Behavioral Assignment

For example if the company is per ashesing admirably, your payments be not going to outgrowth, but if you comp ar this situation With an equity investor, the grocery store leave al one and only(a) incorporate to the declination equipment casualty these results and your remover forget be naughtyer. On the other hand if the company Starts having some problems and cannot achieve its goals, your payments go out remain the same.This situation save changes when the default risk increases, and this doses t happen in a very quick span of time In the human face of equity, the scope for disagreement is larger and more sensitive, because the payoffs ar un veritable and take care on the beliefs of the fundamental value of the company. It can be also seen below that equity payoffs are linear with reward to investor beliefs in relation to underlying summation value however, debt up-side payoffs are fixed at some constant rate, ND are consequently non-linear (I. E. Concave) in the investor beliefs somewhat the fundamental value.Source Hong & Serer 2011 b) Safe debt has less default risk than risky debt, which fee-tails that its payoffs are more protected and the payoff graph has a more cotyloidal work. The more secure an asset is, the less sensitive the investors are to the beliefs about fundamentals. The upside is here more bounded and is less sensitive to disagreement. When a seize is more risky on that prefigure is a greater luck for default and the investors are more sensitive to the changes in the fundamental value of the company. Beliefs start having a greater influence on the asset valuation.In the following formula we can see that if the default luck is very low, the safe debt payoff pass on also be lower and less sensitive to disagreements. C) When optimism increases investors start seeing debt more as a risk-free asset that has less upside with reduced resale option. come up optimism leads to larger misprinting. In this scenario the optim istic investors will continue to buy the bonds from the pessimistic investors, so there will be more optimistic investors holding the asset and the disagreement among the investors will be owe, and lead to a lower worth volatility.The bond will also bind less turnover. The pessimistic investors won t become optimistic, they just want to transmit their bond. The model suggested by Hong and Serer(2013) considers a two-date trading model with dates t -?O, 1, N risky assets and the risk-free rate as r. The dividend delivered by the risky asset at time t=l is given by the equation , where represents the cash flow beta of asset I, and is the pronounce of the macro economy.There are two groups of investors 1) The optimists (group A), who believe that the economy will be better in t=l -b EAIz = +h 2) The sometimes(group B), who believe that the economy will be worse 3) So the expected difference between optimists and pessimists is given by EAIz BEz = When is slim (I. E. Low macro dis agreement) , the equilibrium charge will depend both(prenominal) on the optimists and pessimists valuation, equaling However, when X is large (high disagreement about future macroeconomic conditions), the demand of pessimists (given by ) is so low that it will hit footling sale constraints.Thus, the equilibrium price will be determined only by optimists valuation, since the pessimists will be sidelined from the market . This equilibrium price is higher than the unconstrained price, which means that the stock N will be over-priced, collectible to high macroeconomic disagreement about fundamental factors, when compared to the traditional CAMP model prediction. As predicted by the dividend equation , the higher the beta of the stock, the higher the effect of the disagreement about its future cash flows will be.Thus, in short-sale constraints will occur with higher probability for high-beta, high risk stocks. Short-sales constraints might be binding for some investors due to instit utional reasons. An example are mutual funds, which are prohibited to worth stocks presently by certain government acts and regulations. According to the arguments above, misprinting is more enunciate for high- beta stocks or for periods of higher disagreement. Thus, stocks from higher beta sectors such as technology, consumer retail, automotive, construction are more equally to experience overpricing and bubbles.Higher disagreement occurs either at times, when market optimism prevails -? continuous bull markets, combined with expansionary monetary policy for prolonged period, or when market pessimism prevails crisis times, described by high volatility ND panic sell-offs, causing stocks to be undervalued. Bubbles are often hard to detect and ascertain, but dispose to form close often when certain industry sectors are experiencing a technological transmutation. Bubbles, crashes and financial crisis have been a repeating occurrence for long (e. G. He south Sea Bubble, canals and railroads in the 1 sass, the Internet in the sass) (Predetermine & McKee, 2012). A technological revolution in an industry causes a boom in asset prices however, as the momentum of the bubble increases, the rise