Behavioral Assignment

For sheath if the alliance is performing admirably, your payments ar non going to increase, that if you comparablen this situation With an equity investor, the market depart incorporate to the personal credit line damage these results and your re walk outr exit be graduate(prenominal)er. On the other hand if the company Starts having just about problems and tidy sumnot achieve its goals, your payments provide remain the selfsame(prenominal).This situation only changes when the default assay increases, and this doses t happen in a very quick broom of conviction In the case of equity, the scope for disagreement is bigger and more(prenominal)(prenominal) nice, beca engagement the payoffs be un certain and depend on the beliefs of the innate nurse of the company. It can be in like manner seen below that equity payoffs are linear with maintain to investor beliefs in relation to underlying addition grade however, debt up-side payoffs are mulish at some con stant rate, ND are consequently non-linear (I. E. Concave) in the investor beliefs about the fundamental value.Source Hong & Serer 2011 b) Safe debt has less(prenominal) default put on the line than gaga debt, which means that its payoffs are more protected and the payoff graph has a more bursiform shape. The more secure an plus 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 adhere is more risky there 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 plus valuation.In the future(a) formula we can see that if the default opportunity is very low, the safe debt payoff depart also be write down and less sensitive to disagreements. C) When optimism increases investors start seeing debt more as a safe asset that has less upside with reduced re sales agre ement option. Rising optimism leads to larger misprinting. In this scenario the positive investors pull up stakes continue to barter for the tie ups from the demoralised investors, so there willing be more optimistic investors clutchesing the asset and the disagreement among the investors will be owe, and lead to a deject value volatility.The trammel will also consent less turnover. The pessimistic investors win t become optimistic, they just want to carry their bond. The standard suggested by Hong and Serer(2013) considers a ii-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 give by the equation , where represents the cash black market of import of asset I, and is the state of the macro economy.There are two groups of investors 1) The optimists (group A), who in lead that the economy will be better in t=l -b EAIz = +h 2) The sometimes(group B), who believe that the econom y will be worse 3) So the expected difference between optimists and pessimists is given by EAIz BEz = When is small (I. E. beginning macro disagreement) , the equilibrium set will depend both on the optimists and pessimists valuation, equaling However, when X is large ( b pass(prenominal) disagreement about future macroeconomic conditions), the suppress of pessimists (given by ) is so low that it will hit short sale constraints.Thus, the equilibrium toll will be determined only by optimists valuation, since the pessimists will be sidelined from the market . This equilibrium monetary value is high(prenominal) than the unconstrained charge, which means that the pullulate N will be over-priced, imputable 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 expect, the higher the vogue of the disagreement about its future cash flows will be.Th us, short-sale constraints will befall with higher probability for high-beta, high risk stockpiles. Short-sales constraints big businessman be concealment for some investors ascribable to institutional reasons. An ex large are mutual funds, which are prohibited to worth stocks directly by certain government acts and regulations. harmonise to the arguments above, misprinting is more pronounced for high- beta stocks or for stop consonants of higher disagreement. Thus, stocks from higher beta sectors such as technology, consumer retail, automotive, construction are more promising to take care overpricing and bubbles.Higher disagreement occurs either at times, when market optimism prevails -? continuous bull markets, have with expansionary monetary policy for prolonged period, or when market pessimism prevails crisis times, described by high volatility ND panic wander-offs, causing stocks to be undervalued. Bubbles are lots hard to detect and ascertain, but tend to form mo re or less often when certain industry sectors are experiencing a expert revolution. Bubbles, crashes and fiscal crisis have been a repeating occurrence for long (e. G. He southwest 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 warrant anymore by fundamentals as people continue to tie ever-rising valuations. It is difficult to identify an assets certain fundamental value, and this is especially true for bran-new technologies that have may seem as the next big thing, but have uncertain long-run prospects.Similarly, pastor & Versions (2008) argue that bubbles in stock prices can occur after technological revolutions if the productivity of the technology to be implemented is unknown and subject to learning. This affects both the level and volatility of stock prices. Critical ly, stock prices of innovative inviolables initially rise due to optimism and DOD parole about the productivity of the firm due to the technological instauration, but in the end fall as the technology risk alters from affecting only the firm to existence systematic (Pastor & Versions, 2008).The bubbles can only be observed retrospectively, and are virtually greatly amplified in revolutions than involve high uncertainty and unwavering adoption. For example the expansion of both railroads in the sass and earnings base of operations in the 1 sass was characterized by overstatement that ultimately dismay prices on an aggregate level as additional projects had negative returns due to industrialization. alike, in the case of the internet bubble, investors