Barberis Gfc Cast Study Report Essay

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Report on Global Financial Crisis
Discussions on psychological factors affecting People’s behaviors in the crisis and their motivations

Qiang Sheng 9th May 2011

Financial Risk Management Lecturer: Bernd P. Leudecke

Macquarie University Melbourne

4.1 Three areas of applications were reviewed and investigated: 1. The pricing of financial assets; 2. The portfolio choice and trading decisions of investors; 3. The behavior of firm managers;

4.2 A “Bubble” is an episode in which irrational thinking or a friction causes the price of an asset to rise to a level that is higher than it would be in the absence of the friction or the irrationality; and, moreover, the price level is such that a rational observer, armed with all
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Given that people have a strong preference for lottery-like payoffs – perhaps as Kahneman and Tversky (1979) argue, the brain overweighs low probabilities – they may overvalue these stocks (1990s U.S. Technology Stocks Bubbles).

4.6 The argument on lottery-like investments in the article was explained by Prospect Theory and the psychophysics of the probability weighting function. Prospect Theory was introduced by Kahneman and Tversky in their 1979 paper. It suggested that people do not judge outcomes based on their final asset positions that include their wealth, but the changes of wealth, an idea first introduced by Markowitz. Prospect theory uses Value Function to value outcomes, and the probability weighting function, π (p), is used to value probabilities. Contrary to the Expected Utility Theory, weighting of probabilities exhibited unlinearity (Figure 1). Y.H. Cheung, in his paper further explored and demonstrated the shape of the unlinear graph of the weighting function through Monte Carlo simulation.

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(Figure 1) It was interesting to see that Problem 8 and 14 from Kahneman and Tversky’s paper showed people exhibiting risk-seeking with low probability positive events, whereas Prospect theory showed a general risk-aversion in positive domain and risk-seeking in negative domain. When faced with choosing prospects for specific event, Kahneman and Tversky suggested that

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