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Questions and Answers
What is the tendency for individuals to rely too heavily on one piece of information when making decisions called in Behavioural Finance?
Anchoring
What is the Behavioural Finance concept where individuals seek out information that confirms an existing belief and ignore information that doesn't?
Confirmation Bias
What is the Behavioural Finance concept where an individual's subjective confidence in their judgements is greater than the objective accuracy of those judgements?
Overconfidence
What is the Behavioural Finance concept where individuals take credit for positive outcomes but blame external circumstances for negative ones?
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What is the area of research that attempts to understand and explain how reasoning errors influenced investor decisions and market prices called?
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How does Behavioural Finance recognize investor behaviour is not always based on rational expectations?
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How can Behavioural Finance lead to market prices not being traded at fair value?
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What does the degree of movement in a variable, which indicates market risk, refer to in Behavioural Finance?
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How is Volatility, which indicates market risk, represented in Behavioural Finance?
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What are the characteristics of low and high volatility in Behavioural Finance?
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Study Notes
Determinants of Financial Systems Efficiency
- Decision making that is mutually beneficial to the parties involved, not impeded by information asymmetry or incentive problems
Information Asymmetry
- One party having an information advantage over the other party, leading to not mutually beneficial financial agreements or reluctance to enter contracts
- Examples: potential borrower knowing more about their capacity to repay than the lender, company not disclosing full financial statements to investors
- Can lead to unethical behavior, loss of trust, and not completing settlements
Incentive Problems
- Problematic if incentives motivate unethical behavior, leading to financial contracting issues
- Example: culture failing to deal with moral hazard and information asymmetry, eroding public trust
Financial Markets and Bond Issuance
- Bigger companies can go direct to financial markets, bypassing intermediaries, due to their strong credit ratings and lower risk
- Buyers of bonds want a high credit rating to ensure security of investment repayments
- Credit rating measures trustworthiness, with a lower rating requiring ADIs or NBFIs to raise capital
Credit Spread and Yield
- Credit spread is the gap between yield percentages or basis points between different economic bond markets
- Greater spread indicates higher risk, and a widening spread indicates faster momentum of risk
- Yield is the return on investment, and its shift affects the market rate
Dealer Trading and Market Spread
- Dealers earn a trading spread when selling to and buying from traders on a round-trip transaction
- Dealers compete with other dealers and aim to buy low and sell high
- Market rules and conventions are set by AFMA and ASX, including trading hours and pricing practices
Efficient Market Hypothesis (EMH)
- States that security markets efficiently use information to generate fair prices that move randomly
- Distinguishes between 3 forms of informational efficiency:
- Weak Form Efficiency: prices embed previous price
- Semi-Strong Form Efficiency: prices reflect all publicly available info
- Strong-Form Efficiency: prices reflect all existing price-sensitive info
Behavioural Finance
- Anchoring: relying too heavily on one piece of info when making decisions
- Confirmation Bias: seeking out info that confirms an existing belief and ignoring contradictory info
- Overconfidence: individual's subjective confidence in judgments exceeding objective accuracy
- Self-Attribution: taking credit for positive outcomes and blaming external circumstances for negative ones
- Contribution to an understanding of market prices: behavioural finance recognises that investor behavior is not always based on rational expectations and may be resultative of behavioural bias
Volatility and Market Risk
- Volatility measures degree of movement in a variable, indicating market risk
- Low volatility: relatively smooth line, high volatility: greater spike in graph
- Volatility represented through frequency distribution, recording size and direction of price movements over long periods
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Description
Test your knowledge on key concepts in behavioural finance like Anchoring, Confirmation Bias, Overconfidence, and Self-Attribution. Understand how these biases can impact investment decisions during market cycles.
