Traditional Paradigm of Asset Pricing Development

I think this is turning point of

behavioral finance
 Theoretical Developments in the
asset pricing model
Year Theoretical Developments
1900 Bachelier contribution
1938 Williams contributions
1959 Osborne contributions
1952,1959 Markowitz Theory of Portfolio Selection

1964 CAPM Model by Sharpe

1965 CAPM model by Lintner

1971 CAPM model by Brennan

1972 Zero Beta CAPM by Black

1973 Intertemporal CAPM by Merton

 Theoretical Developments in the
asset pricing model
Year Theoretical Developments

1976 Krow and Litzenberger CAPM

1976 Arbitrage Pricing Theory

1979 Single beta CAPM or consumption beta CAPM

1992 Fama French two factor model

1993 Fama and French three factor model

1996 Conditional CAPM by Jaganathan and Wang

1997 Characteristic model of Daniel and Titman

1997 Four Factor Carhart model

2011 Fear Factor model of Durand et. al.

 Capital Market
• Capital market is a platform to exchange
resources at different points in time between two
economic agents viz. firms and individuals
i. Firm Perspective: Firms transform the current
resources into future resources through
production activities.
ii. Individual Perspective: Current resources can
be sold in exchange for resources to be
obtained in the future and vice versa, resources
to be obtained in the future can be sold now in
exchange for current resources
 Asset Price Formation Process
• In exchange, equilibrium at the beginning of the period
1 is assumed to be reached through a process of
tatonnement with recontracting; that is, investors
come to market with their resources, tastes, and
expectations on market values for period 2, and firms
bring their production opportunity sets.
• Firms announce tentative production and financing
decisions, investors offer their labor to firms and begin
for consumption goods and securities, and a tentative
set of prices for consumption of goods, labor, and
securities is established.
 Cont.
• Prices and decisions are tentative, because it
is agreed that no decisions will be executed
until an equilibrium set of prices, that is, a set
of prices at which all markets can clear at
period 1, has been determined.
 The Market Setting
• The entire market setting between two agents may
undergo in two different scenarios namely certainty
models and a model of uncertainty.
• In certainty model of resource allocation,
(1) some presumptions about the individual’s tastes in
ordering the objects about which decisions must be
made to maximize the utility function
(2)a specification of the opportunities that are available--
opportunity set or constraint set, which is the
collection of possible choices available to the decision
maker
 Certainty model cont.
• In the field of finance …….problem………. the allocation of
financial resources by individuals over time.
(1) objects of choice and
(2) representation of passage of time …..discrete jumps i.e.
points of decisions and payments are made at the start of
these discrete time periods.
Here the market value of any set of claims depends only
on the amounts of the claims and the prices of one
period unit claims and not at all on how the claims
happen to be “packaged”.
Observed market interest rates provide the appropriate
cutoff rates or “cost of capital” for the firm’s production
–investment decisions.
 Cont.
• Capital market serves to reduce wastes and inefficiencies
by efficient exchanges of resources
• In this exchange, ‘separation principles’ can be invoked
(1)Given its operating, that is, production- investment
decisions, the market value of a firm at any point in time is
independent of its financing decisions; thus operating
decisions need not be affected by financing decisions.
(2) In making its operating decisions, an optimal policy for the
firm is to maximize the market value of the holdings of its
current owners, irrespective of the details of owner tastes.
But to take above decisions we need a theory that tells us
how market values are determined.
 Uncertainty Models
• The perfect capital market assumptions are
not sufficient to give real meaning to the
notion of a cutoff rate or cost of capital for a
firm’s investment decisions
• Implementation of utility maximizing
criterion runs into difficulties, because firms
can have more than one type of security
outstanding and the investment decision that
maximizes market value for one group of
security holders need not do so for other
 Cont.
• Discount rates and cost of capital find current
values for future payoffs. But it requires a
detailed theory to probability distributions on
future payoffs that are important to investors
and the way in which optimal consumption
investment decisions by all individuals and
operating decisions by all firms combine to
produce a market equilibrium in which
discount rates are appropriately interpreted as
prices that determine market values.
 Two period consumption-
investment model
• Two assumptions
(1) consumer risk aversion…………. further allows him to restrict
attention to E (R ) and σ (R ) efficient portfolios and
(2) normally distributed portfolio return…………….rank portfolios
on the basis of means and standard deviation of returns
The efficient set theorem is a consequence of consumer risk
aversion and two parameter distributions of portfolio
returns and does not require the more restrictive
specification of the return generating process provided by the
market model
 Implications of Consumption-
Investment Models
• Given a market of risk averse, expected utility
–maximizing consumers
(1) what is the appropriate measure of the risk
of an asset
(2) what is the relationship in equilibrium
between this measure of the asset’s risk and
its one period expected return.
Thus asset pricing model is a natural extension
of the consumption investment model.
 Context of market setting in asset
pricing development
• Perfect and frictionless market
• Consumers and firms are price takers
• Consumers engaged in utility maximization
• Firms engaged in production
• Market equilibrium requires a set of clearing
prices
• Supply and demand is equal for all assets in
equilibrium
Various Models of Efficient Capital Market

• Expected returns or Fair Game Models:

Conditional on some relevant information set, the
equilibrium expected return on a security is a
function of its risk.
E (Pj, t+1/φt) = (1+ E(Rj,t+1/ φt) Pjt
Φt is the symbol of whether set of information is
assumed to be fully reflected in the price at t.
Then E (xj, t+1/ φt) =0
Thus the x j,t is a fair game with respect to the
information sequence φt.
 Cont.
• Submartingale Model
E (Pj, t+1/ φt) >= Pj,t
E(Rj, t+1/ φt) >=0
Expected value of next period’s price, as
projected on the basis of the information φt,
is equal to greater than the current price. If
the above equation holds equality, so that
expected returns and price changes are zero,
the price sequence follows a martingale.
 Cont.
• The Random Walk Model
Current price of a security fully reflects available
information was assumed to imply that successive
price changes or more usually, successive one period
returns, are independent. In addition, it was usually
assumed that successive changes or returns are
identically distributed.
f (Rj, t+1/ φt) = f (Rj)
Thus density function f must be same for all t.
Expected return on security is constant over time.
 Different Models of market
equilibrium (Fama)
• Expected returns on any security are always
positive.
• Expected returns on any security are constant.
• Expected returns on any security conform to
the market model.
• Expected returns on any security conform to a
risk return relationship.
 Stages of portfolio selection
• First stage----observation , experience and
beliefs about future performance of available
securities.
• Second stage ……relevant beliefs about future
performance and the choice of portfolio.
Markowitz theory is primarily concerned with
second stage.
 Markowitz Theory of Portfolio Selection
(1952, 1959)
• Concern with the relevant beliefs about future
performance and ends with the choice of portfolio
• Propose E-V rule “ investors must have both
maximum expected return and minimum variance”.
E-V hypothesis implies “right kind” of diversification
for the “right reason”. It is necessary to avoid
investing in securities with high covariances among
themselves.
• Diversify across industries with different economic
characteristics
 Asset pricing model and firm
• Asset pricing model …..derive production decision
rules….objective functions of all firms.
• Putting differently, equilibrium expected return is the
minimum return required expected one period
return or cost of capital for firm’s production
activities.
• In essence, the firm is just a portfolio of production
activities, and market relationships between risk and
expected return hold for each activity. And in a
perfect capital market, the equilibrium expected
returns are the required expected one period returns
or cost of capital for the firm’s production activities.
 Sharpe Capital Asset Pricing
Model (1964)
Assumptions
(1)The investor’s objective is to maximize the
utility of terminal wealth,
(2) Investors make choices on the basis of risk
and return,
(3) Investors have homogeneous expectations
on the prospects of various investments-
expected values, standard deviations and
correlation coefficients,
(4 )Investors have identical time horizon,
 Cont.
(5) Information is freely and simultaneously
available to investors,
(6) There is a common pure rate of interest with
all investors able to borrow or lend funds on
equal terms,
(7) There are no taxes, transaction costs,
restrictions on short sales, or other market
imperfections, and
(8) Total asset quantity is fixed, and all assets are
marketable and divisible.
 Cont.
• The CAPM provides the following equation;
Big = - ( P)/(Erg-P) + Eri/(Erg-P)
Where Erg is the return on efficient combination
of assets
P is the pure rate of interest
Eri is the expected return on asset i
Big is the slope of the regression line.
 Cont.
• In equilibrium …..simple linear relationship
between expected return and standard
deviation of return for efficient combinations
of risky assets. ……..nothing said for such a
relationship for individual assets.
• Er and σr values associated with single assets
will lie above the capital market line, reflecting
the inefficiency of undiversified holdings.
…….such points scattered throughout the
feasible region but no consistent relationship
 Cont.
• However, consistent relationship between
their expected returns and systematic risk.
• The response of return on individual assets to
changes in return of efficient combination of
assets account for much of the variation in
return of individual assets. It is this
component of the asset’s total risk which we
term the systematic risk. Thus given the risk of
Rg, the systematic risk of each asset can be
determined.
 Cont.
• Rates of return from efficient combinations
will be perfectly correlated to the over all level
of economic activity. If so, diversification
enables the investors to escape all but the risk
resulting from swings in economic activity-
this type of risk remains even in efficient
combinations. And since all other types can be
avoided by diversification, only the
responsiveness of an asset’s rate of return to
the level of economic activity is relevant in
 Cont.
• Prices will adjust until there is a linear
relationship between the magnitude of such
responsiveness and expected return. Assets
which are unaffected by changes in economic
activity will return the pure interest rate;
those which move with economic activity will
promise appropriately higher expected rates
of return.
 Shortcoming of Sharpe’s Model
• There is linear relationship between risk and
return.
• Beta does not suffice to explain average
returns, and
• A fraction of total risk is priced by the market
 Intertemporal CAPM (Merton
,1973)
Merton (1973) ……portfolio behavior for an intertemporal
maximize will be significantly different when he faces a
changing investment opportunity set instead of a constant
one.
Merton (1973) modeled intertemporal uncertainties viz.
(1) relative prices of consumer goods, (2) future labor income
(3) future value of non human assets (4) future investment
opportunities (5) future tastes, (6) future range of
consumption goods and (7) the age of death.
He notes that financial instruments are not created for the last
three sources of uncertainty.
 Cont.
• In Merton model, securities play a dual role- and help
diversification and also help in hedging explicit sources of
uncertainty. The return on any asset is a function of the
returns on each of the 4 factor portfolios and the beta
coefficients with these factor portfolios as shown below.
• Ri – Rf = α + β1F1 + β2 F2+ β3F3+β4F4
• Where F1 is the price of the market factor and F2, F3, and F4
prices of hedging factors and betas are sensitivity coefficients
with these factors. A serious implication of Merton’s models
is the identification of the hedging portfolio.
 Cont.
• Merton’s intertemporal CAPM with stochastic investment
opportunities states that the expected excess return on any
asset is given by a ‘ multi-beta’ version of the CAPM with the
number of betas being equal to one plus the number of state
variables needed to describe the relevant characteristics of
the investment opportunity set.
• All of those state variables are not easily identified
• This model is quite important from a theoretical standpoint, is
not very tractable for empirical testing, nor is it very useful for
financial decision making.
 The Arbitrage Pricing Theory
(Ross, 1976)
Rely on weaker set of assumptions as compared to CAPM and
APT states that the stochastic process generating security
returns is a k factor linear model and is expressed as;
Ri = E(Ri) +β1δ1+…………… βkδk +ei
Where Ri and E(Ri) are realized and expected returns on asset
i.
Βj (j=1,2…….K) is the factor sensitivity with the jth factor
In the absence of arbitrage (δj=0), the realizations should be
equal to expectations. The expected return on an asset I must
incorporate risk premium for all possible sources of risk. Given
countably large number of risk factors, expected return E(Ri)
can be written as
 Cont.
E(Ri) = Rf + sum βik λik
Where Rf is the risk free rate or return on a zero beta
portfolio.
Λik is the market price of risk for the kth factor which is
proxied by a mimic portfolio that exhibits unit beta with the
relevant factor and zero betas with other factors.
Βk are the factor sensitivities.
Thus, expected return on an asset I is approximately equal to
risk free rate plus k risk premia associated with the
anticipated movements in common risk factors. Hence, APT is
a K+1 fund separation theorem involving a risk free asset (or
zero beta portfolio) and K unit beta portfolio that proxy for
the risk factors.
 Cont.
• In reality, the actual return may differ from
expected return owing to unanticipated
movements in risk factors represented by δ.
The δ can take any value due to over or under
realization on the factors. This will ignite the
arbitrage process till the excess return
opportunities are soaked out and investors
achieve their constraint maximization
conditions.
 APT vs CAPM
• APT requires absence of arbitrage, while the CAPM requires
competitive equilibrium. Absence of arbitrage is an important
condition for the state of equilibrium.
• Equilibrium additionally requires that the market is cleared,
i.e. aggregate demand is equal to aggregate supply for all
securities in the market.
• Thus, APT is a more fundamental relationship than CAPM in
the sense that rejection of APT automatically leads to the
rejection of CAPM, while the rejection of CAPM need not
necessarily lead to the rejection of APT.
 Cont.
• The APT based on simpler assumptions and
recognizes multiple risk factors thus making it closer
to reality. However, APT fails to specify the nature or
number of factors.
• These risk factors can be macro-economic in nature,
such as, political upheavals, level of interest rates,
inflation, real growth in GDP etc.
• Alternatively, these can be fundamental factors
based on company characteristics like size, BE/ME,
leverage etc.
 Theory of Factor Models
• In APT, the investors arbitrage away any differences in the
expected return on assets belonging to same risk class. And
returns of the assets are affected by systematic factors and
returns on any asset over time are called return generating
process.
• The return generating process of assets can be expressed as a
linear function of a set of K risk factors. Thus APT will have
K+1 dimension security market line. In APT, models need
compensation for systematic factors. A formal relationship for
this is called as factor model of security returns.
 Cont.
• This return generating process of securities may involve a
single factor or multiple factors.
• A factor model implies that securities or portfolios with equal
force sensitivities will behave in the same way except for non
factor risk (law of one price states that if two assets are
equivalent in all economically relevant aspects, then they
should have same market price).
• Therefore securities or portfolios with the same factor
sensitivity should offer the same expected return. If not so,
then investors will take the advantage of arbitrage
opportunities causing their elimination. This is the essential
logic underlying APT.
• Thus we need to identify risk proxies which can affect
 An Overview of Three Different
Factor Model
Factor or Model Inputs Estimation Outputs
Type Technique

