BEHAVIOURAL FINANCE

KUMAR GAURAV PRASAD

PM2019048
Q 1.b) As a rational investor we always try to maximize our utility from an investment. Although
in reality it differs from one investor to another. Hence we see the price fluctuations in the
market.
For example: X holds stock of reliance at 1000 rupee but according to him the stock is worth
990 rupee. Hence X will sell the stock at the same time Y feels that stock of reliance is having
high growth potential hence according to him the intrinsic value is 1200. Hence he will buy the
stock.
Behavioral finance helps to identify these gaps between actual and prediction.
Steps of studying behavioral finance:
1. Recognize and acknowledge existence of these biases
2. Understand how these biases can affect returns from investments adversely
3. Adopt bias-free investment decisions.
Q 1.a) Behavioral finance is the study of psychology of the investors on how they act when it
comes to investment. It is the combination of finance and psychology. There are various level
on which behavioral finance stress upon i.e., psychological, sociological, cognitive and emotion.
It is very well related to economic theories of rationality and law of diminishing return.
In rationality all individuals are assumed to be rational and take decisions to maximize their
utility. Which can be to maximize the profit or minimize the cost. In behavioral finance also
investors are assumed to be rational and then we study the gap between what a rational
investors should have done and what actually the investor is doing.
In law of diminishing return we know that the marginal utility from each additional unit
consumed diminishes. The same principal is applicable here also as which each unit of increase
in income the risk taking ability does not increase in same proportion i.e., marginal risk taking
ability diminishes.
Q 2.a) Bounded rationality concept implies that the rationality of an investor is bounded by the
limits of their thinking capacity, available information and time. It was given by Herbert and
Simon in 1982. In which Simon stated that:

 Information has a cost associated with it which varies according to the nature of the
information.
 The capability of human beings to access and incorporate and process all the available
information in their decision, is limited and varied from person to person.
Relevance of these assumptions:
Regarding Rational Preferences, there are three states of economic preferences among
economic agents:

 Firstly, an economic agent may choose one over others as the agent is sure of the choice
they made.
 Secondly, an economic agent may be indifferent between the choices available, as all
alternative provide exactly same amount of utility.
 Thirdly, an economic agent may not be able to decide which of the available alternatives
would provide them the maximum utility
Q 2.b)

If the income is plotted against utility the curve above clearly shows that the utility is
diminishing with each unit of additional income hence the marginal utility is diminishing.

 This curve states the risk aversion character as the natural tendency of an Economic
agents.
 A risk averse person obtains more utility from certain income than an equal amount of
income involving risk.
Q 3.a) A coin would be tossed once and a USD 1 would be paid to the player if the coin showed
tail on the first toss. The game will stop if it showed a head. If the player wins USD 1 on the first
toss, he / she will be offered a second toss where he / she could double his / her winnings if the
coin showed tail again. The game would thus continue, with the winning doubling at each stage,
until the toss showed head. How much would a player be willing to pay to play this game?
(Nicholas Bernoulli). According to this principle, the value of an uncertain prospect is the sum
total obtained by multiplying the value of each possible outcome with its probability and then
adding up all the terms. Its implication in behavioral finance is:

 The value of an item must not be based upon its price, but rather on the utility it yields;
(The concept of Intrinsic Value of Financial Assets in this context)
 The price of the item is dependent only on the thing itself and is equal for everyone;
(This concept could be extended to sale by auction also)
 The utility, however, is dependent on the particular circumstances of the person making
the estimate (In an auction bid of one differs from another based on their difference in
perceived utility)
Q 3.b) VNM Utility Function states that when a consumer is faced with a choice of items or
outcomes subject to various levels of chance, the optimal decision will be the one that
maximizes the Expected Value of the utility (i.e., satisfaction) derived from the choice made.
Expected Value is the sum of the products of the various utilities and their associated
probabilities i.e. EV = ∑PiXi
The consumer is expected to be able to rank the items or outcomes in terms of preference, but
the expected value will be determined by their probability of occurrence.
VNM function helps in financial decision making in following ways:

 The VNM Utility Function forms the foundations for modern portfolio theory and risk
management
 Choice between risky asset classes (Stock vs Real Estate) and assets within each risk
class (bank Stocks vs Pharma Stocks) may be explained by the VNM Utility Function;
 Using Beta values to estimate expected returns for stocks or Value at Risk (VaR) to
measure risk exposure in Commercial Banks are extensions of the VNM Utility Functions
Q 4.a) Absolute risk aversion with wealth:

Type of Risk Aversion Description

Increasing absolute risk aversion
Constant absolute risk aversion
Decreasing absolute risk aversion
As wealth increases, investors hold lesser INR
amount in risky assets
As wealth increases, investors hold the same
INR amount in risky assets
As wealth increases, investors hold more INR
amount in risky assets
Relative risk aversion with wealth:

Type of Risk Aversion Description

Increasing relative risk aversion
Constant relative risk aversion
Decreasing relative risk aversion
As wealth increases, investors hold lesser %
of wealth in risky assets
As wealth increases, investors hold the same
% of wealth in risky assets
As wealth increases, investors hold more %
of wealth in risky assets

Q 4.b) The Concept of Certainty Equivalent as Quantitative Measure of Risk Aversion

Assuming we offer an investor a gamble to earn rupee 100 or rupee 10 with a probability of
50% to each outcome.
The expected value of this can be written as follows: EV = 0.50*10 + 0.50*100 = INR 55
The utility that this individual will gain from receiving the expected value with certainty =
U(Expected Value) = In(55) = 4.0073 units
However, the utility from this will be much lower, since the individual is risk averse:
U(Gamble) = o.50*ln(INR10) + 0.50*ln(INR100) = = 0.50*2.3026) + 0.50 4.6051 = 3.4538 units
The Certainty Equivalent is the guaranteed value that will deliver the same utility:
U(Certainty Equivalent) = In(X) = 3.4538 units
Solving for X, we get a certainty equivalent of INR31.62.
The risk premium, in this situation is the difference between the expected
Value of the uncertain gamble and the certainty equivalent of the gamble: Risk Premium =
Expected value - Certainty Equivalent = INR 55 – INR 31.62 = INR 23.38
Using different utility functions will deliver different values for the certainty equivalent
This investor should be indifferent between receiving INR 31.62 with certainty and a gamble
where he will receive INR 10 or INR 100 with equal probabilities.