ASSIGNMENT NO 2

FINANCIAL BEHAVIOUR

SUBMITTED TO SUBMITTED BY

Dr. RAKHEE DEWAN KARISHMA

a) What is meant by credit bubbles?

Ans: Credit Bubbles :

Bubble is an economic cycle characterized by the rapid escalation of asset prices

followed by a contraction. It is created by a surge in asset prices unwarranted by
the fundamentals of the asset and driven by exuberant market behaviour. When
no more investors are willing to buy at the elevated price, a massive sell-
off occurs, causing the bubble to deflate. Changes in investor behaviour are the
primary causes of bubbles that form in economies, securities, stock markets, and
business sectors.
b) Define Heuristics.

Ans : Heuristics :
Heuristics are a problem-solving method that uses shortcuts to produce good-
enough solutions given a limited time frame or deadline. Heuristics are
a flexibility technique for quick decisions, particularly when working with complex
data. Decisions made using an heuristic approach may not necessarily be
optimal. Heuristic is derived from the Greek word meaning “to discover”.
Heuristics are methods for solving problems in a quick way that delivers a result
that is sufficient enough to be useful given time constraints.
Heuristic processes can easily be confused with the use of human logic, and probability. While
these processes share some characteristics with heuristics, the assertion that heuristics are not
as accurate as logic and probability misses the crucial distinction between risk and uncertainty.

c) Explain expected utility theory.

Ans : Expected Utility Theory :

This is a theory which estimates the likely utility of an action – when there is
uncertainty about the outcome. It suggests the rational choice is to choose an
action with the highest expected utility.

This theory notes that the utility of a money is not necessarily the same as the
total value of money. This explains why people may take out insurance. The
expected value from paying for insurance would be to lose out monetarily. But,
the possibility of large-scale losses could lead to a serious decline in utility
because of the diminishing marginal utility of wealth.

a) Explain the relevance of biological perspective in psychology.

The Biological Perspective of Psychology

The Biological Perspective or Biopsychology is a latest development in the field of psychology which has
acquired increasing importance as a specialized branch of psychology in recent times. This branch of
psychology is also known by different names like Psychobiology, Biological Psychology, Behavioural
Neuroscience and Physiological Psychology. The Biological Psychology attempts to analyze the
relationship between physiological or biological processes on the behaviour or psychological processes.
This specialized branch of psychology studies how our brain or the neurotransmitters and other biological
parameters influence our psychology and behaviour, feelings as well as thoughts. Bio-psychologists pay
attention to understanding how various biological factors or parameters influence our mental processes,
emotions and cognitive functioning.

Bio-psychologists attempt to relate the psychological or behavioural variables with the biological, genetic
or physiological variables. Bio-psychologists key area of focus is on understanding the functioning of brain
for understanding behaviour, since central nervous system controls or influences human behaviour. The
major areas of focus perception & sensation, memory & learning, movement control, motivated
behaviours for obtaining food, clothing & shelter, human emotions, biological rhythm and sleep. With the
advancements in technology and in research techniques, various advanced issues such as decision
making, reasoning, language and consciousness, are now considered to be the focus areas of
investigation.

Relevance of Biological Perspective in Psychology:

One of the major perspectives in psychology is biological perspective, which involves the study of brain,
genetics, immune system and also the nervous system. Various schools of thought in psychology since
very long have centred around a debate on nurture versus nature. The school of thought which supports
the nurture aspect of the debate strongly hold that the environment plays a crucial role in moulding or
influencing behaviour. While, those who support the nature facet believe that the biological factors
influence human behaviour.

1. Understanding how traumatic conditions of the brain will have its influence on the behavioural
patterns.
2. Investigating how degenerative diseases of the brain will impact the way the people act.
3. Analysing the link between genetic factors and aggressive behaviour; studying how mental
disorders can be an outcome of damage to the brain.
4. Studying the similarities and dissimilarities amongst twins for determining which characteristics
are an outcome of genetic factors and the characteristics which are an outcome of environmental
factors.

Strengths and Limitations of Biological Perspective :

Biological perspective is considered as the most scientific form of investigation, as it relies heavily on
experimental techniques which provide validity to this approach. Studies which are held using this
approach are performed in controlled lab settings and their research results are reliable as well as
predictable. The research results achieved are also objective as the findings are based on scientific
investigation of the biological variables instead of subjective factors or mere observations. As a result of
which, biological perspective has excellent contributions towards treatment of serious psychological or
mental disorders. One of the major limitations of this approach is that it is considered to be restrictive as
the biological perspective fails to take into consideration the other influences on behaviour such as
environmental factors, socio-cultural influences, childhood experiences and human emotions.

b) What are emotions? State different emotional factors faced by the investor.

Ans : Emotions :

Emotions are biological states associated with the nervous system brought on by

neurophysiological changes variously associated with thoughts, feelings, behavioural
responses, and a degree of pleasure or displeasure. There is currently no scientific
consensus on a definition. Emotion is
often intertwined with mood, temperament, personality, disposition, creativity and motiv
ation.

According to the book "Discovering Psychology" by Don Hockenbury and Sandra E.

Hockenbury, an emotion is a complex psychological state that involves three distinct
components: a subjective experience, a physiological response, and a behavioral or expressive
response.

Different state of emotional factors faced by the investor :

 Fear of loss

Probably the most important emotion connected to the

psychological theory of investment is the fear of loss. Fear of
losing the hard-earned capital of your business, client, or even
your own life savings is the first emotion any investor
experiences. It is absolutely normal to try to control and
eliminate risks, but you should never allow fear to stop you
from taking action. The fear of loss can become paralyzing and
lead people to stalling and finally missing out on opportunities
that will never return. Fear can be assessed, controlled and
eliminated as long as the investor is aware of it and takes the
time to investigate its source.