Macroeconomic Security Returns and Time Series Security Factor

Model Macroeconomic Regression Betas
Variables
Statistical Model Security Returns Iterated Time Series/ Statistical Factors
Cross Sectional and Security Betas
Regression
Fundamental Factor Security Returns and Cross Sectional Fundamental
Model Security Regression Factors
Characteristics
 Underlying Factors in Factor
Models
1. Differences in the risk of stocks generate differential payoffs.
2. Difference in liquidity and transaction costs: Relative
liquidity is determined by price per share, volume of daily
trading relative to total market capitalization, bid ask spread
as a percentage of price, amount of institutional ownership.
It is found that stock with higher liquidity has lower payoffs
or lower expected return after adjusting bid ask spread.
3. Cheapness indicators: factors related to cheapness in price
indicates the relative magnitude of current market price in
relation to the current cash flows (Earning per Share,
Dividend Per Share and Cash Flow Per Share) available to the
firm’s stock investors. In growth stocks, there is high ratio of
price to current cash flows commanding higher price in the
market. Growth stocks are expected to grow fast to higher
 Cont.
levels in the future. In value stocks, cash flow will increase at
slower rate leading to lesser attraction by investors with
lower price. Thus value stocks tend to perform better than
growth stocks. It attracts explanations from two different
schools of thought. One that is premium in value stocks is
expected. The other is that premium is unexpected and
come as surprise to investors leading to overreaction
phenomenon.
4. Technical Factors: The historical pattern of returns has three
different relationship with future expected returns.
• Very short term reversal patterns in returns (one month)
• Intermediate term inertial pattern ( 6-12 month
underreaction phenomenon)
 Application of Factor Model
• Identification, measurement and decomposition of overall risk
of portfolio. Passive portfolio manager will monitor tracking
error to keep it at the lowest level, whereas active managers
design active strategies. Also acquaint with the marginal
impact on total, residual or active risk of changes in portfolio
exposures to factors or changes in stock holding (Grinold and
Kahn).
• Assist investment managers to identify important factors in
the economy and the market place and to assess the extent to
which different securities and portfolios will respond to
changes in these factors (Sharpe et al).
• Also useful for hedging portfolios and eliminating risk.
Single Beta CAPM or consumption
beta CAPM (Breeden, 1979)
• Breeden (1979) laid his framework through inter temporal
asset pricing model study.
• A single beta asset pricing model in a multi good, continuous
time model with uncertain consumption goods prices and
uncertain investment opportunities. When there is no riskless
asset existing, a zero beta pricing model is derived.
• Asset betas are measured relative to changes in the aggregate
real consumption rate, rather than relative to the market. In a
single good model, an individual’s asset portfolios results in an
optimal consumption rate that has the max possible
correlation rate that has the max possible correlation with
change in aggregate consumption.
 Fama French Model (1992)
• Fama and French (1992) study the combined
role of beta, size, B/M, leverage and P/E in
explaining the cross section of average stock
returns. They find three stylized facts that
(a) beta alone cannot explain security returns,
(b) additional risk factors based on company
characteristics significantly explain asset
returns and
(c) size and B/M tend to absorb the role of
leverage and P/E factors in stock returns.
 Fama French Three Factor Model
(1993)
FF(1992) extended into FF(1993) as below
• Set of asset returns to be explained. ….In FF(1992a) we
consider common stocks. FF(1993) include US Government
and corporate bonds as well as stocks for integrated market.
• Set of variables used to explain returns….FF(1992) variables +
term structure variables. The notion is that if markets are
integrated, there is probably some overlap between the
return processes for bonds and stocks.
• They use the time series regression approach of Black, Jensen,
and Scholes.
• As building blocks they use all NYSE stock on CRSP, Amex, and
NASDAQ from 1963 to 1991.
 Cont.
• On the basis of two criteria, size and book to
market (BE/ME), Fama and French construct
25 portfolios, from a sample of the stocks of
the NYSE, AMEX and NASD over 366 months
(from June 1963 to December 1993). Monthly
stock returns show a superiority of stocks of
small capitalization and high book to market
ratio, compared to the stocks of big
capitalizations and low book to market ratio.
 FF(1993) model
The model is expressed in the following form;
Rpt – Rft = a + b Rmt – Rft +s SMBt + lLMHt +ei
• Where SMB = difference between returns on
portfolios of small stock firms and returns on
portfolio of big stock firms.
• LMH = difference between returns on a portfolios
of low price to book stocks and high price to book
stocks.
• S and l are sensitivities coefficients of SMB and
LMH respectively.
• FF model captures average stock returns which is
 FF(1993) conclusion
FF model (1993) documents the 5 common risk
factors involved in stock returns and bond returns.
• Stock market factors include an overall market
factor and factor related to size and B/M.
• Bond market factors, related to maturity and
defaults risks.
• Stock returns have shared variation due to stock
market factors, and they are linked to bond returns
through shared variation in the bond market factors.
Except for low grade corporate, the bond market
factors capture the common variation in bond
 Explanations for Size Effect
Seasonality and Size Effect
• Keim (1983) ………50% of the return differential between small
and large firms …..Jan effect. 50% of the Jan effect accrued in the
first 5 trading days of Jan. Tax loss selling pressure …….explanation
of the Jan effect. ………… March effect in India.
• One explanation for the January effect is that investors are
advised by their holdings of stocks, whose prices have decreases, to
record short term capital losses for saving capital gains at the end of
financial year. This selling pressure at the end of the year, artificially
depresses prices of these low value stocks, and subsequently the
same stocks are brought back in the first week of January, when
their prices are abnormally high as compared to the previous week
/month closing prices. This effect is predicted to be largest for
smaller firms due to higher volatility in the prices of small firm
stocks and hence we get the “ January size effect”.
 Explanations for Size Effect
Liquidity Premium
• Infrequent trading of small stocks lead to lower liquidity as compared to
larger firms. Thus trading of these small stocks entails larger transaction
costs demanding higher compensation or expected return.
• Amihud and Mendelson (1986) studied the payoffs that investors receive
by holding less liquid stocks. They use bid ask spread as the relative
measure of liquidity. They concluded that there is positive and significant
relationship between firm size and liquidity and that less liquid stocks
provide extra normal returns. Thus a part of the size effect may be due to
the liquidity risk inherent in small stocks.
• Using other measures of liquidity viz. trading volumes and the number of
trading days, James and Edmister (1983) concluded that although size and
liquidity are highly correlated there is no liquidity premium for less liquid
stocks.
• Thus there is no unanimity in liquidity premium across various studies.
 Explanations for Size Effect
Distress Premium
• Distress serves as indirect proxy for discounting information
and computing expected return for various firms.
• He and Ng (1994) and Shumway (1996) suggest a measure
of distress that is related to the loss of listing on the stock
exchange.
• While Fama and French (1995) find that their book to
market factor proxies for relative distress, it appears from
Shumway’s (1996) results that size is a better proxy.
• Distressed firms are considered to be highly risky by the
investors and therefore they discount future expected
earnings of distressed firms at a higher rate, thereby
lowering the market value or the size of the firm.
 Explanations for Size Effect
Higher Operating, Financial and Economic Risks
• The fundamental differences in the structural
characteristics of small and large firms that cause them to
react differently over the same economic news are well
argued by Chan and Chen (1991).
• Small firms are marginal firms with low production
efficiency and high financial leverage. These characteristics
make the small firms more vulnerable in turbulent market
raising the basic issue of survival of these firms. Thus size
does the function of indirect proxy. Chan, Chen and Hsieeh
(1985) that small firms are more sensitive to changes in
underlying economic conditions, as the return on small
firms’ stocks tend to be more volatile during economic
contractions and expansions than those of large firms.
 Explanations for Size Effect
Management Holding pattern and Degree of Diversification in
Small firms
• Small sized firms are controlled by small group of management
which makes them less transparent. So the low level of
transparency increases risk exposure of public and hence raises the
expected return of investors.
• Another possible explanation of the size effect lies in the nature of
risk. Apart from concentrated ownership, small firms are expected
to have less diversified product lines. Most of the small firms
provide a single product line –often a single product. Thus the small
firms tend to contain more unsystematic risk than larger firms.
• The typical small firm stock contains about 75% unsystematic risk
compared to 60% in large firms. Thus the higher expected
compensation in small firms is attributed to higher unsystematic
risk in small firms.
 Explanations for Size Effect
Neglected Firm Argument
• FIIs and security analysts neglect the small firms from investment
perspective. Thus the size effect may be partly due to “neglect
effect” argued by Arbel and Strebel (1982). They hypothesized that
after adjusting for risk, less researched companies would provide
excess rates of returns. Since small companies are least researched
upon, the possibility of yielding extra normal return is high among
small companies.
• Arbel, Carvell and Strevel (1983) reported that about one third of
the companies in their small size portfolio were institutionally
neglected, i.e. held by none or just one institution. Thus the
institutional investors prefer large and liquid stocks keeping away
from the small stocks for investment purposes. This preferential
behavior depresses the price of small companies below their
fundamental value and hence they provide above normal returns.
 Explanation for size effect
Information Risk Premium
• Barry and Brown (1984) reported that differential information
hypothesis ( i.e relatively less information is available for small
firms) is related to size effect and can explain a large part of it. The
argument is that if insufficient information is available about a
subset of securities, investors will not hold these securities because
of estimation risk. If investors differ in the amount of information
available, they will limit their diversification to different subsets of
all securities in the market. It is very likely that the amount of
information generated is related to the size of the firm. Therefore,
many investors would not desire to hold the common stock of very
small firms. This lack of information about small firms leads to
limited diversification and therefore to higher returns for the
“undesirable” stocks of small firms.
 Explanation for size effect
Transaction Costs and Size Effect
• Stroll and Whaley (1983) found that small firms stocks
tended to have lower prices and higher transaction costs.
After estimating the risk adjusted returns for smallest stock
portfolio net of transaction costs, they reported that a
round trip transaction every month was sufficient to
eliminate the size effect.
• However, if the round trip transaction occurred once per
year, the average abnormal return was about 4.5% per year
(with a t statistic of 1.75). Hence transaction costs
appeared to be a great investment strategy.
• Schultz (1983) also concluded that high average returns to
small firms’ stocks are attributed to their transaction costs.
 Explanation for size effect
Market Inefficiency or Misspecification of Single Period CAPM
• Size effect is also viewed as evidence of market efficiency if CAPM
holds true. The pure size effect (i.e the size effect net of any value
effect and liquidity effect) is due to irrational behavior of investors.
Lakonishok, Shleifer and Vishny (1994) claim that investors are
irrational because they avoid small stocks that they mistakenly
consider too risky, even though the evidence indicates that this
does not appear to be the case ( at least for conventional measures
of risk).
• Thus market inefficiency seems to be the last resort for abnormal
returns on small firms’ stocks. Thus the trading strategies based on
the size factor provide abnormal returns and the phenomenon of
pure size effect, in fact, generate, pure arbitrage opportunities.
 Explanation for size effect

Market Inefficiency or Misspecification of Single

Period CAPM
• The size effect anomaly can be either an indication of
market efficiency or an error in specification of the
single period CAPM. Basu (1983) suggests that both
size and E/P effects may be proxies for some other
important variable not specified in the CAPM.
• Banz (1981) and Reinganum (1981) clearly assert that
the size effect appears to be misspecification of the
CAPM rather than a measure of inefficient market.
 Explanation for Size Effect
Seasonality Effect (Turn of the Year Effect)
• Seasonality effect implies that average stock returns in specific months
(particularly January) and specific seasons are higher than other months
or seasons. Keim (1983) found the seasonal pattern for returns from small
capitalization stocks. He reported that about 50% of the return differential
between small and large companies is due to abnormal January returns.
• Seasonality effect is due to tax loss selling hypothesis. According to this
hypothesis, there is a general tendency on the part of the investors to sell
loss making stocks (firms which are small and distress) around the end of
the year and repurchase them in the beginning of the new year. Thus
investors save capital gains tax and at the same time depress the market
price of such stocks during the turn of the year and substantially increase
the price of the stock in the beginning of the new year. Hence, abnormally
high returns occur in the initial month of the year on such stocks. Widely
supported widely in developed markets, seasonality effects need to be
tested rigorously in Asian emerging stock markets.
 Explanation for E/P Effect
• Basu (1977) showed the price earnings ratio effect and
found that market portfolios did not seem to be
efficient relative to the portfolios formed on the basis
of price earning ratios. He also found that the risk
adjusted returns for the US listed firms were directly
proportional to the E/P ratio of the firms. The firms
with higher EPS as a % of its price earned significantly
higher average risk adjusted returns as compared to
the firms with lower EPS over price.
• Basu (1983) also proved that the E/P effect was not the
same as size effect.
 Various cross sectional effects
• Banz and Brine (1986) and Reinganum (1981) state that
size effect subsumes the E/P effect, whereas the Basu
(1983) argues that E/P subsumed the size effect. Cook
and Rozeff (1984) show that size and B/M effect
explain all the stock returns and the beta does not have
any explanatory power.
• Fama (1991) suggests a possible common thread
running between the size, E/P and B/M effect ( and
market leverage effect) by pointing out that all these
have market price as a common variable. Therefore the
, the observed anomalous behavior may be only one
effect, showing the impact of previous market price on
current returns.
 Various cross sectional effects
• A presence of cross sectional effects like the size,
E/P and Book to market value, makes role of
CAPM and beta very questionable ( as shown by
Fama French (1992) for the US market). Such a
persistent inefficiency is called an anomaly
because it is inefficiency not arbitraged away
even after its presence is known for a long period
in an otherwise efficient market. The new name
however , does not alter the reality that there is
no economic rationale for the existence of such
anomalies.
 Various cross sectional effects
• We therefore decided to look more closely at
the role of risk in the risk adjusted return used
in all these studies. If the risk measure, used
for adjusting returns is inadequate (especially
for small size effect, high E/P and B/M stocks)
then the additional returns may be a reward
for bearing higher risk and not an inefficiency
or anomaly.
 Momentum Effect:
• In the short run, when past stock return is measured over
periods of days, weeks or months, existence of some
positive serial correlation has been found i.e stock returns
have been observed to follow a continuous pattern. This
anomaly is often referred as “Momentum effect” as it
indicated a trend or momentum in the short run.
• Jagaddesh and Titman (1993) and others have
demonstrated that stocks with high short term past
returns, i.e the returns over the previous 3 to 12 months,
continue to perform better in future than the stocks with
low short term past returns such that momentum strategy
of buying past winners and selling past losers generates
positive excess returns.
 Contrarian Effect or Overreaction
Hypothesis or Reversal Effect
• Contrary to the momentum return , reversal observed in the
direction of stock prices over longer holding period of 3 to 5 years.
• De Bondt and Thaler (1985) demonstrated significant change in the
direction of returns over long periods of time. Specifically, the
stocks that have experienced extreme negative returns during the
previous 3 or 5 years (the formation period) are found to perform
better the following 3 or 5 years (the test period) than those that
previously had the extreme positive returns.
• These findings give some support to investment techniques that
rest on a “contrarian strategy”, in other words, buying the stocks or
group of stocks, that have been out of favour for long periods of
time (losers) and selling those stocks that have run ups over the last
several years (winners).
 Module 2

