ADMS 3530 Study Guide - Quiz Guide: Equity Premium Puzzle, Premium Bond, Sinking Fund
24 Mar 2017
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Document Summary
Behavioral finance focuses on systematic irrationalities that characterize investor decision making. These (cid:498)behavioral shortcomings(cid:499) may be consistent with several efficient market anomalies. Among the information processing errors uncovered in the psychology literature are memory bias, overconfidence, conservatism, and representativeness. Behavioral tendencies include framing, mental accounting, regret avoidance, and loss-aversion. Limits to arbitrage activity impede the ability of rational investors to exploit pricing errors induced by behavioral investors. For example, fundamental risk means that even if a security is mispriced, it still can be risky to attempt to exploit the mispricing. This limits the actions of arbitrageurs who take positions in mispriced securities. Other limits to arbitrage are implementation costs, model risk, and costs to short-selling. Occasional failures of the law of one price suggest that limits to arbitrage are sometimes severe. The various limits to arbitrage mean that even if prices do not equal intrinsic value, it still may be difficult to exploit the mispricing.
