in financial terms in the entire - The standard deviation focuses on the total risk
market associated with a stock.
Direct agency costs Indirect agency costs
- These are costs that a broker or any outsourced - Indirect costs refer to cost incurred to for an example
management consultant is in their benefit than that of the a missed opportunity than could have been chosen
investor. instead of the alternative. An example of this could
- Cost of this nature are quantified to specific objects such be Investment A against Investment B.
as the agency’s commission or incentive from an - These of cost are usually not traceable to any
investment ventured into. particular cost object
-
Weak form of market efficiency Semi-strong form of market efficiency Strong form of market efficiency
- Weak form of market efficiency - On the semi-strong, the market is - Here all information be either
implies that is efficient under the efficient public or private is not withheld
condition that information - All relevant information in this regarding a stock.
regarding past performance is has form of market is publicly - This disadvantage though is that
no relevancy to current stocks. revealed from the past to most returns are based on average for all
- The prices of these stocks are recent partaining a stock. investors with the knowledge or
independent of any historical without.
returns.
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, Differentiate between the following concepts
Lottery Insurance
- Lottery in this regard refers to an attitude of investors - Insurance here refers reluctance to risk,
regarding risk. - Risk averse investors on the other hand look for
- Risk seeking kind of investors has a gambling nature certainty where they put their money.
because they forever sought after high returns and are not
terrified by the degree of risk associated with it.
Segregation integration
-
Risk aversion loss aversion
- Risk aversion refers to the type of investors are reluctant - Loss aversion refers to people avoiding risk in any
to take risk or avoid it altogether usually in a case whereby way they can
they have two or more options of investments - These types of investors would rather settle for type
- In this case these investors prefer lower returns with a of investments with zero returns than losing a penny
degree of certainty that a higher return associated with of what they invested.
uncertainty. - These are more of risk neutral kind of investors
Weighting function event probability
- -
Differentiate between the following concepts
Momentum Reversal
- Momentum - Reversal refers to fluctuations in prices of assets
- Momentum strategy invested in responding to trends in the market
- Reversal strategy follows a negative relationship in
buying and selling of assets
Value stocks Growth stocks
- Value stocks are stocks commonly referred to as - Growth stocks on the other hand higher in prices
“undervalued” due to their nature of lower prices relative to relative to dividends or earning associated with
factors they are based on like dividends or earnings. them, this is because of higher expectations I future
- Though these stocks are low in price, commonly they are growth
characterised by high dividend yield. - Their nature is not to pay dividends but reinvesting
for capital gain in future.
Fundamental risk Noise-trader risk
-
Carve-out Stub value
- Carve out is where a principal company decides to sell an - Stub value refers to the residual value left over after
equity stake of some of its subsidiary portfolios or any a principal company has outsourced some of its
business unit to outside investors portfolios due to either a demerger, restructuring
- In other words certain business units are outsourced in order amongst other things.
for the company to focus mainly on it core business. - This could be a result of the buying out company
offering a lower price than the actual value
• Arbitrage is limited because the wealth of arbitrageurs is limited. Discuss this statement in the
context of those managing their own money and those managing other people’s money
o Arbitration involves the simultaneous buying and selling of securities in pursuit to lock in a
risk-free profit
o When investors who are on the lookout for opportunities identify a mispricing, naturally they
will try to take advantage through their trading.
o Market efficiencies suggest that the collective action of such traders opportunities be
arbitraged away
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