Theory of Under –reaction and Over-

reaction
 Trend of Asset Prices
• In short run…exhibit momentum
• In long run …tendency towards reversal or
fundamental reversion
• It is empirically observed ( out of the sample and out of
the period tests)
• Inertia of three types
1. Short term (less than one month)
2. Medium term (9-12 months)
3. Long term (3-5 years)
Thus these departures from classical assumptions of strict
rationality must be addressed.
 BSV (1998) and DHS(1998) argument
• Price is f ( representative heuristic)
• Thus short term momentum is by default
• Continue…continue….overreact….long term
reversal
• After certain time, continuance is
unaffordable so reversal is inevitable.
 Heterogeneous Beliefs of Two Pillars
• Two important agents (1) news watchers and (2)
momentum traders.
• Their beliefs can be heterogeneous but bounded rationality
and interaction
• News watchers forecast on private signals about
fundamentals and act slowly diffusion ….under-reaction
• Momentum traders chase trend and earn by momentum
strategies in the beginning
• Later price reversal and everything comes back to
equilibrium
• Biggest paradox is earnings follow random walk model
instead of trending or mean reverting ( investors love time
series rather than sporadic events)
Who can time the gradual diffusion of
news?
• Early momentum buyers impose a negative externality
on the “late” momentum buyers
• News watchers slow movers and momentum traders
exploits arbitrage benefits
• Speed of momentum increases culminating into
overreaction
• Thus the very existence of under reaction sows the
seeds of overreaction ( by luring momentum traders)
• Thus the source of under reaction and over reaction is
….” gradually diffusing news about the fundamentals”
.It is also called as Grand Daddy of under reaction
 Empirical Observations
• Assets Returns………..positive autocorrelation
at short horizons…..momentum (trending)
• Asset Returns…………negative correlation at
longer horizons…..long term reversal (mean
reverting)
• Impulse response function may be useful to
judge how long reaction will continue
 Cont.
• High (E/P, or C/P or BE/ME) ………..tend to have poor post
earnings growth (losers) ………overreact………high future
returns
• Low (E/P, or C/P or BE/ME) ………..tend to higher post
earnings growth (winners) ………overreact………low future
returns
• High price….IPO……poor long term post event
return…….overreaction………(it is part of market correction
to fundamental value and mean reverting)…..but if IPO
value weighted……abnormal return shrink for all
benchmark, and they are not reliably different from
zero……………thus this anomaly is largely restricted to tiny
firms…..source of bad model problems
 Cont.
• Divesting firms …..become merger
target…..under reaction…….post event
abnormal returns for parent and spin offs are
positive
• Repurchase ……..under react………..positive
long term post event abnormal return
• Dividend initiations…..positive……..under react
• Dividend omissions…..negative……..under
react
 Cont.
• Investors in mean reverting regime….change
in earnings…..investors under reacts….wait for
further confirmation…..thus response is
delayed…..momentum persists
• Investors in trending regime…..change in
earnings….investors extrapolate the
earnings…..overreaction…..reversal of long
term return
 Cont.
• Stock split……positive abnormal return after
the split………..brings drift in the price
 Emerging Cross Sectional Anomalies
• Chance deviations to be expected under market
efficiency
• Persistent across time and space
• Size, value and momentum
• Pattern lead to events studies…
1. People want premia rationally as per Sharpe ratio
2. Can be exploited by utility function with strong habit
persistence for predictive variations in market return
3. Observed irrationality
 Contrarian Investment, Extrapolation
and Risk Trends
• Variety of investment strategies that involve buying out
of the favor (value) stocks have outperformed glamour
strategies
• Actual future growth rates of earnings, cash flow, etc.
of value stocks are higher than glamour stocks
• Value strategies are less risky and more rewarding
provided you stay for longer invested (However
metaphysical explanation of risk should be
commensurate with returns).
• The plausible explanation is data snooping and higher
ex post return
 Cont.
• We can conjecture the preference of both
individuals and institutional investors in
agency context
• Individual investors focus on glamour
strategies by extrapolating growth past
growth rates and make judgmental errors.
Putting excessive weight on recent past
history is most common judgmental error in
psychological experiments.
 Cont.
• Institutional investors also gravitate towards
glamour stocks in order to show that they are
prudent investors and they justify easily to
their sponsors. It is also related to the career
of money managers of these institutions who
are given the responsibility of performing
better than benchmark in short term. Thus
they are more tilted towards the glamour
stocks
 Cont.
Money managers can’t afford to
underperform with respect to their peers for
any non trivial period of time , for if they do
so, their sponsors will withdraw the fund.
Value strategies will generate positive payoffs
in the long run. It is too late and money
managers may lose their jobs. Thus they are
deprived of the arbitrage benefits emanating
from value stocks.
 Behavioral Theory of Asset Pricing
• It should rest on assumptions about investors behavior
that are either a priori plausible or consistent with
causal observation
• Evidence required with parsimony and unified evidence
( slowly diffusing news about future fundamentals)
without any other exogenous source of investor
sentiment and liquidity disturbances)
• Prediction must be testable and prone to validation
• It has bounded rationality referring to the ability to
process small subset of information in an unbiased
way)
 Testable Predictions in the Theory
• Under reaction and overreaction are more
pronounced in small and low analyst coverage
firms where information diffuse very slowly
• There should be relationship between
momentum traders’ horizon and pattern of
return auto correlation
• The moment the news reaches to public
domain from private one, under- reaction is
surpassed by overreaction
 Psychological Biases have important
role to play
• Investors’ overconfidence about the precision of
private information…..( It implies negative long lag
autocorrelations, excess volatility, and when
managerial actions are correlated with stock
mispricing, public event based return predictability).
• Biased self attribution causing asymmetric shift in
investors confidence as a function of their investment
outcomes ( positive short lag autocorrelations or
momentums or short run earnings drift.
• Confidence is also time dependent, priori dependent,
and framing. Also =f( age, education, experience, status
of wealth)
 Few Mixed Explanations
• Investors +analysts……..generate information
1. By interviewing management
2. Verifying rumors
3. Analyzing financial statements
• Investors may boast of overconfidence and their
data generating skills and can think of lesser
pricing errors in forecasting….underestimation
of errors
• Stock market over-react to private signal and
under react to public signal
 Cont.
• Repurchase ……….proxy of under-valuation……..predict
positive abnormal returns
• Equity offering ….proxy of overvaluation…….predict
negative abnormal return
• Cash flow or earnings surprise….initially confidence
increases…..cause same direction average stock price trend
…..later reversal…..overreaction
• Investors are quasi rational (Bayesian optimizers)
• Smart traders should dominate rational ones but never
happens
• Analysts or investors may form “Herd” in few stocks when
they receive some private information prior to others
Explanation of Self Attribution Theory
• Too strongly attribute events that confirm the validity
of their actions to high ability (Take credit for past
success and blame external factors for failures)
• Rather than Events that disconfirm the actions to
external noise or sabotage
• It adds confidence if the public information is in
congruent with his beliefs
• But confidence does not fall commensurately when
public information contradicts his private information
• HEADS I WIN, TAILS ITS CHANCE
 Cont.
• Notion of cognitive dissonance in which
individuals internally suppress information
that conflicts with past choices
• Good news after buy and bad news after sale
are boasting ones
• Investors does something….further confirmed
by public information ……become
overconfident…..momentum…..carry
on…..long run….long term reversal
 Explanation of Overconfidence
• More prevalent in diffuse task ( in judgment based
rather than lab one)
• High for task where feedback is delayed
• Lead to underestimating of forecasting errors
• People overestimate their abilities and perceive more
favorably than they are viewed by others
• “ perhaps the most robust findings in
the psychology of judgment is that
people are overconfident” in all
professionals.
 BSV arguments
• Representative biases…..too much weigh to
recent pattern of data……too little to the
properties of the population they belong to
• Conservatism biases…….slow updates of
models or information in the face of new
evidence
 DHS arguments
• Investors are of two types
1. Informed …………….prone to judgmental bias
emanating from overconfidence and biased
self attribution
2. Uninformed …………..no judgmental
biases………..passive investors
 Road ahead
• Under-reaction and overreaction are equally frequent
and probable. It is chance results.
• It is randomly split
• It can not be timed
• Thus indirectly leading to market efficiency
• Over-reaction is a long term anomaly….we have to be
cautious and sensitive to methodology, time
period…..it is highly likely that it may disappear in the
return generating process. Long term anomalies are
statistically and economically marginal and can be
reduced by measurement biases.
 Road Ahead
• Anomaly may disappear if methodology of
estimating abnormal return is reasonably
changed. It is on shaky footing. It is highly likely
that anomaly could be the outcome of replication
and robustness checks that followed publication
of original studies
• On the other hand Under-reaction is
only Pyrrhic victory for market
efficiency.
 Return Metric
• BHAR ( Buy and Hold Abnormal Return)
• AAR (Average Abnormal Return)
• Time: daily, monthly, quarterly, yearly
 Other Interpretations
• Anomalies may be ubiquitous but attribute to
bad model problems
• It could be methodological illusions
• Are you dredging for anomalies……rewarding
occupation …………..called as “data snooping”
evidences.
• Can be spurious correlations
• Publication hungry professors also distort the
information (publish or perish)
 Cont.
• Bad models contaminated with mugged or
recurring factors only.
• We require beta and alpha from out of the
period and out of the sample for solving bad
model problems
• Sorting can’t be restricted to size and
BE/ME……….styled managers
 Cont.
• Anomaly is no guarantee against efficiency
 Let us explain with
• Disposition effect : the tendency of investors
to hold losing investments too long while
selling winners too soon.
• Propensity of investors to trade excessively
attributed to overconfidence
 Disposition Effect
• Investors keep separate mental investment
accounts and treat gains and losses as
described by prospect theory
• Tend to hold losers and sell winners
• Status quo is taken as reference point
• There are situations where gains and losses
are coded relative to an expectation or
aspiration level that differs from the status
quo
 Cont.
• Many times purchase price is taken as
reference point.
• Sometimes reference point can be changed by
investors
• Consider an investor with two stocks ….one is
up and other is down……investor has liquidity
crunch and need money ……no new
information about the stock……thus investors
are more likely to sell the stock that is up.
 Cont.
• Most of the time, reference point is purchase
price but if stay invested for long, price path with
average pattern may become reference point.
• For tax reasons, investors should capture tax
losses by selling their losing investments and
postpone taxable gains by holding profitable
investments.
• Investors might sell winners and hold losers in an
effort to rebalance their portfolios.
 Cont.
• Selling winners and holding losers may also be
attributed to the belief of overreaction in loser
stocks which may outperform in future
• It is also suggested that investors’ reticence to sell
losers may be due to their sensitivity to higher
trading costs at lower stock prices.
• People also think that losers will bounce back
(mean reverting) and outperform yielding good
returns. It is highly probable that buying spree
persists for losers
 Cont.
• In ESOPs, instead of purchase price, recent
maximum price may be taken as reference.
• Investors may buy the stock if it is at a
monthly low and may sell the stock if it is at
monthly high (trend)
• Young investors have buying spree and oldest
investors have selling spree. (age)
• Disposition effect is also pronounced in real
estates (sector)
Overconfidence and Excessive Trading
• Overconfident people tend to overestimate their
abilities and the precision of their
information…….indulge in excessive
trading…..lower their expected utilities
• Overconfident investors are too certain about
their own opinions and refute the opinion of
others………….it causes heterogeneity of
beliefs……………..leads to excessive trading
• Source of overconfidence is mis-calibration of
subjective probabilities and unrealistic optimism
about future outcomes.
 Cont.
• Overconfidence also emanates form
unrealistic self evaluations ( think better than
others unreasonably). Rate their abilities and
prospects better than peers. They recollect
positive outcomes of the past more easily
than negative outcomes of the failure.
• Overconfident investors “misremember their
own predictions so as to exaggerate in
hindsight what they knew in foresight”.
 Cont.
• Informed overconfidence……interpreted
rightly…..manage well
• Uninformed overconfidence ……lose in the
form of trading cost
• Overconfidence but misinterpretation lead to
wrong position with trading loss
 Cont.
• Investors switched to online trading
mode……….feeling of
empowerment………..investors feel that they
can affect outcomes by personal involvement,
seems as illusion of control
• This illusion of control lead investors to trade
too often and too speculatively.
• It is confused control.
 Cont.
• However overconfidence in abilities may lead
to higher motivation, greater persistence,
more effective performance, and ultimately,
greater success.
 Loss aversion
• Loss aversion leads to……….endowment effect (value a
good or service when a property right to it is
established………evolution of private property) +status
quo (conservatism bias)…..cognitive heuristic
“Anchoring”……..motivate to take decisions based on
primary anchors….relative thinking preferred…….under
reaction
• Loss aversion has greater impact on decisions or
preferences rather than gains
• It is clubbed with frequent monitoring of
wealth…..myopic loss aversion
 Other behavioral features
• Ambiguity Aversion: …….Preference for known risk
rather than unknown risk
• Self deception………….. ……overconfidence ( I will beat
the market) + optimism (stock market will rise)
• Dominance hierarchy……..boys are always boys and
tend to dominate with peers …..want high fitness and
high status………….boys overconfident….information
disadvantage………bad bets and trade
frequently…….unfortunately finance industry is male
dominated
 Cont.
• Probability…..either frequency or
Bayesian……if frequency……….fast and
frugal……….full of errors…..base rate
neglect……..problem of representativeness or
similarity or stereotyping…….if
similarity……then overreaction (long periods
or very short periods) ……if
representativeness…….technical analysis (use
of historical data to forecast future)……relies
on data generating by market action.
 Behavioral explanations of technical
analysis
• Transaction cost decreases….market participation
increases….market efficient……….role of technical analyst
decreases…………..but books, training will balance it
• It is communal reinforcement (belief formed by a
community rather than empirical evidence)………..it is
selective thinking (focus on favorable evidences to justify
our belief)
• Confirmation bias (tends to look for information which
reinforces our preferences)
• Self fulfilling ( conditioning on price, …support and
resistance) vs. Self destructive (conditioning on time
………weak end effect, month effect)
 Media Behavior
• Media creates a biased image or impression of
the world around us……it is very
fast……………….lead to information cascades and
herding with many investors behaving in the
similar fashion………crowd
effect…….bubble…….bubble burst…..crash
• News always come after event…..thus surprise
and unpredictable……post mortem
• Normal death rarely reported…………..Death due
to Dengu in metro, high profile murder case too
much reported
 Cont.
• News may be sponsored…..If it is full of good tips,
why don’t they charge tip for it?.........smell of
sponsorship
• More press and analyst coverage…….lower
return……..availability heuristic……investors rely
on easily available information……many investors
invested…..price goes up…..return is lower
• Long ago……gossip was of great importance from
an evolutionary perspective
 Cognitive Dissonance
• Two simultaneous cognitions and
inconsistencies
• Decision paralysis
• Status quo
• Conservatism
 Prospect Theory
• Gain region is endowed with risk aversion
• Loss region is endowed with risk taking
• Risk aversion prevail in gain of high probability
and loss of low probability
• Risk seeking prevails in gain of low probability
and loss of high probability
 Mental accounting
• Cognitive operations used by individuals and
households to organize, evaluate, and keep
track of financial activities…………..resulting
into weak form efficiencies
 Preference
• Either loss aversion
• Or Endowment effect……with right on
properties
 Disposition Effect
• Dispose or sell winner
• Long with losers for long time
 Gradual Diffusion
• Firm specific negative
information………..diffuse slowly……….under
reaction…………..momentum
• FII……positive feedback traders
 Heuristic
• Six general purpose
1. Affect (specific quality of goodness or
badness)
2. Availability (weight)
3. Causality (feedback)
4. Fluency ( mugged)
5. Similarity (representativeness)
6. Surprise (overreact)
 cont.
• Six specific purpose heuristic
1. Attribution substitution
2. Outrage
3. Prototype
4. Recognition
5. Choosing by liking
6. Choosing by default
 Cont.
• Anchoring and adjustment is replaced by
affect heuristic
• Representativeness replaced by similarity and
prototype
 Bounded rational agents
• News watchers and momentum traders fall
under the purview of bounded rationality
• News watchers create short term momentum
• Momentum traders create long period over
reaction
• Overreact to bad news in good times
• Under react to good news in bad
times
 Description of Heuristics
• Affect: it concerns goodness or badness.
Affective response to a stimulus occur rapidly
and automatically: note how quickly you
sense the feelings associated with the
stimulus words treasure or hate
• Availability: It is cognitive heuristic in which a
decision maker relies upon knowledge that is
readily available rather than examine other
alternatives or proedures
 Cont.
• Similarity: it leads us to believe that “ like
causes like” and “ appearance equals reality”.
The heuristic is used to account for how
people make judgments based on the
similarity between current situations and
other situations or prototypes of these
situations.
 Serial happenings
• 3-5 years……….series of good
news….winner….winner….winner….persistent
momentum….price too high
….overvalued….overreact…..return to mean….low
return
• 3-5 years……….series of bad
news….loser….loser….loser….persistent
momentum….price too low
….undervalued….overreact…..return to
mean….high return
 Behavioral Issues
• Few stocks…observed as growth stocks…investors
may conjecture the whole class as growth
stocks…….growth may change…….people don’t
update immediately……slow in
updates…..conservatism……under
reaction…..status quo bias……..clubbed with
representativeness
• Representativeness is the tendency of
experimental subjects to view events as typical or
representative of specific class ignoring the law of
probability
 Cont.
• One leading investing and one asset…..consensus
forecast…..may represent a group of investors
having different expectations………….all are
dragged by the actions of leading investor
(consensus forecast)
• Investor sentiment is partly predictable…..change
very fast in short period….noise trading
effect……arbitrageurs are running investors
money, leveraged and risk averse…..price gap
may widen……gap is reduced to a certain extent
by arbitrageurs
 Cont.
• Actually earnings is random model….investors
don’t know this….they believe that earning
oscillate between two states or regimes e. g
mean reverting and trending. …….investor see the
trend of earnings in a period and updates their
beliefs….if positive after positive
earnings….seems trending up……positive
followed by negative…..clue for mean reverting
one…..form beliefs with (overconfidence and self
attribution) and lead to either under reaction and
overreaction.
 Cont.
• Investors reactions benchmarked to Bayesian
experiments …….reactions to new experiments is
observed against the true normative
value…….people update their beliefs in direction
but not in magnitude……thus full content of
information is not regarded……partial revision in
valuation of shares……fail to aggregate the
information in new earnings and use priori
information to form a posterior estimate…….tend
to underweight useful statistical evidence relative
to less useful evidence…….by virtue of being
overconfident about prior information
 Cont.
• Investors…..evaluate the probability of
uncertain event…..take decision about the
entire population having few similar
characteristics…….or similar process of data
generating…..individuals matches with
subjects’ experience with people of particular
profession……overestimate the actual
probability and underweight the unknown
information…..representative heuristic
 Cont.
• Pattern in truly random
sequence…………confused
market………….overreact..…….order in chaos
• Firm consistently good
performance……investors enthusiastic…..but it
may just be lucky draw…..inference about the
entire group may be misleading……..people
may overvalue…..return may be
less….overreact
 Weight and Strength Theory
• Evidence….high strength and low
weight…..overreaction consistently with
representative heuristic
• Strength refers the quality aspects of the
evidence
• Weight refers to the statistical information
such as sample size
• Forecast ….too much strength and little weight
 Cont.
• In recommendation letter, the strength of the
letter refers to how positive and warm its
content is; weight on the other hand
measures the credibility and stature of the
letter writer or professor or researcher
 Cont.
• Isolated quarterly earnings announcement
…..weakly information……no particular
pattern…..high weight and low strength…..under
reaction
• If earnings pattern consistent for many
years….high strength and low
weight…..overreaction
• How long earnings should increase?
• How to measure strength and weight?
These two issues are clear so psychological
evidence is much more important.
 Subjects (Investors)
• Only trade …..new set of price appear….then again
trade
• Trade with time series rather than with other investors
• Only trade (long overvalued and short overvalued)
• Will trade even in random walk model
• Trading is universal behavior
• Extrapolate past trend (momentum)
• Investors indeed chase trend once they think they see
them
 Truths
• People pay too much attention to strength and lesser
attention to low statistical weight
• Earnings announcement or similar events….low
strength and high weight…..under-reaction
• Volatility is mean reverting
• Stock market crash…..high strength and low
weight……overreaction……people gather information
from press or selling spree of FII
• Consistent pattern of good news or bad news…3-5
years….high strength and low weight…..overreaction
• Thus we need a priori way of classifying events by their
strength and weight
 Determinants of Trading Behavior
• Past returns
• Reference price effects
• Tax loss selling
• Reluctance to realize losses
 Modern Portfolio Theory
• Modern portfolio theories have rational and risk averse
investors and is efficient and prescribe
diversification………Thus don’t time the market, buy it.
• Efficient market hypothesis ….strictly speaking
false……in spirit profoundly true

