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Lecture 12

BU457 Lecture Notes - Lecture 12: Prospect Theory, Risk Measure, Capital Asset Pricing Model

Course Code
Bixia Xu

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Measurement Approach REVIEW
Measurement approach approach to financial reporting under which
accountants undertake a responsibility to incorporate current values into the
financial statements proper, providing that this can be done with reasonable
reliability, thereby recognizing and increased obligation to assist investors to
predict firm performance and value.
If a measurement approach is to be useful for investors, increased relevance
must outweigh any reduction in reliability
There has been a trend toward greater use of the measurement approach and
this chapter looks at the possible reasons why
Securities market is not being considered as efficient as once thought
According to CAPM, beta is the only relevant risk measure, but there are other
accounting variables, such as firm size and book-to-market ratio, that do a better
job than beta of predicting share return.
o This means that accountants should take more responsibility for
reporting on firm risk
Security prices at times depart significantly from fundamental value. However,
the important question for efficiency is whether securities prices reflect publicly
available information
o It can be concluded that securities market are close enough to full
efficiency that the theory can serve as a guide to accountants
Are securities markets fully efficient?
The average investor behaviour may not correspond with the rational
decision theory and investment model
They may have limited attention (may not have the time, inclination, or
ability to process all information
o They may focus on information they know about such as bottom line
and ignore info in the FS
o They may also be conservative in their reaction to new evidence
Individuals may also be overconfident. They will overreact to information
collected and understood themselves, and under react to information that
may seem abstract
There is also representativeness where there is too much weight assigned
to evidence that is consistent with the individual’s impression of the
population from which the evidence is drawn. ]
Self-attribution bias is where individuals feel that good decisions outcomes
are due to their abilities, where bad outcomes are unfortunate realizations of
states of nature, hence not their fault.
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o Price momentum can develop when reinforced confidence following
a rise in share price leads to purchase of more shares, therefore share
prices rise further.
Motivated reasoning is where individuals accept information at face value
that is consistent with their preferences. If they are inconsistent it is received
with skepticism, and the individual attempts to discredit it.
o Contrasts with the decision theory, where the decision-maker accepts
objective probabilities of the information system, revising
probabilities accordingly to GN or BN
All of the above reasons are examples of bahavioural-based securities market
inefficiencies called behavioural finance.
Prospect Theory
Behavioural-based alternative to the rational decision theory
An investor considering a risky investment will separately evaluate
prospective gains and losses
Prospect Theory Utility Function,
These separate evaluations of gains and losses reflects the psychological
concept of narrow framing
o This is where individuals analyze problems in a too isolated
Prospect theory assumes loss aversion, where individuals dislike even the
smallest of losses (see graph above)
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