in prices cannot be justified anymore by fundamentals as people continue to make ever-rising valuations. It is difficult to delineate an assets true fundamental value, and this is especially true for new technologies that have may seem as the next big thing, but have uncertain long prospects.Similarly, pastor & Versions (2008) argue that bubbles in stock prices can occur aft(prenominal) technological revolutions if the productivity of the technology to be implemented is unknown and subject to learning. This usurps both the level and volatility of stock prices. Critically, stock prices of innovative firms initially rise due to optimism and DOD news about the productivity of the firm due to the technological innovation, but eventually fall as the technology risk alters from affecting only the firm to being systematic (Pastor & Versions, 2008).The bubbles can only be discovered retrospectively, and are most greatly amplified in revolutions than involve high uncertainty and fast adoption. For example the expansion of both railroads in the sass and internet fundament in the 1 sass was characterized by overstatement that ultimately depressed prices on an aggregate level as additional projects had negative returns due to industrialization.Also, in the case of the internet bubble, investors were lured in to invest by promising companies such as Amazon and America Online, but later companies had often no predilection how to be commercially viable and essentially were riding the bubble (Dominant, 2014). Bubbles may hence be amplified by speculation and the idea that individuals observe and adopt the style of others (Levine & Jack, 2007). Especially in the case of the internet bubble optimists tend to push up the asset price, whereas more pessimistic i nvestors cannot counterbalance this due to short-sale constraints (Predetermine & McKee, 2012).Thus genealogical revolution tends to lead to projects with initial profits, and leads to overoptimistic tendencies for the whole industry. As prices exceed fundamentals and new entrants/projects turn sour, the bubble eventually collapses. In the case where there is only one share of the asset available and there is one optimist and one pessimist in the market, the pessimist will sell the asset to the optimist at a price higher than the mean evaluation of the two investors.Here the single optimistic buyer can absorb the entire supply of one share. The average price is 75, thus the traded price will be in the range 75. The traded price rises when there are two homogeneous groups Of investors, I. E. When there are more optimistic traders in the market. They will period of play up the price until it reaches the valuation of the optimists, I. E. 100. This will be the traded price. Thus, as m atch to Miller (1977) without short selling the price of the asset is increased if there is a divergence of opinion.In such a market the demand for the asset will come from the traders who have the most optimistic expectations of its value. The most optimistic investor tends to win the tender and their evaluation of the asset ends up being its actual price. This can be also seen in the diagram below. Supply is inelastic at N, so the price is higher than the equilibrium rate. Only optimistic traders will trade at the prices where the demand curve meets the inelastic supply curve.Also, as seen in the diagram, different investors have different demand curves the most optimistic one will have the highest valuation. (Source Miller, 1977) Due to the binding short selling constraint, less optimistic traders who would like to short an asset cannot do so. Thus this is necessary for optimists to be able to set prices. Also volume is crucial. The more optimists there are will signify that the assets price will be bid up to the valuation of optimists. This is especially true when the asset is scarce (e. . Only one or a few exist), as in this case there will be ample demand by the optimists (who may be a minority in the market) bid up and set the prices. The price of a security is higher the greater the divergence of opinion about the return from the security (Miller 1977). So we can say that if there is a big divergence of opinion in the market, the price will be even higher because the price only reflects the optimistic investors, and this also causes more volatility and more risk to the stock. Since the annual discount rate is a variable, and the time to maturity T is a constant, we can apply the rule then the expected value that the optimist attaches to the bond is given by , 51 once The expected value Of the pessimist is given by b) The difference of the natural logarithms of their attached value is In According to the result, there is a positive correlation between the bond maturity T and the level of the disagreement between the investors, so the yearlong the bond maturity T, the higher the disagreement between the optimist and the pessimist will be. ) According to Miller (1977) the greater the disagreement the higher the rice. As we saw in the introductory step bonds with longer maturity have greater disagreement, which leads to stronger misprinting because the price of the