• Efficient…………” fully reflect” the information

• Rational investors want time value of money,
compensation for systematic risk, demand more for
risky portfolio
 Empirical Observation
• Two pervasive anomalies
1. Under-reaction of stock prices to news such as
earnings announcement
2. Overreaction of stock prices to a series of good
or bad news

Let us learn the parsimonious model of investor

sentiment , where investors can form beliefs
consistent with the pervasive empirical
observation
 Can we accommodate this in asset
pricing model?
• FF (1993) subsumed overreaction but under
reaction unexplained
• Thus it is challenge to efficient market
hypothesis and can lead to profitable trading
strategies
 Investors and Properties of data
• CAPM advocate normal distribution return
• Investors want positively skewed return but
don’t like kurtosis
• Investors want free lunch and arbitrage but it
is leveraged and costly
• Only free lunch in finance is diversification
• We want to beat the market…………big
illusion……it is sheer luck
 Can we ease our pain

Naive Diversification Strategies in

Defined Contributions Savings Plans
 Let us learn how individuals deal
with a complex problem of selecting
a portfolio in their retirement
accounts
What is offered to you?
 Modus Operandi
• People use a simple rule of thumb to help
themselves
• It is called as “ diversification heuristic” or 1/n
heuristic
• Traditionally people spread their savings
evenly across the investment options
irrespective of the particular mix of options in
the plan
 Cont.
• Thus array of funds offered to plan
participants can have a strong influence on
the asset allocation people select i.e as the
number of stock funds increases, so does the
allocation to equities.
• Diversification heuristic can produce a
reasonable portfolio , it does not assure
sensible or coherent decision making
 cont.
• If the plan offers many fixed income funds ,
the participants might invest too
conservatively.
• If the plan offers many equity funds , the
participants might invest too aggressively.
• Otherwise hybrid
• Or may listen the prudent investment advisors
 Issues in the current offer
• Should I go for public or private retirement
plans?
• What is the right mix of fixed income and
equity funds to offer?
• Am I going to consider my age , income and
requirement?
• Or should I listen my investment advisor?
• It depends.
 It depends
• Our tax bracket and need of the investment
• Trust on private or public fund managers
• It is long horizon. By and large, it is buy and
hold
• Choice……asset allocation, size, value,
momentum, sector, theme, horizon
• Familiarity, trust, belief, representativeness,
overconfidence, endowment effect
 Behavioral Finance

