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Behavioral Finance and Behavioral Finance and

Corporate Governance p
Michael Christensen
Michael Christensen
D t t f E i d B i Department of Economics and Business
School of Business and Social Sciences
Building 2632, Room 134
E-mail: mic@asb.dk @
Phone: +45 871 65001
Associate professor 1994 present Associate professor, 1994 present
PhD, University of Southampton, England
Practical experience:
7 years in a bank, broker company and Dansk Supermarked.
Active learning
L t Lectures:
Teaching will be in Danish and
Blackboard (math. and examples) will be in English
Power Point slides (text) will be in English !
Exercises:
Part of each lecture
Research presentations Research presentations
End of chapter questions:
Solutions will be provided in the following lecture Solutions will be provided in the following lecture
Exampreparation successively:
M lti l h i t t Multiple choice tests
Old exams
Behavioral Finance Behavioral Finance
Lucy F. Ackert and Richard Deaves
Chapter 1
Michael Christensen
Neoclassical economics
Th b i ti f l i l i i th t The basic assumption of neoclassical economics is that consumers
and firms act rationally, i.e. consumers maximize utility, and firms
maximize profits.
The rationality assumption is a convenient way to analyze
economic behaviour, and often economic modelling becomes , g
easier if we assume that economic agents behave rationally when
making economic decisions.
In the ideal neoclassical world there is no uncertainty; this makes
decision-making uncomplicated. However, the real world is
uncertain (stochastic) and economic decision making must take uncertain (stochastic), and economic decision-making must take
expectations into account.
Neoclassical economics
Wh i t k d i i b d t d l When economic agents make decisions based on expected values
(state of nature), the neoclassical theory assumes that they make
use of all public information, which implies that financial markets
become informationally efficient.
The implication of an informationally efficient capital market is that p y p
asset prices will be unpredictable, i.e. no investor will be able to
earn an abnormal return. The return on any asset will reflect the
risk of that particular asset risk of that particular asset.
Most investors are risk-averse, which means that they dislike risk.
The typical investor therefore prefers more return to less return The typical investor therefore prefers more return to less return,
and prefers less risk to higher risk.
Neoclassical economics
WWe can sum up:
1. Consumers have rational preferences across possible
outcomes or states of nature.
2. Consumers maximize utility, and firms maximize profits.
3. Consumers make independent decisions based on all relevant p
information.
Expected utility
The purpose of expected utility is to determine methods that can be The purpose of expected utility is to determine methods that can be
used to make optimal choices among scarce resources in an
economy, where the future is uncertain.
Expected utility
W di ti i h b t di l d di l tilit If tilit b We distinguish between ordinal and cardinal utility. If utility can be
measured cardinally, we can relate specific numbers to the utility of
products or services, e.g. that the utility of apples is 15, oranges 10
and bananas 5. These numbers can be interpreted as the
satisfaction received.
If utility is ordinal, we can only measure whether one product is
preferred to another product, e.g. that apples are preferred to
oranges or that the consumer is indifferent between bananas and oranges or that the consumer is indifferent between bananas and
grapes.
Rational preferences require: Rational preferences require:
1. Preferences are complete
2 P f t iti 2. Preferences are transitive
#1
Expected utility
Th t d tilit th th t i di id l h ld t h The expected utility theory says that individuals should act when
confronted with decision-making under uncertainty in a certain way.
The theory is really set up to deal with risk, not uncertainty:
Risk is when you know what the outcomes could be, and you y , y
can assign probabilities.
Uncertainty is when you cant assign probabilities; or you cant Uncertainty is when you cant assign probabilities; or you cant
come up with a list of possible outcomes.
Risk averse consumers have concave utility functions which Risk averse consumers have concave utility functions, which
implies that the marginal utility is positive and diminishing.
Expected utility
Examples of concave utility functions:
U(W) = ln(W)
10
12
U(W) =
W
1
4
6
8
ln(W)
SQRT
Reciprocal
U(W) =
1
W

0
2
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
CRRA
U(W) =
1 a
W 1
1 a

2
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
#2
Exercise 1
Sh th t th C t t R l ti Ri kA i (CRRA) tilit Show that the Constant Relative Risk Aversion (CRRA) utility
function:
1 a
W 1

U(W) =
W 1
1 a

where W = wealth and a = the risk aversion parameter has


constant Relative Risk Aversion.
#3
Supplementary readings
Ch i t M 2014 Akti i t i DJ F F l Ch t 3 Christensen, M., 2014: Aktieinvestering, DJ Fs Forlag. Chapter 3,
(Danish).
Copeland, T.E, J Fred Weston and K. Shastri, (2005), Financial
Theory and Corporate Policy, Pearson. Chapter 3.

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