were lured in to invest by shining companies such as Amazon and America Online, but later companies had often no melodic theme how to be commercially viable and essentially were horseback riding the bubble (Dominant, 2014). Bubbles may hence be amplified by speculation and the idea that individuals observe and adopt the behavior of others (Levine & 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 & McKee, 2012).Thus genealogical revolution tends to lead to projects with initial pelf, and leads to overoptimistic tendencies for the solid industry. As prices exceed fundamentals and new entrants/projects turn sour, the bubble in the end collapses. In the case where there is only one share of the asset usable 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 valuation of the two investors.Here the single optimistic buyer can absorb the replete(p) supply of one share. The average price is 75, hence 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 bid up the price until it reaches the valuation of the optimists, I. E. 100. This will be the traded price. Thus, as according to Miller (1977) without short selling the price of the asset is increase if there is a divergence of printing.In such a market the pick out for the asset will come from the traders who have the most optimistic anticipations of its value. The most optimistic investor tends to win the bidding and their evaluation of the asset ends up being its genuine price. This can be also seen in the diagram below. add up is springless 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 ine dwellic supply curve.Also, as seen in the diagram, different investors have different demand curves the most optimistic one will have the highest valuation. (Source Mi ller, 1977) Due to the stick 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 values is In consort to the result, there is a positive correlation between the bond maturity T and the level of the disagreement between the investors, so the durable 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 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, accor ding to a regular bond emergence curve. If misprinting is more pronounced, the price of bonds will go up, causing a stir downward(prenominal)s in the lied curve, so average genuineized 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 thickening 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 flop 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 sign of the zodiacize dud and du since at dud his expectation of an upward move is , while at du it equals . genuinely these positions represent one and the same designate on the binomial tree, where the fundamental value of the asset should be constant.Behavioral assignment yet though according to Prospect theory the individualistically function is concave in the gains contribution, implying that they are risk averse, its shape changes to convex for very small probabilities. commonly people treat the outcomes based on a reference 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 recreateing any meaningful utility to lets say average middle-class individual, while the possibility, even though small, of winning SIS 000 would unfeignedly bring a quite solid 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 life ana logues of the conducted experiment baron be buy a draftsmanship ticket, where the individual even gets a small, but negative payoff, on average, or establishing a start-up business, where an entrepreneur invests capital with the hope Of receiving higher return in time, instead of investing the money in a bond or a bank deposit 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 quite an positively skewed, with higher percentage 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 unsymmetrical loss function, imp lying 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 averse 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) count on at least six reasons for the analysts downward bias when producing forecasts internal storms for earning higher brokerage commissions, pressure from management of companies that analysts cover, herding behav ior 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/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 keener 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 sto ck 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 marrow 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 education 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 safekeeping anymore.The most important thing for him in order to make a decision for buy or sell is to rec eive a distinguish 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 pure 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 parade 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 th e considerable 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 the more rational choice of choosing sustainable mix of debt and equity financial backing, 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 pricy and believe that the market is undervaluing their company. . Overbidding in acquisitions scholarly research has anchor separate 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 undertake mergers that actually bring lower than expected value. A proof for this might be found in market reactions after resolve, 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 in all likelihood they would have acted in a different way, because their actions caused losses amounting to roughly $220 one thousand million (Maintained, Tate 2007). B) CEO overconfidence does not necessarily have to be a bad thing, since this aspect is quite c flake outly con nested with affinity to fetching 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, simoon (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 anomic $100, regardless if that amount o f 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 satisfaction of having more money. The feeling when you lose is deeper than when you win.