bond will only be affected by the optimistic investors (since pessimistic investors cannot affect the prices because of short-sale constraints). Thus, misprinting will be more pronounced at the long end of maturities, than at the short end.Also the longer the maturity of the bond the higher the expected return, match to a regular bond yield curve. If misprinting is more pronounced, the price of bonds will go up, causing a shift down(prenominal)s in the lied curve, so average realized bond returns should be lower than the expected. A) Investor B starts with rational b eliefs at t-?O, so his expectation of an upward move is 10=0. In case of an upward move at boss u his expectation of an upward move TTL is given by , A further move up to military position u will give A move down to position dud gives An initial downward move to d yields Going another node down to ad And moving up in the second period to du gives b) Investor Bis beliefs about the value of the stock seem irrational at point dud and du since at dud his expectation of an upward move is , go at du it equals . Actually these positions represent one and the same point on the binomial tree, where the fundamental value of the asset should be constant.Behavioral assignmentEven though according to Prospect theory the individualistically bit is concave in the gains region, implying that they are risk averse, its shape changes to convex for very small probabilities. Usually people treat the outcomes based on a reference point, usually their current wealth, from which they evaluate gains and sackes. For that reason a certain gain of $1 0 is not perceived as bringing any significant utility to lets say average middle-class individual, while the possibility, even though small, of winning SIS 000 would actually bring a quite significant change to his wealth.The opposite goes for the perceived utilities and the utility function, when in the loss region. Even a small probability of losing a significant amount ($10 000), which will severely affect the wealth of the individuals is misperceived as relatively high and undesirable as opposed to the certain, but small loss of $10, which will not affect the wealth of the person around his reference point.Some real feel analogues of the conducted experiment might be buying a lottery ticket, where the individual even gets a small, but negative payoff, on average, or establishing a start-up business, where an enterpriser invests capital with the hope Of receiving higher return in time, instead of investing the cash in a bond or a bank nonplus at a risk-free rate. Examples for certain small losses might be a person buying insurance policies and paying a small premium, but avoiding the risk of theft, road accident etc. Q.The distribution is not normal, but rather positively skewed, with higher percentage of positive earnings storm than negative. There is also bunching at the O value, inferring a high probability that the average of analysts forecasts coincides with the actual earnings reported. This distribution of recast errors actually implies that analysts have a downward bias when producing their estimations. A reason for this might be that analysts have asymmetric loss function, implying that they can be more harshly punished for under-prediction than for over-prediction.This is due to reactions of investors who, in most cases, have prospect theory utility functions, rather than conventional expected utility functions I. E. Their losses hurt more than gains of the same magna etude increase utility. In terms of the earnings surprise this means that when the actual earnings miss analysts projections, he negative returns on stocks in the following days are much more pronounced due to investors unwilling to hold the stock and selling with larger volumes.In the opposite case of a positive surprise, investors utility function is less steep in the gains region and the magnitude of increased purchases of the stock is less pronounced. Boon and Woman (2002) estimate at least six reasons for the analysts downward bias when producing forecasts internal pressures for earning higher brokerage commissions, pressure from management of companies that analysts cover, herding behavior to follow other analysts projections, pressure from large institutional investors that analysts work with, conflicts with analysts personal investments or unintentional cognitive biases of the analysts.Other plausible reference points in terms of expected earnings might be results from past quarters + some premium/dis count, depending on how the company performed in the most recent quarter, or the earnings reported by companies, operating in the same industry I. E. Competitors. Investor A If the stock goes up, he would be sweller to sell in order to realize his gains. The Prospect Theory utility function, which is concave in the region of gains, wows us there will be a point where an increase in his profit will bring very low marginal utility, so at this point the investor would be keen to sell.If we assume that the investor bought when , the more the stock rises and moves into more concave regions, , until it reaches the point of