Behavioral Assignment

For simulation if the company is playacting admirably, your payments ar non going to increase, but if you comp argon this situation With an virtue investor, the commercialise pass on incorporate to the farm animal care for these results and your re travelr allow be higher(prenominal). On the other moot if the company Starts having intimately problems and burnnot achieve its goals, your payments forget remain the same.This situation only changes when the default risk of infection increases, and this doses t make it in a really quick span of time In the topic of equity, the scope for contrariety is giantr and more than than stark naked, because the payoffs are unsettled and dep conclusion on the spirits of the central apprize of the company. It enkindle be likewise seen below that equity payoffs are linear with respect to investor beliefs in intercourse to underlying plus value however, debt up-side payoffs are fixed at some constant rate, ND are co nsequently non-linear (I. E. Concave) in the investor beliefs rough the fundamental value.Source Hong &038 Serer 2011 b) Safe debt has little default risk than risky debt, which means that its payoffs are more protected and the payoff graph has a more saucer-shaped shape. The more secure an asset is, the less sensitive the investors are to the beliefs nearly fundamentals. The upside is here more bounded and is less sensitive to disagreement. When a bond is more risky at that place is a great prospect 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 pursuit formula we stinkpot see that if the default fortune is very low, the steady-going debt payoff implement also be reject 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. Rising optimism leads to larger misprinting. In this scenario the plausive investors provide continue to deal the bonds from the pessimistic investors, so on that pinnacle ordain be more starry-eyed investors holding the asset and the disagreement among the investors entrust be owe, and lead to a lower hurt volatility.The bond go forth also have less turnover. The pessimistic investors won t sound positive, they just want to grass their bond. The model suggested by Hong and Serer(2013) analyses a two-date merchandise 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 pr one(a) by the equation , where represents the cash flow beta of asset I, and is the state of the macro economy.There are two groups of investors 1) The optimists (group A), who study 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 appreciate bal ance between optimists and pessimists is given by EAIz BEz = When is flyspeck (I. E. Low macro disagreement) , the balance wheel monetary value will depend both 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 short sale constraints. then, the equilibrium price will be determined only by optimists valuation, since the pessimists will be sidelined from the commercialize . This equilibrium price is higher than the un bound price, which means that the telephone circuit N will be over-priced, collect 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 parenthood, the higher the effect of the disagreement about its future cash flows will be.Thus, short-sale constraints will transcend with higher proba bility for high-beta, high risk stock(a)s. Short-sales constraints might be binding for some investors out-of-pocket to institutional reasons. An example are mutual funds, which are prohibited to deserving stocks directly by real government acts and regulations. According to the arguments above, misprinting is more pronounce 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 likely to experience overpricing and bubbles.Higher disagreement occurs all at times, when securities industry optimism prevails -? continuous bull commercialises, combined with expanding uponary m 1tary insurance for prolonged period, or when market pessimism prevails crisis times, described by high volatility ND panic apportion-offs, causing stocks to be undervalued. Bubbles are often punishing to detect and as legitimate, but tend to form approximately often when certain industr y sectors are experiencing a technological revolution. 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 &038 McKee, 2012). A technological revolution in an industry causes a boom in asset prices however, as the impetus 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 draw an assets true fundamental value, and this is especially true for new technologies that have may seem as the next big thing, but have incertain long-run prospects.Similarly, ancientor &038 Versions (2008) argue that bubbles in stock prices can occur after technological revolutions if the productiveness of the technology to be implemented is cabalistic and subject to learning. This impresss both the level and volatility of stock prices. Critically, stock prices of inn ovational firms initially rise due to optimism and DOD news about the productivity of the firm due to the technological innovation, but so fartually fall as the technology risk alters from partakeing only the firm to being self-opinionated (Pastor &038 Versions, 2008).The bubbles can only be observed retrospectively, and are most(prenominal) greatly amplified in revolutions than involve high uncertainty and fast getion. For example the expansion of both railroads in the sass and internet infrastructure in the 1 sass was characterized by overstatement that ultimately depressed prices on an inwardness level as additional projects had negative returns due to industrialization.Also, in the human face 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 stem how to be commercially viable and essentially were riding the bubble (Dominant, 2014). Bubbles may hence be amplified by speculat ion and the idea that individuals observe and adopt the behavior of others (Levine &038 Jack, 2007). Especially in the case of the internet bubble optimists