Chapter 6: Theory of finance Flashcards

1
Q

Outline the ideas behind

  • Framing
  • Overconfidence
A

Framing

  • Suggests taht the way in wwhich choicce is presented or ‘framed’ can have an enormous impact on answer given or deciion made
  • Equally, response to quesiton can be influenced by way its worded

Overconfidence

  • People tend to overestimate own knowledge and skills. Discrepancy between accuracy and overconfidence increases with knowledge

May result from

  • Hindsight bias - events that happen/dont happen will be thought of as having been preditable/unlikly prior to event
  • Confirmation bias - people tend to look for evidence that confirms their point of view (and dismiss evidence that does not justify it)
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2
Q

What is meant by anchoring and adjustment

A
  • People’s perceptions are anchored by past experience or ‘exper’ opinon, and fall to adjust fuly to reflext current conditions
  • Effect grows with size of difference between anchor value - original estimate provided - and pre-anchor estimate - mean estimate people make before eposed to explict anchor
  • Effects of anchoring difficult ot ignore, even when people aware of effect and away that anchor is ridculous
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3
Q

Explain what

  • Is meant by the term estimating probilities
  • myopic loss aversion suggests
    *
A

Estimating probabilities

  • Invesetors edstimates of prbabilities may be influenced by
    • Dislike of negative events
    • Representative heristics - as amount of detail describing circumstance or outcome increases, its apparent likelihood may increase (althought true probability can only decrease)
    • Availability - suggests more generally that people tend to over-estimate probility of events they can esily imagine, and vice versa

Myopic loss aversion

  • People take short term view in assessing gains and losses, which leads them to overcautious, even when investing for long term
  • Also, invetors are less risk - averse when faced with repeated series of gambles than when faced with single gamble
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4
Q

Explain what is suggested by

  • Prospect theory
  • mental accounting
A

Prospect theory

  • Suggests that whilst investors are typically risk averse when considering gains relative to some benchmark, they are likely to be risk -loving when considering losses - ie they would prefer to take chance on gamble with higher expected losses than to incur certain loss

Mental accouting

  • Suggests people show tendency to seperate related events and decisions and find it difficult to aggregate events and decisions and find it difficult to aggregate events
  • Rather than netting out all gains and losses, people set up series of mental accounts and view individual decisions as relating to one or another of these accounts
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5
Q

Describe how the order of a range of choices may influence choice

give four other influences of the range of options choice

A

How order of range of choices may influence choice

  • Primary effect suggests people are more likely to choose first option presented
  • recency effect suggests that final option may be preferred
  • other research suggests people are more likely to choose an intermediate option than one at either end

Other influences of range or options on choice

  • Greater range of options discourages decision making
  • satus quo bias - people have marked preference for keeping things as they are
  • regret acersion - by retaining existing arrangements, people minimise possibility of regret (pain assoicated with feeling responisble for loss)
  • ambiguilty aversion - people dislike uncertainty and are preapred to pay a premium for rules
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6
Q

List of six asset classes that one would expect to give high future returns, starting from a time point when market sentiment is low

A
  • Small stocks
  • highly volatile stocks
  • the stocks of unprofitable companies
  • non-dividend paying stocks
  • extrememly high growth stocks
  • distressed stocks
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7
Q

List four ways to measure investor sentiment at any point in time

A
  • The average discount on closed end funds (should be low when sentiment is high)
  • Share turnover (should be high when sentiment is high)
  • The level of activity in the IPO market and the level of issue of new equity (should be high when sentiment is high)
  • The level of the dividend premium, which is a proxy fo rthe relative demand for dividend payers among investors (demand for high dividend shares should be low when sentiment is high)
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8
Q

Describe four examples of where investor mood can affect markets returns

A
  • Calender effects - blue mondays and good returns preholidays
  • Sunshine - daily market returns in world markets have been found to be strongly correlated with the amount of morning sunshire in the city fo th ecountry’s leading stock exchange
  • sports results
  • aviation disasters have been shown to leaad to losses of stock market value which are a large mutiple of the estimated actual economic losses
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9
Q

Outline what is meant by long term financial planning

A
  • Concerned with long tem investment decisions and capital requirements
  • looks several years ahead and develops financial plans vased on firm’s business plans - its anticipated product development and sales objectives
  • uses sensitivity analysis to explore impact of different scenaios
  • once business plans have been developed, they can be convereted into financial plans starting with forecasts of future cashflows
  • considers non - operational issues, e.g. financial covenants and credit ratings
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10
Q

Outline what is meant by short term financial planning

A
  • Concerned with management of
    • Working capital requriemets (current assets and liabilities)
    • Trade credit
    • stock (inventory) policy
  • Often takes the form of a 12 month rolling plan
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11
Q

List the main classes of current assets and current liabilities

A
  • Current assets included
    • Inventories
    • Trade receivables
    • cash and short term securities held
  • Current liabilities include
    • Trade payables
    • outstanding dividend and tax payments
    • short term borrowings and loans
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