Learnt traditional models but does it

make sense
 Agenda of the Discussion
• Return Generating Process and its Limitations ----
mispricing, inefficiency, arbitrage
• Evolution of Behavioral Finance
• Building Blocks (Limits to arbitrage and Psychology
(Beliefs and Preferences))
• Application and Utility
i. Trading Strategies,
ii. Corporate Finance,
iii. Portfolio Selection,
iv. Valuation,
v. Cross Sectional Returns
It is well said “Arbitrage wiped out”
or
Limits to arbitrage
No free lunch except diversification
 What is your dream?
• Bankers
• Merchant Bankers
• Investment Bankers
• Hedge Fund Managers
• IAS, Politicians
• Fund Mangers
• Credit Managers
• Treasury Managers
• Financial Analyst
• Financial Correspondent
• Professor
 Expectations and Refutations
• Traditional asset pricing models (frictionless
market, and rational agents)
• Received all inputs………….(using Bayes Theorem)
updates beliefs
• Maximize utility………make preference and
application
• But all agents are not rational so substantial and
long lived impact on prices….mispricing….limits to
arbitrage….Rescued by Behavioral Finance
Professionals
 Cont.
Expected Actual
Frictionless Full of Frictions
Rational (arbitrageurs) Irrational (noise traders)
Reap Arbitrage Limits to Arbitrage (caused by
less rational traders)
Fair price Fluctuating and Mispriced
Efficient (EMH) Inefficient
Short term Anomaly Sustained Anomaly
Market Efficiency and Friedman’s Line
of Argument
• Price Deviation (Mispricing) creates attractive
Investment opportunity
• Rational agents will come forward for correction
• But correction is costly ,risky and may not be well
timed
• Thus mispricing will sustain
• Well proved “Efficiency” challenged
• “Prices are right”----------”No free lunch” (arbitrage)
• But if no free lunch ………does it guarantee “ prices are
right”
 Various Types of Risk
Fundamental risk
• Arbitrageurs tend to buy at low price and
wait for opportunity
• Further bad news surfaced
• Price goes down
• Try to short a substitute (rarely available)
• Mispricing may worsen further
• So we are bound to forced liquidation
 Cont.
Noise Trader Risk
• Professional Arbitrageurs take positions (separation of money and
brain)
• In short run, irrational may be highly irrational and pessimistic
• Price further decreases
• Forced liquidation by rational agents and lose money
• Creditor also call loans in poor return case to avoid further erosion
of collaterals
• Investors appreciate money managers by their performance in the
short run
• Think long and act short …..lead to paradox only……it will come
 cont
Implementation Costs
• Well understood transaction costs-----
Commissions, bid ask spread, price impact
make arbitrage less attractive
Horizon Risk
• Longer horizon of investment…..erosion of
profits………accumulation of
costs……………mispricing less attractive
 Is mispricing sustained?
• Persistent noise traders with least
contributions to predictability
• Real world arbitrage is costly and risky
• Lack of close substitutes
• Shorter horizons
• May trade in same direction both arbitrageurs
and noise traders making situation worse
 Cont.
• Positive feedback traders buy winners and wait
for further momentum and price rise-----May
earn profit if everything goes well-----may not
earn if inefficiency prevails
• Overpriced firm issue shares ….price may be back
to fundamental value. But it is costly as well as
overpricing and its timing is subjective. It will
deviate from desired capital structure without
additional return
• Thus arbitrage is risky, costly and limits
effectiveness leading to persistent mispricing
 Then what should I do?
• Mispricing is the sustained problem
• So can we make the problem as business. yes
• Thus we can aspire for Arbitrageurs (Rational
Traders or Hedge Fund Managers)
• For this we need to understand psychology of
various stakeholders rather than abstract number
• Thus Mr Finance take the solemn vow “ I will
learn abstract finance theory as reference frame,
but act with the help of finance psychologist”.
 Psychology (Beliefs and
Preferences)
Mr Finance got the partial solution
 Issues
• Who will resolve behavioral biases?
• Can we address specific irrationality?
• Do we understand belief formation process
and making preferences?
• Is it really the sum total of varied expectations
of various agents of the financial market
setting?
 Beliefs Formation
Overconfidence
• Confidence interval to the estimate of the
quantity
• Poor calibration when estimating probability
• Attributed to self attribution bias ( take credit
of favorable outcomes and curse bad luck for
unfavorable outcomes)and hindsight bias (
once predicted , happened favorably, so
motivated for bigger predictions)
 Cont.
• Optimism…….Unrealistic rosy views of their
abilities and prospects (e.g driving , sense of
humor, ability to get along with people)
• Anchoring…..often start with initial values and
tend to hover around it ( oscillate around
initial values)
Initial value is 80 then final estimates 70-90.
 Cont.
Belief Perseverance…
• form opinion and cling to it too tightly for too
long
• if of higher order called as confirmation bias
(analyst meet or conference)
• contrary evidence misinterpreted
• Reluctance for contrary evidence but if found
then substantial skepticism
 Cont.
Availability Bias
• Difficult to retrieve all inputs so more weight on
recent, salient, and mugged events
• Economist argue rationally that events
repeated…bias repeated …..error
committed….errors learnt……bias not
repeated……errors disappear due to higher
incentives
Conservatism
• Overweight on base rate, too much trust on
priori, hardly react to new happenings
 cont
Representativeness
• Base rate neglect and sample size neglect (decision based
on few representatives)
• When people try to determine the probability that a data
set A was generated by a model B or than an object A
belongs to a class B, often used the representative heuristic
• Leads to “ hot hand phenomenon” …a player may succeed
thrice so people think that next time also he will do the
same.
• Small representative sample but big forecasting….law of
small numbers ……gamblers fallacy effect ( after three
successive heads, people think three successive tails are
due).
Professor, I have formed my
beliefs
Can you tell you how to make
preferences
 Making Preferences
• Weighted utility theory
• Implicit expected utility
• Disappointment aversion
• Regret theory
• Rank dependent utility theory
• Prospect theory (descriptive only,
promissory, parsimonious, also captures
experimental results, captures peoples’
attitude to risky gambles.
 Cont.
Prospect theory
• Outcomes and objective probabilities known
• Utility = f( gain or losses) rather than final wealth position
• Two non zero outcome or more than two
(x, p; y, q) where outcome x with probability p and outcome
y with probability q)
x<=0<=y or y<=0<=x
Which ever gives you higher prospects you lock your
preferences
• Risk averse while gains and risk seeking while loses
• Kink at origin confirms greater sensitivity to losses than
gains
 Cont.
• Value function is concave in gain region and convex in
loss region
• Small probabilities are over-weighted
• People place much more weight on outcomes that are
certain relative to outcomes that are merely possible ,
a feature known as certainty effect.
• Coefficient of loss aversion is the relative sensitivity to
gains and losses.
• Prospect theory can explain why people make different
choices despite similar level of final wealth.
 Cont.
Example of prospect theory
(1) (5000, 0.001) > (5, 1)
Gain as much as possible
(2) (-5000, 0.001) < (-5,1)
Avoid loss to the maximum possible extent
Thus same wealth , different choices but click to
one which is more prospective…..is prospect
theory.
 Cont.
• (3000,1) > (4000, 0.8; 0, 0.2) certainty effect
• (4000,0.2;0,0.80 )> (3000, 0.25)
• People are more sensitive to differences in
probabilities at higher levels
• The intuition is that the 20% jump in probability
from 0.8 to 1.0 is more striking to people than
the 20 % jump from 0.2 to 0.25. People place
much more weight on outcomes that are certain
relative to outcomes that are merely possible , a
feature known as “certainty effect”.
 Cont.
Framing, Narrow Framing and Mental
Accounting
• E1= 100
• E2=-50
• E3=+200
• E4= -300
I am confused between recent and cumulative.
 Cont.
• This confusion and dilemma of decision is
called as framing. And the process by which
people formulate such problems for
themselves is called as mental accounting.
• Any way, if we isolate an event from the
previous events and take it as if it is the last
opportunity………………Narrow Framing
 Cont.
Ambiguity Aversion
• People don’t like the situations where they are uncertain
about the probability distribution of the
gamble………….situations of ambiguity
• Problem can be addressed by the competence of individual
or acquaintance of individual with the problem to assess
probability distribution (competence hypothesis)
• Conversely , people may opt “ preference for the familiar” .
• Respondent vs. chance machine to predict football match
results
• If respondent is football coach, we can trust on respondent
Can we apply these theories?

Off course in every financial decision

making process
 Mostly applied in
1. Aggregate stock market
2. Cross Sectional Returns
3. Closed End funds
4. Investors Behavior
5. Corporate Finance
1. Application: Aggregate Stock Market
(1) Equity Premium: Return on equity > return
on bonds historically ( buy and hold).
(2) Volatility…globally observed in stock returns
and scaled price ratios. Sources are rational
and irrational agents
(3) Predictability: Fama French model (2014) has
forecasted successfully
These are persistent puzzles.
 Equity Premium Puzzles
• Equity looks rewarding but having low covariance
with consumption …..investors are unwilling to
hold …………….if ready to hold ………wants
significant premium compensation
• Uncertainty in equity lead to premium charged
• Sources of uncertainty in preferences in equity
premium puzzles: prospect theory and ambiguity
aversion
 Cont.
• Thus compute gains and losses and select the
one with highest prospective utility
• Loss aversion and frequent
evaluation….myopic loss aversion.
• May use temporal narrow framing ( forget
total loss or gain in wealth and focus on loss
and gain today in stock market).
• Non consumption utility or regret can be
useful.
 Cont.
• Regret is the pain we feel when we realize that
we would be better off if we had not taken a
certain action in the past. If the investor’s
stock holdings fall in value, he may regret the
specific decision he made to invest in stocks.
Such feelings are naturally captured by
defining utility directly over changes in the
investors’ financial wealth or in the value of
his stock holdings.
 Cont.
• Ambiguity aversion is partial resolution
• People dislike the ambiguity or where the P.D
of outcomes are unknown
• Can be used reference P.D of the agents on
adhoc basis.
 Volatility Puzzles
• Volatility of returns > volatility of dividends
growth
• Change in expectations………change in dividends
growth rates…..change in discount
rates………change in forecasted
returns……………….change in risk
aversion….change in habit framework and
consumption
• Thus this variation helps to plug the gap between
the volatility of dividend growth and the volatility
of returns.
 Cont.
• Investors believe ………mean dividend growth rate
is more than actual……….surge in dividend brings
exuberance………..push the price up…………add
volatility.
• Two consecutive periods of good
earnings……future seems prospective……..but
may turn bad or average…………..people trust only
on good ……….adding volatility………it is based on
representativeness or based on small numbers.
 Cont.
• Investors too much weight on private research
and bypass public information …………too much
weight on his findings………..overestimation of
accuracy…………..push the price ….add to
volatility…………..overconfidence
• Past return ……..extrapolate in future
returns…..up and down moved ………adds
volatility…………….representativeness or law of
small number
 Cont.
• Evidence on aggregate level….decision on firm
level……….adds volatility
• Money illusion between nominal and actual
return adds volatility.
1. Thus separate discount rate should be used
for nominal and real cash flows.
2. Inflation will affect cash flow as well as
interest rates.
 Cont.
• Degree of loss aversion = f( prior loss or gain)
• It is dynamic in nature
• Loss leads to non participation because loss is
more painful after loss.
• Gain leads to over-participation because loss is
less painful after gain.
• Thus the gamblers’ willingness increases to bet
when they are ahead
• It is called as house money effect.
 Cont.
• Good cash flows…………….price will go
up…………gain to investors………..less loss
aversion………..discount future at lower
rate………………price pushed up……….adds to
volatility
 2. Application: The cross section of
average returns
• Thus many more empirical evidences are highly frustrating
for rational paradigm and they are called as anomalies
1. Size premium
2. Long term reversal
3. Predictive power of scaled ratios ( high BE/ME –value
stocks and low BE/ME –glamour stocks)
4. Momentum
5. Events studies of earnings announcement
6. Events studies of dividend initiations and omissions
7. Stock repurchase
8. IPOs
 Related facts or truths
• Poor performance……..sold at year end to offset capital
gains………..price decreases………further loss………..adding
loser momentum…….at the end of the year selling spree
eases………prior losers rebound………weaken the
momentum effect
• Firms of share repurchase outperformed the control group
( Surplus cash….buyback….supply of shares reduced)
• Firms with IPOs underperformed the control group (deficit
cash…..sell…..supply of shares increased)
• Post earning announcement drift is positive if good news (
investors are slow to react due to conservatism)
• Dividend initiations outperform and omission
underperform a control group
 Illusions may appear
• Data snooping biases
• Data mining biases
• Out of the sample tests
• Different sorting technique
• Buy and hold vs short term churning
• high alpha not necessary celebration
• High r square no joy any more
• Survivorship bias
Contradictory Findings of Two Finance
Deans
• Fama and French ………..average returns =f(
factor loadings) not factors
• Daniel and Titman ……..different loadings on
stock but same BE/ME………..lead to same
return……………refute FF…………FF (2000)
refuted the claim of Daniel and Titman using
longer series.
 Belief Based models
• Public information form expectations
…………cause systematic errors………………………..F(
conservatism and representativeness)
• Few series of good
announcements…representativeness….overreact
….price pushed up……….people think that
increased growth rate is new growth rate…thus
average ignored……new average is law of small
numbers….price reversal…..lower price …loss
 Cont.
• Earnings….(1) mean reverting regime (faith on
prior information, conservatism) (2) Trending
regime (capture new trend,
representativeness)….future earnings pattern
reflected by current earning trend
• Investor (positive private information and neutral
public information)…..overconfidence….ignore
public domain information….price pushed
up…..after some time price pulled down by public
information……long term reversal and scaled
price effect
 Cont.
• Excessive optimism and pessimism……long term reversal
• Positive feed back…..price up….slow
diffusion….extrapolation…momentum added
• News watchers make forecasts based on private
information…..diffuse slowly….true for small firms and low
analyst coverage firms…..under-react…momentum
• Low analyst coverage firms…..if good news ….known to few
people…..adds momentum….if bad news …no
diffusion….losers…..big losers….momentum added
 Cont.
• Continued
diffusion….momentum….momentum…long
term reversal
• Investors irrationality (overconfidence and
heterogeneous beliefs) and institutional
frictions ( short sale constraints and legal
restrictions on it) …..justify cross sectional
evidence without convergence
 Cont.
Miller philosophy
• Bullish investors are long
• Bearish investors want short but may not be
available so sit out of the market.
• Thus stock market reflects the opinion of
bullish investors only. It leads to price increase
followed by price decrease. Thus price is
skewed. …..It will also cause volatility.
 Cont.
• Aggregate stock market = f ( time varying loss
aversion, narrow framing)
• Individual stocks= f( loss aversion, narrow
framing, long term reversals, scaled price
ratios)
 Cont.
• Investor with many stocks….narrow frame will
induce to derive utility from gains and losses
in the value of individual stocks…..pain of loss
depends on the last performance…….a stock
poor performance in past…..investors take it
painful and riskier and discount the future
cash flow at higher rates…….P/E pushed
down….higher subsequent return……..value
premium
 3. Application: closed end funds
• Closed end funds….issue fixed units….traded on
exchange…….few investors may be noise traders (
optimistic or pessimistic) …..exhibit irrational
swing in their expectations about future fund
returns…..premium is desired for it.
• Closed funds are created when the market is
bullish and investors are exuberant…sell at
premium
 Cont.
Co-movement
• Economic minus frictions +rational view
………..then price and fundamental value move
together
• Froot and Dabora’s evidence ( Habitat view of co-
movement)….many investors trade subset of all
available securities…..sentiment may
change….proportion of securities may
change….but restricted co-movement of investors
affecting the price of sub-sample securities
 Cont.
• Closed funds----portfolio selection process---investors
select portfolios (double sorted ) and allocate funds
…..if noise traders also enter……rational traders may
exit……irrational price pressure on these
portfolio…..price may be away from fundamental value
• Category view of co-movement---stocks before the
inclusion in the index and stocks after the inclusion in
the index-----beta increases after inclusion….beta
decreases after exclusion…..not synchronous with the
cash flow view of co-movement
 4. Application: Investors Behavior
• Home bias: USA, Japan, UK investors invest
more than 90% in domestic equities
• Investors interest have grown due to reduced
cost of trading and the financial planning and
retirement planning in contributory mode.
• Diversification is naïve …either under-
diversified or over-diversified
 Cont.
Home Bias within Countries
• Trade in stocks of closer geographical locations
• Trade in stocks of whose CEO is from native
language
• Trade in stocks where report is published in local
language
• Thus people evaluate gamble based on previous
familiarity
• Avoid ambiguity aversion increasing degree of
confidence
 Cont.
Naïve Diversification
• 100 Rs and two funds ….equal division…lab
treatment to diversification….it is
wrong…investment prowess needed
• Use constant dollar plan , ratio plan and
benefit plan
• 1/n to n funds is a naïve diversification
 Cont.
Excessive Trading
• Rational models…rational agents….buy and hold…trade
less
• Actual market….trading is high…..lower trading
cost…..return is less than benchmark….boys are more
tempted…..it is gender specific and herd
mentality….feel overconfident and keep on
trading…cost adjusted return is less
• Change in mode of trading from phone to online…raise
the confidence of investors…have better access to
information…greater degree of control….thus
overconfident…..frequent trading….less return
 Cont.
Disposition effect
• No one wants to sell securities lower than the price of
purchase…..wants to sell when the price has gone
above purchase price…prospect theory and narrow
framing…thus they wait for favors…..if not profit wait
for break even to avoid painful loss….thus waiting adds
momentum in stocks
• This is more pronounced in housing market
• Professional trader…mid of the day….profit
(losses)….they will be loss aversion (risk taking)
• Thus sell focused on winners only
 Cont.
• Buying decision is evenly split between loser
and winner…..attention effect
• People don’t buy best stock by sifting through
thousands of stocks in exchange rather buy “
to best attention stock” or “best performing
stock”
• Buying = f( attention) = f( performance, news,
trading volume)
 5. Application : Corporate Finance
Security Issuance, Capital Structure, and Investment
• Market timing framework….exuberance….low
…repurchase…..if exuberance high….issue shares
• Issue of securities….decide capital
structure….cumulative financing decisions
• Price increase….don’t issue new shares….keep
cash with you….start new projects with positive
NPV…..managers know what to start and what to
leave….don’t fall in the trap of
exuberance…investment decisions
 Cont.
• Today A and B have equal BE/ME
• In past , A has lower value of BE/ME
• Thus A issued capital at overpriced level
• So firm A has more equity today
• Conclude: BE/ME is a good predictor of capital
structure
 Price status
High Low
• Financing: issue new • Financing: Repurchase
shares • Investing: No shut down
• Investing: may start of projects, status quo
new projects
Equity dependent firm more sensitive
to gyration (oscillation) in stock prices
Investors sentiment Investor sentiment
optimistic pessimistic
• No lack of funds • Forgo attractive
• Go for extra miles in investment
investments opportunities
 Mr. Manager, are you crazy ?
Managers……….crazy to maximize the size of the
firm………………to enhance their prestige………..go
for investment distortion…………….in exuberance
may go for negative NPV projects for empire
building projects….managers influenced by
investors’ sentiment….may try for acquiring sick
firms or hostile takeover ……..ultimately fail to
maximize the true value….loss of the firm…..may
be fired from the firm……trap of prestige, whims
and fancies
 Dilemma of dividends
• Dividends……high tax rate and the capital gains …low
tax rate ………..but still dividend preferred why? Why
not share repurchase?
• However tax exempt shareholders are indifferent
between dividend and share repurchase.
• Investors like dividend…….notion of self control
problems ( want to deny indulgence and take oath that
we will not take tomorrow….tomorrow again
overeating)
• Slogan of only consume dividends , don’t touch the
portfolio at all. It is better to consume today rather
than tomorrow
 Non dividend paying firms
Investors need money for consumption
• Price has gone up and selling will lead to loss
• If no dividend, so price rise at this time more
regret
• If dividend, less regret due to increased
perceived utility
 cont
• Scenario 1: Rs 2 dividend + Rs 8 capital gains
• Scenario2: Rs 10 capital gain