 Unfounded optimism

Usually present with non-professional or beginner investors,

unfounded optimism can lead to irrational decisions. The belief
that things will eventually turn out all right can be an asset
when it is backed up by strong evidence. However, if
unfounded optimism is the leading emotion for an investor’s
decision-making process, chances are they are not going to be
very successful. There are a lot of sources dedicated
to avoiding emotional investments, which can become
dangerous and even damaging.

 Uncertainty
Any investor will tell you that uncertainty is a key part of their
professional life, as markets are unstable, and shifts can
happen overnight. Uncertainty is embedded in the very idea of
financial investment, but on an emotional level, it can damage
the quality of the decision. You should never second guess a
decision you have made, as uncertainty towards your own
abilities will lead to an array of highly damaging emotions such
as insecurity and low self-esteem.

 Insecurity

Investors are always subject to insecurity due to the very

nature of their field of activity. Emotional insecurity is caused
by the uncertain aspect of a specific market, and while it is a
natural feeling, it can easily become destructive. In times
when markets seem to plummet without warning, the degree
of insecurity rises and investors become overly cautious. Too
much caution most of the time leads to missing out on major
opportunities that never wait for too long.

 Low Self-Esteem

Self-esteem is a key emotion in both our professional and

personal life. The image you have of yourself deeply affects
any activity you perform, and the overall quality of life. A low
level of self-esteem is one of the main enemies for investors as
they base their decisions on a combination of knowledge and
intuition. If you don’t trust yourself with making the best
possible decisions, you don’t have many chances of becoming
a successful investor. Therefore, low self-esteem is an issue
that must be addressed at once.

c) Differentiate Gambler‘s and Hot Fallacy.

Ans :The hot-hand fallacy occurs when gamblers think that a winning streak is
more likely to continue. This belief is based on the idea that having already won a
number of bets improves the probability that they will win the next bet or the
next number of bets. Luck will continue favouring them, and the same outcome
of winning bets gets more likely the more times it happens.

The gambler's fallacy works in the opposite direction. This is the idea that during
a losing streak, it is likely that a gambler's luck will turn around and that they will
start winning. Here, repeatedly getting the same outcome decreases the
probability of that outcome occurring in the future.

The problem with both of these, and the reason they're labelled fallacies, is the
fact that, in most games of chance, subsequent outcomes are independent from
each other. A roulette ball landing on red after one spin has zero effect on what
happens on the next spin. A pair of dice landing on 7 on one roll doesn't do
anything to the next roll. Each time the game is played, the universe essentially
forgets all previous outcomes and starts from scratch.

This independent nature of gambling games means that streaks have no

particular meaning. Winning bets five times in a row has no effect on what
happens on the sixth bet. This means that both the hot-hand fallacy, saying that
winning many times in a row increases your chances of winning on the next bet,
and the gambler's fallacy, saying that losing many times in a row increases your
chances of winning on the next bet, are wrong.

d) Explain the risk faced by arbitrageur in financial markets.

Ans: Arbitrageur :

Arbitrageur is a type of investor who attempts to profit from market inefficiencies.

These inefficiencies can relate to any aspect of the markets, whether it is price or
dividends or regulation. The most common form of arbitrage is price.

Arbitrage transactions in modern securities markets involve fairly low day-to-day risks,
but can face extremely high risk in rare situations, particularly financial crises, and can
lead to bankruptcy. Formally, arbitrage transactions have negative skew – prices
can get a small amount closer , while they can get very far apart. The day-to-day risks
are generally small because the transactions involve small differences in price, so an
execution failure will generally cause a small loss. The rare case risks are extremely
high because these small price differences are converted to large profits via leverage 
and in the rare event of a large price move, this may yield a large loss.

Risk faced by arbitrageur in financial markets :

Execution Risk :
Generally it is impossible to close two or three transactions at the same instant;
therefore, there is the possibility that when one part of the deal is closed, a quick shift in
prices makes it impossible to close the other at a profitable price. However, this is not
necessarily the case. Many exchanges and inter-dealer brokers allow multi legged
trades .

In this form of speculation, one trades a security that is clearly undervalued or

overvalued, when it is seen that the wrong valuation is about to be corrected by events.
The standard example is the stock of a company, undervalued in the stock market,
which is about to be the object of a takeover bid; the price of the takeover will more truly
reflect the value of the company, giving a large profit to those who bought at the current
price—if the merger goes through as predicted.

Mismatch Risk :
Another risk occurs if the items being bought and sold are not identical and the
arbitrage is conducted under the assumption that the prices of the items are correlated
or predictable; this is more narrowly referred to as a convergence trade. In the
extreme case this is merger arbitrage, described below. In comparison to the classical
quick arbitrage transaction, such an operation can produce disastrous losses.

Counterparty Risk :
As arbitrages generally involve future movements of cash, they are subject
to counterparty risk: if a counterparty fails to fulfil their side of a transaction. This is a
serious problem if one has either a single trade or many related trades with a single
counterparty, whose failure thus poses a threat, or in the event of a financial crisis when
many counterparties fail. This hazard is serious because of the large quantities one
must trade in order to make a profit on small price differences.

Liquidity Risk :
Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a short
position. If the assets used are not identical , or the margin treatment is not identical,
and the trader is accordingly required to post margin , the trader may run out of capital
and be forced to sell these assets at a loss even though the trades may be expected to
ultimately make money. In effect, arbitrage traders synthesize a put option on their
ability to finance themselves.