Behavioral Assignment

Last Updated: 06 Jul 2020
Essay type: Assignment
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For example if the company is performing admirably, your payments are not going to increase, but if you compare this situation With an equity investor, the market will incorporate to the stock price these results and your remover will be higher. On the other hand if the company Starts having some problems and cannot achieve its goals, your payments will remain the same.

This situation only changes when the default risk increases, and this doses "t happen in a very quick p of time In the case of equity, the scope for disagreement is larger and more sensitive, because the payoffs are uncertain and depend on the beliefs of the fundamental value of the company. It can be also seen below that equity payoffs are linear with respect to investor beliefs in relation to underlying asset value; however, debt up-side payoffs are fixed at some constant rate, ND are consequently non-linear (I. E. Concave) in the investor beliefs about the fundamental value.

Source: Hong & Serer 2011 b) Safe debt has less default risk than risky debt, which means that its payoffs are more protected and the payoff graph has a more concave shape. The more secure an asset is, the less sensitive the investors are to the beliefs about fundamentals. The upside is here more bounded and is less sensitive to disagreement. When a bond is more risky there is a greater probability for default and the investors are more sensitive to the changes in the fundamental value of the company. Beliefs start having a greater influence on the asset valuation.

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In the following formula we can see that if the default probability is very low, the safe debt payoff will also be lower and less sensitive to disagreements. C) When optimism increases investors start seeing debt more as a risk-free asset that has less upside with reduced resale option. Rising optimism leads to larger misprinting. In this scenario the optimistic investors will continue to buy the bonds from the pessimistic investors, so there will be more optimistic investors holding the asset and the disagreement among the investors will be owe, and lead to a lower price volatility.

The bond will also have less turnover. The pessimistic investors won t become optimistic, they just want to sell their bond. The model suggested by Hong and Serer(2013) considers a two-date trading model with dates t -?O, 1, N risky assets and the risk-free rate as r. The dividend delivered by the risky asset at time t=l is given by the equation: , where represents the cash flow beta of asset I, and is the state of the macro economy.

There are two groups of investors: 1) The optimists (group A), who believe that the economy will be better in t=l -b EAI[z = +h 2) The sometimes(group B), who believe that the economy will be worse - 3) So the expected difference between optimists and pessimists is given by: EAI[z] - BE[z] = When is small (I. E. Low macro disagreement) , the equilibrium price will depend both on the optimists and pessimists valuation, equaling However, when X is large (high disagreement about future macroeconomic conditions), the demand of pessimists (given by ) is so low that it will hit short sale constraints.

Thus, the equilibrium price will be determined only by optimists' valuation, since the pessimists will be sidelined from the market: . This equilibrium price is higher than the unconstrained price, which means that the stock N will be over-priced, due to high macroeconomic disagreement about fundamental factors, when compared to the traditional CAMP model prediction. As predicted by the dividend equation: , the higher the beta of the stock, the higher the effect of the disagreement about its future cash flows will be.

Thus, short-sale constraints will occur with higher probability for high-beta, high risk stocks. Short-sales constraints might be binding for some investors due to institutional reasons. An example are mutual funds, which are prohibited to worth stocks directly by certain government acts and regulations. According to the arguments above, misprinting is more pronounced for high- beta stocks or for periods of higher disagreement. Thus, stocks from higher beta sectors such as technology, consumer retail, automotive, construction are more likely to experience overpricing and bubbles.

Higher disagreement occurs either at times, when market optimism prevails -? continuous bull markets, combined with expansionary monetary policy for prolonged period, or when market pessimism prevails - crisis times, described by high volatility ND panic sell-offs, causing stocks to be undervalued. Bubbles are often hard to detect and ascertain, but tend to form most often when certain industry sectors are experiencing a technological revolution. Bubbles, crashes and financial crisis have been a repeating occurrence for long (e. G. He South Sea Bubble, canals and railroads in the 1 sass, the Internet in the sass) (Predetermine & McKee, 2012). A technological revolution in an industry causes a boom in asset prices; however, as the momentum of the bubble increases, the rise in prices cannot be justified anymore by fundamentals as people continue to make ever-rising valuations. It is difficult to identify an asset's true fundamental value, and this is especially true for new technologies that have may seem as the next big thing, but have uncertain long-run prospects.

Similarly, pastor & Versions (2008) argue that bubbles in stock prices can occur after technological revolutions if the productivity of the technology to be implemented is unknown and subject to learning. This affects both the level and volatility of stock prices. Critically, stock prices of innovative firms initially rise due to optimism and DOD news about the productivity of the firm due to the technological innovation, but eventually fall as the technology risk alters from affecting only the firm to being systematic (Pastor & Versions, 2008).