First is better due to higher perceived utility

(prospective theory)(regret is avoided)
 Cont.
• Scenario 1: Rs 10 loss
• Scenario 2: Rs 12 loss + Rs 2 gain in dividends

Scenario 2 is better because of higher perceived

utility , less regret, lesser frustration

Regret is stronger for error of commission rather

than errors of omission.
 Cont.
• Change in dividend policy……………affect
sentiment…………price increase or decrease
• Risk averse investors…..prefer dividend paying
stocks………..because of confused notion of
less risk “ bird in the hand”
fallacy………………managers may think of
increase in short run value………he will get
more compensation…….forced to revise
dividend policy
 Fixation of dividend payout ratio
• Max firm value concept is ignored
• Asymmetry in increase or decrease in
dividends
• Perception of fairness is used to decide the
target payout ratio
• Firms try to increase the dividends to level
from where they will not reduce them in
future
 Managerial Irrationality
• They get ESOP (Employee stock ownership
plan)to maximize value of the firm…………..but
they think “ I am the boss, and Boss is always
right”
• Irrationality is byproduct of their positions,
prestige, whims and fancies
• Well explained by “ hubris hypothesis”.
 Hubris hypothesis
• Irrational managers…..overconfident…wanted
takeover (despite insignificant overall
gains)…..valuation synergies……………..if
valuation is higher than market price….launch
the bid to take over…..excessive trading will
pick up…..investors become
overconfident…..many more bidder may join
in bidding…..price of target goes
up………..overall lead to zero profit.
 Cont.
• Managers……overestimate the probability of
future performance….explain pecking order rules
for capital structure (first use internal accruals,
then debt followed by equity) …..think equity is
undervalued and don’t issue until exhausted
internal accruals and debt.
• If cash flow low…forgo investment
opportunities…..don’t use external means
• Excessive optimistic CEO….more sensitivity of
investment to cash flows…sensitive point is when
they exercise their stock options
Let us learn “ The Limits of
Arbitrage” in detail
I thought it is zero sum game with
positive profits……….big illusion
 Arbitrage
• Zero sum game , positive profits
• No capital investment required
• Bring the price to fundamental value
• Keep market efficient
• May have others money to manage to specially skilled
people so performance and effectiveness are important
(separation of brain and capital)
• Less capital…so forced to liquidate sometime
• More capital…may sustain in the market
• Large number of arbitrageurs…infinitesimal position against
mispricing….price moves close to fundamentals…arbitrage
disappear…short term anomaly
 Cont.
• Performance based arbitrage prevails now (agency
managed)
• Arbitrageurs may find suitable positions to invest but
may be constrained by capital irrespective of the status
of risky and risk free investments
• Investors want only performance without wait and give
funds to good performers or well performing hedge
fund managers
• Thus despite favorable situations, arbitrageurs may
require bail out or forced liquidation ( marked to
margin may be a problem)……it limits the market
efficiency
 Cont.
• Money managers ….”window dress” their
portfolios to impress investors …..churn portfolios
to mislead their investors……may become more
efficient…..distort the mispricing further
• Young and unseasoned arbitrage funds ---more
sensitive performance
• Long and seasoned arbitrage funds less sensitive
• Loss of arbitrage can be reduced by
diversification of funds
 Cont.
• Agency issues….boss not convinced of the
ability of subordinates in taking
positions….Boss is forced to liquidate before
the uncertainty works out.
• Non stationary economic variables….response
may be based on latest updates…….limit the
arbitrage effectiveness
 Which market attract arbitrage
resources
• Specialized arbitrage avoid (risk averse) in volatile
market and extreme situations
• Market has become leveraged, short selling and
performance based, agency based
• Stock market arbitrage is difficult because of difficulty
in calculating relative value and absolute value
• High volatility…more opportunity for arbitrage…..bit
noise trading may be…performance may be averaged
out with average alpha…..thus high volatility is useless
unless we get commensurate alpha
 Cont.
• Understanding anomalies…..find source of
noise trading generating mispricing…..find the
demand of potential noise traders =f (
sentiment or institutional
holding)……………….evaluate the cost of
arbitrage….evaluate volatility and
return…..find volatile securities….may have
higher mispricing…..may give high return and
arbitrage
 Mr. Arbitrage , how are you?
• Investors gave money……specialized
performance based arbitrageurs…..they avoid
volatile arbitrage position…..may be good for
high returns but volatility exposed to risk of
losses or forced liquidation under pressure
from investors……..Life is tough and
demanding but highly paid.
Do we have some resolution for
mispricing
Prospect theory can help to a certain
extent
 Prospect Theory
• It is descriptive model of decision making under risk to explain the
numerous violations of expected utility paradigm documented over
the years
• Utility defined over gains or losses relative to some neutral
reference point contrary to wealth in expected utility theory
• Utility =f ( higher sensitive to decrease in financial wealth than to
increase , called as loss aversions)
• Utility of investors in asset prices= f( less dependent on
consumption, more dependent on fluctuations in the value of their
financial wealth)
• Degree of loss aversion = f( prior investment outcomes)…prior
outcome will guide our subsequent behavior
 Cont.
• After prior gain…less loss averse (house money
effect)….because it will cushion only subsequent loss (
further loss is less painful)
• After prior loss….more loss averse….burnt by initial
loss….more sensitive to initial setbacks (post loss is
extremely painful)
• Change in risk aversion= f(past performance, dividend
news)
• Investors ….loss averse….f(loss in the individual
securities) = f( loss in the value of the entire
portfolios)……This summary is called as mental
accounting.
 We always befool ourselves being
long run investors but we are short
sighted
Myopic loss aversion and the equity
premium puzzle
 Loss aversion
• Tendency of individuals to be more sensitive
to reductions in their well being than to its
increase
• It is a decision making process
• Origin will have its own kink with slope of
aversion steeper and slope of gain function
less steeper…………..and ration of these slopes
at origin is the measure of loss aversion
 Cont.
• Disutility of giving up > utility of acquiring it
Thus loss aversion is greater or equal to 2
• Rs 200 with 50% vs Rs -100 with 50%
Here loss of 100 rs is more scary than the gain of rs
200.
• Individuals use methods to code, evaluate
financial outcomes, transactions, investments,
gambles, etc………..these methods in aggregate
called as mental accounting. It is dynamic
aggregation
 Cont.
• Two factors responsible for unwillingness to bear the
risk associated with holding risk asset…….loss aversion
and short evaluation period…..contributing to myopic
loss aversion
• In longer horizon……..our risk taking capacity
increases……….we are attracted to risky assets. But in
short term , we avoid risk and wants less risky asset.
• Equity premium ….(1) loss aversion (fact of life) and (2)
frequent evaluation (policy choice) (3) cost of excessive
vigilance ….we may be satisfied with lower return in
longer run by paying the rent to resist the temptation
to count their money frequently.
 Cont.
• Pension funds….longer longer horizon……but less
invested in stocks…..big paradox……….or a myopic
loss aversion
• Fund manager……….frequent report of fund level
and returns……………plan for short…………..thus
conflict of interest between managers and theme
of fund………….people money managers plan for
3-5 years ………end up with near term loss and
long term insignificant results………agency cost
lead to myopic loss aversion
 Cont.
• Endowment funds….perpetuities….myopic
loss aversion…..agency problem….president
says go for 100% in stocks which always
outperforms bonds………….but aligns with
definite horizon period of board
members…..thus interest of potential
beneficiary ignored……………myopic loss
aversion
 Cont.
• Equity premium is a puzzle
1. Reconcile higher rates of return on stocks with very
low risk free rate
2. Higher sensitivity to loss with a prudent tendency to
frequently monitor one’s wealth
First is shift from consumption to return
Second is that people should demand a large premium or
compensation to accept return variability
In myopic loss aversion, investors are unwilling to accept
return variability even if the short run returns have
effect on consumption……useful in decision making
under uncertainty.
Status Quo Bias and Endowment
Effect
Since it is mine, it is very costly.
 Story of Busy Investor (Status Quo
Bias)
• I have Rs 1 crore portfolio with lopsided
investments and don’t have time to churn.
• Appointment received with portfolio manager
• After inputs, he told “ I will let you know”
• Came with wife.
• Next time came with CA
• Next time came with investor
• Next time he forgot and went to Johannesburg
• Let you know
• “decision paralysis”
 Cont.
• He can’t make decisions and he is resilient to change
• He just could not decide what to do
• He fears change and prefers maintaining the status quo
• He understands that he needs to take action but he
can’t
• Thus loss aversion, regret for bad decisions and
preference for older things (endowment effect) may
contribute to decision paralysis.
• Most prominent in real estate
 Truths
• I may defer purchase of raw materials, and end up with
higher payment in future
• Seen many clothes, which one is best…I don’t know.
• More than 10000 stock with 800 plus battery of mutual
funds………….what a complicated finance mall we have
• Seen many flats and land, which one to buy….I don’t
know.
• There was a good stock, I missed, today it is at peak.
• Opportunists never hesitate to
worship the rising son
 Peer pressure on fund manager
• Good performing fund + fund manager
• Old fund manager left
• New one joined
• If he changes the weightage of stocks in
portfolio……………fear of losing and getting
compared with predecessor and previous
benchmark
• Active churning is restricted
• Thus he is pressurized to maintain the status quo
or previous weightage of stocks
 Other examples
• Tech stock boom
• UTI monopoly came to an end ( Deepak
Parekh committee recommendation
ignored)…..it took couple of years to recover
once again.
• Thus status quo is mental make up of
remaining in comfort zone
 Cont.
• Deciding not to take a decision is also a
decision…status quo bias
• Actually difficult to come out of the comfort
zone
• But if you don’t decide, 50% you are right and
50% probability of losing right things
We are afraid to take decisions due to
• Fear of going wrong
• The possibility of making loss
• Desire to avoid looking foolish
• Unwillingness to take risks
 Endowment Effect
• Examples
1. Price is 300…..price limit 305….price is
310…price limit 320…….price is 340…price limit
350………nosedived to 292 ( You fall in love with
your stocks)(you don’t want to sell….be ready to
lose)
2. Stereo…..used ….satisfied ……then buy after 10
days……after using 10 days ………hardly you can
afford to separate the stereo…..bound to
buy…..conceptually bought
 Cont.
• Investment banker and his friend
Swati………decided to date in March…..analyst
meet was announced by the company……….he
informed Swati that they need to cancel their
dates because of analyst meet of Jindal
steel…..He is holding stocks and researched
enough…..wanted to know the management
opinion….Swati asked whether you are going to
buy or sell…he said nothing ….just to
confirm…………..
 Cont.
He is married to Jindal stocks
conceptually………Please don’t marry with
stocks….take it as a business only…….it seems
he is going to fools paradise….if company has
called …..they will talk good about
them…..motivate you buy more stocks….offer you
high tea and luxury dinner at the cost of
friend….they will hardly disclose that I am
suffering from cancer…..company visit + analyst
meet and NDTV profit expert discussion
(confirmation trap) in endowment effect
 Cont.
• One asset + two quotations+ buyer and seller
………………..as buyer you want to pay as low as
possible ……………as seller you want to receive as
much as possible………….Mr finance believes that
if it belongs to him…it is costly….if it belongs to
others….it is useless and less
priced…………….ownership of asset will govern the
price of the asset.
• People tend to overvalue what belongs to them
relative to the value they would place on the
same possession if it belonged to someone else
 Cont.
• You keep all previously owned assets
1. Chain of elephant
2. Torn and old costly shows
3. High value but very old gifted goods
4. Old Swiss watch (non working)
5. Grand daddy box
You make museum in your house but no sale of
scrap…………….you like your goods….you are
attached to your goods……….heart dominates on
your mind.
 Cont.
• When you buy a house in a particular
area…..you tend to justify the whole world
that it is the best area
• When you buy a stock….you convince the herd
to buy the same despite poor performance of
the company
• When you graduate from your college (well
placed)…..you tell the whole world it is the
best college…………This is mine.
 Plan of Action
• Deciding not to decide is a decision….(probability
of winning 50% is lost)….come on ignited
minds….come out of your comfort zone
• Consider the opportunity costs
• Put yourself on autopilot (alogrithm or process
driven……if confused start jotting down on paper)
• Change your frame of reference (world is
dynamic)
 Cont.
• Don’t get married to your stocks
• There is no free lunch so pay TIPS for TIPS
• Do scenario analysis and take decision
Greed of gains and Fear of losses

