Lecture4 - Behavioral Finance Lecture 4 Florian Peters UvA...

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Behavioral Finance Lecture 4 Florian Peters UvA November 20, 2012
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Announcements Make sure to form groups of 2 until next week, when the assignment is handed out I will create an assignment on Blackboard, where you can (1) download the pdf of the assignment and (2) upload the solutions. Your solutions need to be in pdf format, so convert if you use,eg, MS Word. More popular reading on Psychology, esp. optimism: Martin Seligman “Learned Optimism” Florian Peters Behavioral Finance November 20, 2012 1
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Topic Today: Differences in Beliefs and Asset Pricing Recall the standard economist conception of human behavior: max w W X s S p ( s ) u ( x | s , w ) ... where under the standard specification beliefs are rational (=objective) ... and thus should be the same for all investors Today we will focus on some implications of differences in beliefs some people may be too optimistic others rational or pessimistic Florian Peters Behavioral Finance November 20, 2012 2
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Outline 1 How do Bubbles Arise? What do we Know about Bubbles? A Simple Framework for Bubbles 2 Bubbles and Crises Bubbles and Overinvestment Bubbles and Credit Crises Florian Peters Behavioral Finance November 20, 2012 3
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Outline 1 How do Bubbles Arise? What do we Know about Bubbles? A Simple Framework for Bubbles 2 Bubbles and Crises Bubbles and Overinvestment Bubbles and Credit Crises Florian Peters Behavioral Finance November 20, 2012 4
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The Recent History of Bubbles The financial crisis followed two great bubbles: the Internet bubble and the housing bubble. The burst of the Internet bubble led to an expansionary US monetary policy for a prolonged period The low interest rate together with financial innovations such as securitization of subprime mortgages had fueled housing speculation and led to a great housing bubble The burst of the housing bubble eroded the balance sheets of many financial institutions, and eventually dragged down the world economy. Florian Peters Behavioral Finance November 20, 2012 5
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Why Should We Care About Bubbles? Mispricing leads to misallocation of investment. Mispricing distorts investment rules, leading to overinvestment in overpriced assets. Bubbles followed by crashes imply excess volatility. People overconsume in a bubble, and are forced to underconsume after the bubble bursts. With concave utility this decreases welfare for an individual (Kyle, Laibson, Mollerstrom, 2011). Mispricing has distributional consequences with welfare effects. The seller of an overpriced asset wins, the buyer loses. With concave utility, the total effect on utility is negative (Kyle, Laibson, Mollerstrom, 2011). Florian Peters Behavioral Finance November 20, 2012 6
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What Do We Know About Bubbles? It is common to see price bubbles in new technologies, such as railroad, radio, biotech, Internet, securitization, ...
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