sell If the stock goes down, he will hold the stock because he won t accept his loss and try to hold it until the price of the stock returns to the price where he bought the stock (his reference point). He would be more concerned with the capableness value of losses and gains than the total wealth outcome, so he would be more inclined to sell when the stock was in the gain-making region, and less likely to sell and more likely to hold at the loss-making region.This is an observation of the disposition effect, tested by Dean (1998). Investor B If the stock goes up he will like to buy more shares. As an optimistic investor, he would trade more because of the profits that he is making, and the belief that he has information that others don t and that if the stock its going up, the momentum is likely to continue. If the stock goes down, he will like to sell because for him the market its telling him that this stock its not worth holding anymore.The most important thing for him in order to make a decision for buy or sell is to receive a signal from the market and as an overconfident investor he would think that he has information that the market doses t and could benefit from that In other words he will consider the stark(a) noise from the stock price movement as a signal and overweight it () The two investors could trade when the price of the stock rises, relative to their reference point because in that point investor A is more willing to sell and realize the gain and investor B is more willing to buy, because of the overestimated weight on the signal.Also they could trade when the price goes down and reaches a certain point when investor A no longer can hold the position (has sustained huge losses) and investor B could get a signal from the market, that the stock is already undervalued. A) 1 . Overstatement empirical data show that there are cases when Coos truly believe that certain investment policies are creating value for the company. However, their beliefs are quite often in discrepancy with the broad view of market participants, which is reflected in the stock value.These investment incentives are more pronounced in companies, that are cash rich, nice Coos will not be constrained by lack of funds and allocate the available cash according to their overconfident beliefs. 2. Corporate Financing instead of opting for th e more rational choice of choosing sustainable mix of debt and equity financing, combined with the use of the companys outstanding cash, overconfident Coos tend to use larger percentage of financing with cash or debt, since they consider equity financing excessively costly and believe that the market is undervaluing their company. . Overbidding in acquisitions donnish research has found evidence that overconfident Coos overestimate their ability to generate returns for their company. This is why such Coos have a tendency to overpay for target companies and assure mergers that actually bring lower than expected value. A proof for this might be found in market reactions after announcement, where the negative return after the announcement is more pronounced for companies, whose managers are considered as overconfident by investors.In the last two decades U. S firms spent more than $ 3. 4 trillion on mergers, and if chief executive officer s were thinking only about the interests f their shareowners probably they would have acted in a different way, because their actions caused losses amounting to roughly $220 billion (Maintained, Tate 2007). B) CEO cocksureness does not necessarily have to be a bad thing, since this aspect is quite closely con nested with affinity to taking higher risk.Higher risk, in turn, might lead either to more pronounced negative or positive outcome for the company, and thus also allowing for a beneficial outcome to shareholder interests. Also, such individuals, for reasons connected with their genetics or upbringing, are among the most successful and influential people n society. As discussed in the paper CEO overconfidence and innovation by Galas, Simoom (2011 more confident Coos tend to disregard the risk of failure and thus more eagerly indulge in R&D and innovation strategies, which eventually bring higher value to shareholders.Real life examples of such Coos might be Steve Jobs (Apple Inc. ), Leon Musk (Tests Motors). Question 5 In the presented case, an overoptimistic person will tend to have higher anticipatory utility during his youth, but eventually as time progresses the actual realization will with a high probability be less than his anticipations, so e will get lower realization utility. The total utility he gets will depend on the weights he puts on those two utilities.If you educate your child to be overoptimistic, in the future for example when he receives his pension fund he will expect certain amount of money, lets say $1,000 per month, but instead if he actually receives $900 he will feel as if he lost $100, regardless if that amount of money represents a good income for him or not. On the other hand if he receives $1 r 1 00 he won t feel the gratification of having more money. The feeling when you lose is deeper than when you win.