Loss aversion and Endowment effect

 Adage
• Buy when others are fearful and sell when
others are greedy
• Greed of grains and fear of losses duly impact
our decision making process
• People don’t hate uncertainty, but rather they
hate losing
 Anomalies of Loss
• Our reluctance and fear of making a
loss….Loss Aversion (future)
• Our inability to forget money that is already
spent………..sunk cost fallacy (past)
• Decision in present
 Anomalies of Gains
• Status Quo: our inability to make decisions
• Endowment Effect: tendency to fall in love
with what we own and thus makes us resist
change
 Stories of Loss Aversion
• I don’t want risky stock market, so invest in
bonds
• Invested at 1000, saw a high of 2000, today it
is 400, I will hold on to it. I am a long term
investor ( if you sell, you incur losses)
• 30% exposure in tech…after crisis I had 100 %
exposure in tech…waiting that stocks are
bound to rebound
 Cont.
• Scenario 1: you have 1000 rs
1. Guaranteed win of 500 rs
2. Flip of coin…if heads you will get 1000 rs
otherwise zero
• Scenario 2: you have 2000 rs
1. Guaranteed loss of 500 rs
2. Flip of coin. If tail , you lose 1000 rs and
otherwise zero
 answer
• Option 1 in first scenario (loss aversion)
• Option 2 in second scenario (loss taking)

• Mind is very biased, we look at the portfolios

in isolation rather than whole portfolio
 How loss aversion impact investors
behavior
• Investors tend to prefer fixed income securities
• Investors tend to take their profits early (instant
gratification)
• Investors take more risk when threatened with a
loss
• Investors have a tendency to hold on to losers
and sell winners
• Tax aversion: you love total income. You should
focus on tax adjusted income
 Sunk Cost Fallacy
• I paid Rs 1999 for this book……I read 5
pages…………extremely boring …but anyhow I will finish
• Star night and we paid 5000 rs for tickets…..weather is too
bad….raining heavily…….but we will go
• Bank with more NPA….old business client came and asked
for more money…..you credit to relationship rather than
business
• Blue chip stocks of five years back….you still like
them….fundamentals changed…they are not current
flavor………..but you still like them
• I did CA…..spent 7 years….now want to become software
engineer
 Sunk cost fallacy and its impact on
investors and spenders
• Average cost of purchase……once purchase at
high price…..now price declining ….purchase
same stock to reduce the average price
• Spending on repairs…..if too high…go for new
• Govt. spending on delayed and unviable
projects……installed initially……..later found
unviable.....back track difficult…..useless
expenditure
 Thus wise decisions
• Estimate your appetite of loss
• Diversify within assets and across assets
• Total portfolio vision
• Let bygones, be bygones, take care in future
• Reframe losses as gains
• Segregate gains and integrate losses
• Pay less attention to your investments
 Mental Accounting

Differential treatment to different

sources of fund
 Story
• Dilip and Sonia ( finance students of Ivy league)
• Married but Sonia was from service class
• Dilip left high paid job and started stock trading with Rs 4 lakhs
offered from in laws sources
• Reached to Rs 60 lakhs, without any other asset allocation
• Had a foreign trip
• Sub prime crisis came and he is left with again Rs 2 lakhs
• Sonia approached family court for divorce on financial grounds that
he is not able to accumulate wealth in last six years . He has lost Rs
60 lakhs. He is not capable to earn. He is big liar
• Dilip informed court that he has lost only Rs 2 lakhs
Court confused in settlement
 Two Irrational Friends
• John and Don…decided to party on every Friday
evening in Five star hotel
• Both equally paid staff
• One used to pay by credit card and another by cash
• After four weeks, John said it is expensive….Don said
come on man…. don’t worry
• Again both went
• Next time again John reluctant
• Why all these developments
• How long you can tolerate irrationality ?
 Money contexts
• You have bought a movie ticket of Rs 500…….you
reached to hall and found ticket lost.....you have
spared Rs 500 with only
• You have carrying Rs 10000 and lost Rs 500 on
the way before reaching hall. You have left with
Rs 9500.
• In which scenario, will you see the movie?
• Answer: second
• You are processing both loss differently. You are
less frustrated in second case
 Facts
• People differentiate money in their mind as per the sources
of fund
• Bonus can be used for luxury
• Black money or bribe can be used for drinking
• Monthly salary is most valuable
• If sources are sponsored…..we tend to misuse
• If it is paid……….we tend to use economically
• Once Dilip lost money…he is thinking with respect to
original sources
• Don, credit card user was more extravagent ( payments are
postponed)
• John , cash payer was more careful of the money used
 Facts
• Different mental accounts for the same sums
of money and is directly correlated to
emotional state
1. Earned income vs gift income
2. Size of money in question
3. Cash ( Instant gratification or frustration vs
credit cards (temptation of deferral of
payments)
4. Large purchase vs small purchase
 Mental accounting and investors
• Why do investors hold on to losing investments?
(you lose but don’t realize….fools paradise)
• Why do investors earn less interest and pay more
( having savings account and derivative trading) (
safe money vs risk money)
• Bonus share or split share ….you think it is
windfall….but readjusted from reserves
only…balance sheet remains same
• Day and high frequency traders: pay much more
to brokerage and tax authorities (which is
deferred annually)…so not visible
 Plan of action
• Think of present and future both
• Always pay cash
• Credit card is emergency only
• Buy whatever you want….but don’t take tea with sales
personnel…….they may push many unnecessary
products with one prime product
• Be patient
• Imagine all income as hard earned income
• Never trust on shopping mall bill ( do your calculations
and count your particulars….no hurry up please)
 Mental Heuristics

Short cut processing of information

leading to biases (efficiency reflects
“fully reflecting” information)
 Examples
• Out of three birds, two decide to fly…how many
left
• Two boys of equal height…..horizontal vs vertical
stripes shirt
• Two arrows with equal length but inward and
outward orientation of wings
• Rush at mega store…..good store……cash people
on leave and people backlash with faulty items or
bumper sale….never trust on half baked
information.
 Cont.
• Gas basin discovery…….without drilling and
extraction and purification… we are really
herd
• www.ecommerce.com.............think of
bumper profit only
 What is mental heuristics
• It is the short cut the brain takes when
processing information. It does not process
full information and this leads to biases
• Heuristics refers to the process by which
people find things out for themselves, usually
by trial and error. This leads to the
development of rules of thumb further
committing errors.
 Types of Heuristics
• Availability Heuristic…..one bias associated with
availability or ease of recall or mugged
events…………..shining India………PM wanted
….IAS followed………..media followed….people
followed…………we are really herd mentally
people………….ground work zero…..anti
incumbency…………election lost in 2004
• Representative heuristic…law of small
numbers…..asses the likelihood of an event by
the similarity of the occurrence to their
stereotype of similar occurrence…….overreaction
 Cont.
• Saliency heuristic: Individual overreact to a
one kind of event assuming that it is
permanent trend…………WTO attack…….people
stop travelling by flights for next one or two
weeks………although it is the safest period
 Anchoring
• Price trend 150 (purchase price)………..1800………1050
can we sale……….no because I am frustrated with the
reference point of 1800 which may be irrational price
of 1800. decisions are anchored with respect to 1800.
• Just passed out finance grad of Wharton School of
Business…..overconfident…does not listen
market…..thinks I ahead of time by virtue of knowledge
without experience…..anchor his decision to high grade
in finance…………lead to loss in market whenever he is
confident……..thus please respect the market. You
don’t generate returns but the performance of the
market does the same.
 Herd Mentality
• Mutual fund managers ( 80% investments of
80% managers are on same stock)……Thus
they don’t perform but the market rewards
the customers……In poor
performance…………..they blame on
market….thus job is safer for
them……………….trend is the best
friend
 cont
• People follow analyst advice on NDTV profit
• People trust on prospects of policy
announcements
• People buy stock not business but they should
buy business rather than stock
• Reference is the source of herd mentality
 Bigness Bias
• John and Don……..john invests for first 10
years …..Don invests for latter 15
years……after 30 years………..John gets more
than Don ……………..Compounding effect (we
are attracted to 15 years with respect to 10
years )….may create big number biases
• Thus you want to become big, invest small
with regular for longer horizon
• You should buy time for longer duration
 facts
• Expense ratio (0.75% -2% per year) should not
be ignored
• Intraday trading is costly due to transaction
and tax implications
 BF in Corporate Finance
• Managerial Optimism
• Earnings announcement
• Capital budgeting in irrational world
Managerial optimism
and
corporate finance

BF Class
 Facts
Managers are “optimistic "when they systematically overestimate
the probability of good firm performance and underestimate the
probability of bad firm performance.

Higher P………………………………+ Ri

Lower P……………………………….-Ri
 Cont.
 People are more optimistic about outcomes that they
believe they can control………………….ignore the
inherent uncertainty………………think that they will have
full control of any contingencies appearing in future.

 People are more optimistic about outcomes to which

they are highly committed………………….committed to
firms’ success…………………….committed to wealth,
reputation and employment of the firm they belong to
 Caution

•I have two salient

objections.
 The "arbitrage" objection
 Rational agents will exploit irrational agents …………………. weaker, because
there are larger arbitrage bounds protecting managerial irrationality than
protecting security market mispricing………………….
e.g in corporate takeover
1. Higher transaction cost
2. Specialized investors who pursue takeovers bear idiosyncratic risk
3. Human assets are involved which can’t be traded
 The “learning” objection
 Irrational agents will learn from experience to be
rational……..weaker ………….because corporate finance
decisions ( capital structure, dividend policy, capital
budgeting) are not frequent like
trading……………….longer delayed outcomes…….noisier
feedback

 Behavioral approaches are now common in asset

pricing

 Little work in corporate finance dropping the

assumption that managers are fully rational
 What about internal incentive
mechanism or corporate culture ?
Can it eliminate managerial irrationality?
Some internal incentive mechanisms (e.g., "tournaments”) may select
against rational managers, in favor of irrational managers
Irrational managers may take larger risks…………….increasing the
probability of winning the tournament
Interests of principals may be served best by the design of mechanism
that exploit managerial irrationality rather than quash it.
Principals may design incentive mechanism that underpay irrational
agents by exploiting the agents’ incorrect assessment of their ability or
the firm’s risk.
 Free cash flow have further
connections
Asymmetric information approach (Myers and Majluf,
1984):
1. Free cash flow is beneficial because managers are loyal
to existing shareholders are assumed to have
information the market does not have.
2. The main claim is that managers will sometimes decline
new positive net present value investment
opportunities when taking them requires issuance of
undervalued securities to the under informed capital
market.
3. The financial slack provided by the large amounts of free
cash flow prevents this socially undesirable outcome.
 Cont.
Agency cost approach (Jensen, 1986)
1. Free cash flow may be costly in case of conflict between
managers and shareholders.
2. Managers want to retain free cash flows for investing in
projects which increases their reputations and power. (
Wall of fame).
3. Leverage increasing transactions that bond the firm to pay
out free cash flows increase shareholder value and
mitigate the conflict of interest between shareholder and
managers

4. Managerial optimism theory links the benefits and costs

of free cash flow to two variable
 Leads to

• Underinvestment overinvestment
trade off from managerial
optimism without invoking
asymmetric information or
rational agency cost.
 Cntd…..
Mangers believe that an efficient capital market undervalues their firm’s
risky securities, leading to internal funds preference which is socially costly.
But ………….Managers overvalue the firm’s investment opportunities.

Optimistic managers may decline good NPV projects if he finds that

external financing is necessary simply because of the faith that external
finance is costly…………………..because of incorrectly perceived cost of
external finance.

“ Free cash flow is

Hence concluded

highly valuable”………..mistaken
Free cash flow is very- very poisonous
1. Managers may not take good NPV projects
which are externally financed.
2. Managers have not exploited the leverage
capacity of the firm.
3. FCF may motivate to take projects looking like
good NPV but actually may highly negative NPV
projects.
4. You projects are rarely vetted by external
agencies.
5. You may be good but no one knows that you are
actually good or financially disciplined.
 Linkage between FCF and Managerial
Optimism
• Level of managerial optimism
• Investment opportunities available to the firm
• What the agents want?
• What about principals?
• Do they have any conflict?
• External finance is underused, optimally used
or badly used………….million dollar
question……….interests of shareholders
 A simple Model
Three date-two period model:

The asymmetric information approach

assumes that managers have information that the capital market
does not have

The empire-building/rational agency cost approach

assumes that it is impossible to write contracts that fully control
managerial incentives
 New assumptions
Information about the firm’s cash flows and the investment
opportunities is simultaneously available to the capital market and the
managers

Managers take all projects that they believe have positive net present
values and never take projects including perquisite consumption that they
believe to have negative net present value

Security prices always reflect discounted expected future cash flows

under the true probability distributions
 Agency Theory (AT)

 Berle and Means (1932): separation of ownership from control

 Jesen and Meckling (1976):

 agency relationship
 agency cost= monitoring expenditures ( BoG cost, ESOP) + bonding
expenditures ( remain in firm despite potential opportunities) + residual loss
( when agents and principals divert)

 Fama and Jensen (1983): agency problems arise because contracts are both
costly to write and enforce

Jensen and Meckling defined:

“A contract under which one or more persons (the principal(s)) engage another person (the
agent) to perform some service on their behalf which involves delegating some decision
making authority to the agent.”
 Assumptions Of AT

 Bounded rationality
 Opportunism
 Information asymmetry

 AT assumes that the interests of principles and agents diverge (Hill,

Charles and Jones 1992)

 Both parties intends to promote their own self-interest (Kunz, Alexis and
Pfaff, 2002)
 Information Asymmetry

 Information available to the insiders (managers) are not the same available
to public or outsiders (stakeholders)

 Asymmetry of information does not allow the principals to be sure whether

the agents are carrying out the duties that they should according to the
contract Contract does not have to be written contract. That is, it may be
simply constitute implicit terms about how the principal expects the
mangers to behave (Deegan 2009)
 Agency problem
The Principal-Agent Relationship

A conflict, known as an "agency problem," arises when there is a conflict

of interest between the needs of the principal and the needs of the agent.

The Agency Problem tries to solve the natural conflict of interest that
arises as a result of this principal agent problem

The dilemma exists because sometimes the agent is motivated to act in

his own best interests rather than those of the principal.
 Reasons for Agency Problem

 Managers maximize their wealth at the cost of shareholders

 Excessive remuneration or unjustified benefits

 Focus on short-term performance at the expense of long-term growth

 Differences in attitudes towards risk

 Agency relationships

In finance, there are two primary agency relationships:

 Managers and stockholders

 Managers and creditors

Agency Costs
These are costs incurred in an attempt to push agents to act in the
principal’s best interest.