tend to push up the asset price, whereas more pessimistic investors cannot counterbalance this due to short-sale constraints (Predetermine &038 McKee, 2012).Thus genealogical revolution tends to lead to projects with initial profits, and leads to overoptimistic tendencies for the whole industry. As prices lapse 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 angiotensin-converting enzyme 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 ther e are two homogeneous groups Of investors, I. E. When there are more optimistic traders in the market. They will bid up the price until it reaches the valuation of the optimists, I. E. 100. This will be the traded price. Thus, as consort to milling machine (1977) without short sell the price of the asset is increase if there is a disparity of opinion.In such a market the demand for the asset will come from the traders who have the most optimistic anticipations of its value. The most optimistic investor tends to get along the bidding 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 exactly (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 judge 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 dissolve rate is a variable, and the time to due date T is a constant, we can apply the rule Then the evalua te value that the optimist attaches to the bond is given by , 51 once The evaluate value Of the pessimist is given by b) The difference of the natural logarithms of their attached values 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 longer 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 previous graduation 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 marked at the long end of maturities, than at the short end.Also the longer the maturity of the bond the higher the expected return, accordin g to a regular bond yield curve. If misprinting is more pronounced, the price of bonds will go up, causing a shift downs in the lied curve, so average realized bond returns should be lower than the expected. A) Investor B starts with rational beliefs at t-?O, so his expectation of an upward move is 10=0. In case of an upward move at thickener u his expectation of an upward move TTL is given by , A further move up to 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 , while 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 nominee theory the individualistically function is bur siform in the gains region, implying that they are risk averse, its shape changes to convex for very small probabilities. Usually people diplomacy the end points based on a computer address point, usually their current wealth, from which they evaluate gains and losses. For that reason a certain gain of $1 0 is not perceived as imparting any significant emolument to lets feel out 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 antagonist goes for the perceived utilities and the utility function, when in the loss region. Even a small probability of losing a significant amount of money ($10 000), which will poorly affect the wealth of the individuals is misperceived as intercoursely 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 life analogues of the conduct ed test 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 money in a bond or a confide deposit at a risk-free rate. Examples for certain small losses might be a person buying insurance policies and salaried a small premium, but avoiding the risk of theft, road accident and so forth Q.The scattering is not normal, but rather positively skewed, with higher fortune of positive earnings surprise 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 mor e 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 overtop analysts projections, he negative returns on stocks in the following days are much more pronounced due to investors unwill 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 instancys for earning higher brokerage commissions, pressure from management of companies that analysts cover, herding behavior to follow other a nalysts 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/discount, 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 crisper 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 potential value of losses and gains than the quantity 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 pulsing 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 all-important(prenominal) thing for him in order to make a decision for buy or sell is to receive a signal from the market and as an plus 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 pure noise from the stock price movement as a signal and over clog 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 carry on 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 p articipants, 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 over self-assured beliefs. 2. Corporate Financing instead of opting for the more rational prime(a) 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 scholarly research has found evidence that overconfident Coos overestimate their ability to generate returns for their company. This is why such Coos have a tilt to overpay for target companies and undertake mergers that actually bring lower than expected value. A proof for this might be found in market reactions afte r 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 CEO s were thinking only about the interests f their shareholders 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 opinion 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 story CEO overconfidence and innovation by Ga las, Simoom (2011 more confident Coos tend to disregard the risk of failure and thus more thirstily indulge in R&038D 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). heading 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 ha nd if he receives $1 r 1 00 he won t feel the satisfaction of having more money. The feeling when you lose is deeper than when you win.