The bubbles can only be observed retrospectively, and are most greatly amplified in revolutions than involve high uncertainty and fast adoption. For example the expansion of both railroads in the sass and internet infrastructure in the 1 sass was characterized by overstatement that ultimately depressed prices on an aggregate level as additional projects had negative returns due to industrialization.

Also, in the case of the internet bubble, investors were lured in to invest by promising companies such as Amazon and America Online, but later companies had often no idea how to be commercially viable and essentially were riding the bubble (Dominant, 2014). Bubbles may hence be amplified by speculation and the idea that individuals observe and adopt the behavior of others (Levine & Jack, 2007). Especially in the case of the internet bubble optimists tend to push up the asset price, whereas more pessimistic investors cannot counterbalance this due to short-sale constraints (Predetermine & McKee, 2012).

Thus genealogical revolution tends to lead to projects with initial profits, and leads to overoptimistic tendencies for the whole industry. As prices exceed fundamentals and new entrants/projects turn sour, the bubble eventually collapses. In the case where there is only one share of the asset available and there is one optimist and one pessimist in the market, the pessimist will sell the asset to the optimist at a price higher than the mean evaluation of the two investors.

Here the single optimistic buyer can absorb the entire supply of one share. The average price is 75, thus the traded price will be in the range 75. The traded price rises when there are two homogeneous groups Of investors, I. E. When there are more optimistic traders in the market. They will bid up the price until it reaches the valuation of the optimists, I. E. 100. This will be the traded price. Thus, as according to Miller (1977) without short selling the price of the asset is increased if there is a divergence of opinion.

In such a market the demand for the asset will come from the traders who have the most optimistic expectations of its value. The most optimistic investor tends to win the bidding and their evaluation of the asset ends up being its actual price. This can be also seen in the diagram below. Supply is inelastic at N, so the price is higher than the equilibrium rate. Only optimistic traders will trade at the prices where the demand curve meets the inelastic supply curve.

Also, as seen in the diagram, different investors have different demand curves; the most optimistic one will have the highest valuation. (Source: Miller, 1977) Due to the binding short selling constraint, less optimistic traders who would like to short an asset cannot do so. Thus this is necessary for optimists to be able to set prices. Also volume is crucial. The more optimists there are will signify that the asset's price will be bid up to the valuation of optimists. This is especially true when the asset is scarce (e. . Only one or a few exist), as in this case there will be ample demand by the optimists (who may be a minority in the market) bid up and set the prices. The price of a security is higher the greater the divergence of opinion about the return from the security (Miller 1977). So we can say that if there is a big divergence of opinion in the market, the price will be even higher because the price only reflects the optimistic investors, and this also causes more volatility and more risk to the stock. Since the annual discount rate is a variable, and the time to maturity T is a constant, we can apply the rule: Then the expected value that the optimist attaches to the bond is given by: , 51 once The expected value Of the pessimist is given by: b) The difference of the natural logarithms of their attached values is: In According to the result, there is a positive correlation between the bond maturity T and the level of the disagreement between the investors, so the longer the bond maturity T, the higher the disagreement between the optimist and the pessimist will be. ) According to Miller (1977) the greater the disagreement the higher the rice. As we saw in the previous step bonds with longer maturity have greater disagreement, which leads to stronger misprinting because the price of the bond will only be affected by the optimistic investors (since pessimistic investors cannot affect the prices because of short-sale constraints). Thus, misprinting will be more pronounced at the long end of maturities, than at the short end.

Also the longer the maturity of the bond the higher the expected return, according to a regular bond yield curve. If misprinting is more pronounced, the price of bonds will go up, causing a shift downwards in the lied curve, so average realized bond returns should be lower than the expected. A) Investor B starts with rational beliefs at t-?O, so his expectation of an upward move is "10=0. In case of an upward move at node u his expectation of an upward move TTL is given by: , A further move up to position u will give: A move down to position dud gives: An initial downward move to d yields: Going another node down to ad: And moving up in the second period to du gives: b) Investor Bi's beliefs about the value of the stock seem irrational at point 'dud' and 'du' since at 'dud' his expectation of an upward move is , while at 'du' it equals . Actually these positions represent one and the same point on the binomial tree, where the fundamental value of the asset should be constant.

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Behavioral Assignment. (2018, Apr 06). Retrieved from https://phdessay.com/behavioral-assignment/

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