They consist of three types:

Direct contracting costs
Monitoring costs
Loss of principal’s wealth due to residual, unresolved agency
problems.
 Audit Committee vs Agency Theory
Expertise
Independence
Responsible for Composition
managing top Size
Level of Activity
management

Delegates Audit
Board of Director Financial Committee
Reporting
Oversight

Management(A Agency Shareholders

gents) Problem (Principal)
 Archetypical agency problem
Jensen and Meckling (1976)- maximizes her utility rather than her
shareholders’ wealth
 An entrepreneur, initially owning her firm entirely - initial public offering
(IPO) to sell some shares - retaining the rest

 divert corporate resources to augment her utility - purchasing

unnecessary - funding pet charities
 Milgram’s experiment ( Test of
tolerance)
 Experiment features a box with switches labeled 15 volts,30 volts, and so on
up to 450 volts

 Subject of experiment on how punishment stimulates learning – asked to

assist by working the switches.

 Milgram asked a series of questions and, each time the actor answered
incorrectly, instructed to pull a higher voltage switch - actor feigned increasing
pain

 At 120 volts he complains verbally; at 150 he demands to be released from the

experiment

 His protests continue as the shocks escalate, growing increasingly vehement

and emotional - At 285 only agonized scream.
 Mergers and acquisitions
 U.S. firms spent more than $3.4 trillion -12,000 mergers

 Strategically enhancement of shareholders wealth

 Truth something different

 Lost over $220 billion at the announcement of merger bids from 1980 to
2001
 M&A and Behavioral finance
 Stock market valuations
 Cheap Financing
 Ego Defense ( ward off unpleasant feelings)

Who makes acquisitions? CEO overconfidence and the market’s

reaction
 Overconfident CEOs over-estimate their ability to generate returns
 The impact of overconfidence is strongest when CEOs can finance mergers
internally.
 Negative reactions for takeover bids
 Strong influence on overconfident managers
Why do acquiring companies overpay?

 Hubris
 Roll (1986, JB): also greater for larger firms
 Demsetz and Lehn : greater share ownership for larger firms

 Managerial optimism
 Heaton (2002, FM): behavioral finance; wrong perceptions of
decision-makers
 Malmendier and Tate : CEO overconfidence; investment of
overconfident CEOs is significantly more responsive to cash flow

 Free Cash Flow

 Jensen (1986, Midland CF Journal): Excess cash Flow
FRAMEWORK - FISHBONE
 FINANCE

Example
• Time Warner and AOL merger during the dot com
bubble burst which led to US $99 Bn loss to AOL.
 Conclusion
 the more optimistic the manager, the less likely he is to finance the
projects externally

 Over confidence and Ego defense tend to super impose in case of M&A

 Rationality not always overtakes irrationality

 Managerial optimism predicts
• The existence of biased cash flow forecasts.
• The pecking order capital structure
preferences.
• The false wedge between the internal and
external cost of funds
• The takeover resistance
 Dividend Theory and Earnings
Management to Exceed Threshold

Let us proceed to specific

judgements
 Dividend theory
• Earnings of the firm can either be retained or distributed to the
shareholders.

• Dividends are a part of earnings that are distributed to the equity

shareholders.

• Dividend payout ratio (D/P ratio) = dividend/net earnings.

• Dividend policy deals with decision about the optimal dividend payout
ratio and the retention ratio that would maximize the shareholder’s wealth.
 Dividend policy
Dividend models fall under two categories:

(a) Models explaining relevance of dividends:

• Traditional approach
• Walter’s model
• Gordon's Model
(b) Models explaining irrelevance of dividends:
• Modigliani and Miller Approach
• Rational Expectations Model
 Traditional approach
• It emphasis the relationship between dividends and stock market

• According to this approach, stock value responds positively to higher

dividends and negatively when there are lower dividends.

• The model expresses the relationship between market price and dividends
as:
P= m(d+e/3)………………differential treatment
where, P is the market price of the share
m is a multiplier
D is dividend per share
E is the earnings per share.
 Walter’s model
 According to this model dividends effect the share price of the firm.

 It explains relevance of dividend policy in three situations:

situation Dividend policy D/P ratio

Growth firm Low dividend 0%
payout
Distressed firm High dividend p/o 100%
Neutral Dividend policy will
not affect.
 Walter’s model
Assumptions:
(1) Firm has an infinite value
(2) Retained earnings is the only source of finance.
(3) Required rate of return (r ) and Cost of capital remain constant.
(4) The DPS and EPS remain constant.
• Price of the firm according to Walter’s model:
p=d + Ra/Rc(E-D)
Rc
where, d is the dividend per share and E is earnings per share
Rc is the cost of capital
Ra is the rate of return.
 Gordon’s model
• According to this model, investors put a premium on a certain returns
(i.e. dividends) and discount uncertain returns (i.e. capital gains).

Assumptions:
1) The firm is an all equity firm and has an infinite life.
2) Investors are risk-averse
3) Return on investment (r ) and cost of equity capital (k) remain constant.
4) Retention ratio and growth rate remain constant
5) Cost of equity capital is greater than the growth rate.

P0= D1/Ke-g
D1 = Expected Dividend
Ke = Cost of equity
G = Expected growth rate
 MM Approach
MM have argued that the value of a
firm depends solely on its earning
power and is not influenced by the
manner in which earnings are split
between dividends and retained
earnings.
 Assumption
• No tax advantage or disadvantage associated with dividend.

• Investment & dividend decisions are independent.

• Firms can issue stocks without incurring any floatation or transaction cost.
 Rationale expectation theory
• In a world of rational expectations, unexpected dividend announcements
would transmit messages about changes in earnings potential which were
not incorporated in the market price earlier.
• The reappraisal that occurs as a result of these signals leads to price
movements which look like responses to the dividends themselves, though
they are actually caused by an underlying revision of the estimate of
earnings potential.
 Continued..
The above analysis is helpful in reconciling the practitioner’s view that
dividends matter very much and the academic view that dividends do not
matter. As Merton Miller said: “Both views are correct in their own way.
The academic is thinking of the expected dividend; the practitioner of the
unexpected”
 Radical position hypothesis
Directly or indirectly dividends are generally taxed more heavily than capital
gains. So radicalists argue that firms should pay as little dividends as they
can get away with so that investors earn more by way of capital gains and
less by way of dividends
 Why pay dividends???
 Plausible Reasons
• Investor preference for dividends
• Information signaling

 Dubious Reasons for Paying Dividends

• Bird-in-hand fallacy
• Temporary excess cash
 Key consideration for dividend policy
• Investment decisions have the greatest impact on value creation.

• External equity is more expensive than internal equity (retained earnings)

because of issue costs and under pricing.

• Most promoters are averse to dilute their stake in equity and hence are
reluctant to issue external equity.

• There is a limit beyond which a firm would have real difficulty in raising
debt financing.

• The dividend decision of the firm is an important means by which the

management conveys information about the prospects of the firm.
 Conference board survey
• A survey of dividend policies and practice, conducted by the Conference
Board in the U.S., revealed that five considerations or guidelines were
dominant in the minds of dividend decision makers:

o The company’s earnings record and its future prospects.

o The company’s record of continuity or regularity of dividend
payments.
o The need to maintain a stable rate of dividends per share of stock.
o The company’s cash flow, present cash position, and the anticipated
need for funds.
o The needs and expectation of the owners of the common stock
 Linter’s hypothesis
Linter's survey of corporate dividend behavior showed that:
• Firms set long-run target payout ratios.

• Managers are concerned more about the change in the dividend than the
absolute level.
• Dividends tend to follow earnings, but dividends follow a smoother path
than earnings.
• Dividends are sticky in nature because managers have a reluctance to
effect dividend changes that may have to be reversed.
 Earnings Management to Exceed
Threshold
• Earnings
– Information for investment decision
• how thresholds induces specific type of earnings management.
• Empirical exploration deify earnings management to exceed each of three
thresholds:
– Report positive profits
– Sustain recent performance
– Meet analyst expectation
 CONTINUED…
• Firms Earnings
– Return to equity
– Dividends
– Cash flows
– Capital Investments
• Rewards to senior executive (depends upon earnings)
– Employment decision
– Compensatory benefits
• Earnings Management – “The strategic exercise of managerial
discretion in influencing the earning figures to the reported
audience.”

• Three thresholds that help drive EM:

– the first is to report profits
– distinction between positive numbers and negative numbers
– The second and third benchmarks rely on performance
relative to widely reported firm-specific values.
– Able to meet benchmark
– benchmarks are performance relative
 to the prior comparable period and
 relative to analysts’ earnings projections.
• The management of earnings to meet first two thresholds, delves more
deeply into
– accounting issues and
– identifies the “misreporting” mechanisms—for example,
• the manipulation of cash flow from operations, or
• changes in working capital—that permit earnings
to be moved from negative to positive ranges.

• the motivations for EM (Earnings and stock Price Performance)

– reaping a bonus or
– retaining a job
 A Threshold Model of Earnings
Management
• Utilize thresholds as a standard for judging and rewarding executives
• When executives respond distributions of reported earnings get distorted:
 Too few earnings fall just below a threshold
 Too many just above it
 Why Thresholds?
• For earnings
• People concerned with the firm’s viability and profitability because they
make firm-specific investments
• For both rational and perceptual reasons
• The salience of thresholds arises from at least three psychological
effects:
 There is something fundamental about positive and non positive numbers
 Individuals choosing among risky alternatives behave as if they evaluate
outcomes as changes from a reference point
 Thresholds come to the fore because people depend on rules of thumb to
reduce transactions costs
 Three Thresholds
1. To report positive profits, that is, report earnings that are above zero

2. To sustain recent performance, that is, make at least last year’s earnings

3. To meet analysts’ expectations, particularly the analysts’ consensus

earnings forecast
 Cont.
• Earning management is the flexibility in accounting rules to improve the
apparent profitability of the firm.

• Many corporate houses perform Earning management using pro forma

earnings.

• Earning management mostly done where an executive earnings & bonuses

hinges on company’s performance. Also to bolster shareholder’s interests.
 Maintaining Threshold
• Executive managers manage earnings to influence perception of outsider.
• Evaluation is done by comparing to threshold.
• Threshold theory linked to psychology because:
Fundamentality of positive & negative numbers in human
thought process.
 Saliency of prospect theory.
 Reduction of transaction cost.
 The Implication of Earnings Management for
Future Earnings
• Earnings management to meet thresholds in this period will affect next period’s
earnings.

• It examine the performance of the suspect firms that just meet the threshold
relative to the performance of firms that just miss the threshold or easily surpass
it.

• Divide firms into three groups, depending on their earnings. Group A fails to
meet the threshold, B just meets or exceeds it, C beats it easily.

• Group B is likely to include a number of firms that managed their earnings

upward to meet the threshold.

• Group C is less likely to have boosted earnings and may have reined them in.
 The Implication of Earnings
Management for Future Earnings
 By assumption, we have c1 > b1 > a1 for period 1.

 Absent any earnings management, we would expect

c2 > b2 > a2 for period 2.

 How might EM affect these inequalities? Earnings recorded by group B are

suspect of upward manipulation.

 Hence, b2 would move down relative to both c2 and a2, giving

c2 − b2 > b2 − a2.
 Behavioral Finance Theory

• Ego Defense
• Status Quo Bias
• Anchoring
 CONCLUSION
• Analysts, investors, and boards are keenly interested in financial reports of
earnings because earnings provide critical information for investment
decisions.

• Due to linkage of managerial rewards to earnings outcomes this nexus of

relations generates strong incentives for executives to manage earnings is
hardly surprising.

• It infers that the thresholds are hierarchically ordered; it is most important

first to make positive profits, second to report quarterly profits at least
equal to profits of four quarters ago, and third to meet analysts’
expectations.
 CONTINUED…
• It also find evidence that the future performances of firms just meeting
thresholds appear worse than those of control groups that are less suspect.

• Although earnings are a continuous variable, outsiders and insiders use

psychological bright lines such as zero earnings, past earnings, and
analysts’ projected earnings as meaningful thresholds for assessing firms’
performance.
Rational Capital Budgeting in
an Irrational World

Now we will zero in on with capital

budgeting
 Some refutations
• Cross section returns bear little or discernible
relationship to Beta
• A number of other variables have substantial
predictive power

We are confused how to fix the hurdle

rate/required rate of return/expected rate/cut
off rate
 Questions for finance community
• Can we still follow the standard textbook
treatments with a clear conscience ?
• Can we march through weighted average cost of
capital or adjusted present value calculations
based on CAPM?
• Or we should abandon CAPM for capital
budgeting decisions in favor of alternative
models that seem to do a better job of fitting
actual stock returns.
 Illustration
• Low B/E………Low factor loadings………….Low
premium desired…………..Low expected
return……………..Hence lower hurdle rate ( Hence
proved).
• Company investing in new plant……….hurdle rate
set as lower………but actually may rise over
time…………dynamic values not considered
…………misleading to firms and creditors
…………….hence constant hurdle rate not
approved. It is not correct we are sure.
 NEER approach will rescue
• Investors make systematic errors in forming
expectations, so that stocks can become
significantly over or under valued at particular
points in time. There is one to one link
between the expected return on a stock and the
fundamental economic risks of underlying
assets. FF (1993) suggested NEER approach to
overcome it.
 FAR approach may interfere
• FAR approach can consider better the variance
and covariance of the cash flows of assets
under consideration.
• It is quiet possible that cash flows from the
new plant is more related to the cash flows of
other assets rather than fundamentals of the
chemical plant.
 NEER & FAR approach
NEER FAR

a) managers are interested in • Preferable when managers are

maximizing short term stock price interested in maximizing long run
b) firm faces financial constraints value and the firm is not
financially constrained
Hurdle rate depends on book to market
ratio and conditional expected return on
• Variance & covariance properties
its stock
of cash flows on the assets
 Can we conclude Beta is dead?
• “Beta is dead”……………….well published
• In stock market, we may not use it.
• In capital budgeting decisions, it is still
prescribed.
• It depends on the users and type of utility
they have.