Part I Summer 2008 Instructor: Tao LI - Faculty of Business and ...

THE UNIVERSITY OF HONG KONGFACULTY OF BUSINESS AND ECONOMICSMFIN7015 Behavioral Finance: Part ISummer 2008Instructor: Tao LIN, Ph.D.Email: tlin@hku.hkCOURSE INFORMAITON:Course Overview:Traditional finance, relying on economic agents’ rationality, fails to account for manyempirical facts about the aggregate stock market, the cross-section of average returns andindividual trading behaviors. Behavioral finance proposes psychological explanations andintroduces less than fully rational agents. In doing so, it helps solve many difficultiesencountered in the traditional finance framework.Course Objective:1. To identify key assumption differences between traditional finance and behavioralfinance frameworks.2. To understand key psychological biases that affect decision making process3. To apply psychology research findings into finance anomaliesTextbook:There are no required textbook for this course.Class notes will be distributed in lectures.Selected academic papers will be provided.References:1. Thaler, Richard H. (ed.), 2005, Advances in behavioral finance, Vol. II, New York,Russell Sage Foundation2. Shleifer, Andrei, 2000, Inefficient markets: an introduction to behavioral finance,Oxford University Press3. Kahneman, Daniel, Paul Slovic, and Amos Tversky (ed.), 1982, Judgment underuncertainty: Heuristics and biases, Cambridge University Press4. Kahneman, Daniel, and Amos Tversky (ed.), 2000, Choices, values and frames,Cambridge University Press.TEACHING FORMATThe course will be consisted of 6 lectures. Your classroom participation is strongly encouragedand will be taken into consideration in your performance evaluation. An individual-based projectwill be the basis for the course evaluation.

PROJECTAnalyze a finance related phenomenon using behavioral finance arguments discussed in thiscourse. Document the evidence care fully and bring forward your logical explanations. You mayhunt for topics related to hedge fund materials to be discussed in the second half of the course.The report is limited to 15 pages (you do not need to write 15 pages if can use 10 pages to finishyour story) excluding references, tables, figures and appendix (if any). The specification of theformat is as follows: A4 paper, double space with minimum one-inch margin on all sides, a fontof 12 Times New Roman.The written report in WORD or PDF format is due in my email box (tlin@hku.hk) 6:00pm July7, 2008. Later report will be accepted with 1% grade penalty for each hour late.COURSE OUTLINE: (Tentative)1 Introductiona) Efficient market hypothesisb) Anomalies – inconsistent with EMHc) Rising of behavioral financeSuggested Readings:• Eugene Fama (1998). Market efficiency, long-term returns and behavioral finance,Journal of Financial Economics 49: 283-307• Eugene Fama (1970). Efficient capital markets: a review of theory and empirical work,Journal of Finance 25: 383-4172 Psychological Foundationa) Non expected utility• Prospect theory• Reference dependence and loss aversion• Frame dependence and loss aversion• Ambiguity aversionb) Heuristic bias• Representativeness• Availability• Anchoring• Overconfidence• Wishful thinkingSuggested Readings• Amos Tversky and Daniel Kahneman (1974). Judgment under uncertainty: heuristicsand biases, Science 185: 1124-1131

• Daniel Kahneman and Amos Tversky (1979). Prospect theory: an analysis of decisionunder risk, Econometrica 47: 263-2923 Applications: Stock Returns and the Equity Premiuma) Valuation ratios and its predicative power on equity returnsb) Equity premium puzzleSuggested Readings• Campbell, John Y., and Robert J. Shiller (1996). Valuation ratios and long run stockmarket outlook, Journal of Portfolio Management 24:1-10• Bernantzi, Shlomo and Richard Thaler (1995). Myopic loss aversion and the equitypremium puzzle, Quarterly Journal of Economics 110: 73-92• Barberis, Nicholas, Ming Huang and Tano Santos (2001). Prospect theory and assetprices, Quarterly Journal of Economics 116: 1-534 Applications: Overreaction and Underreactiona) Value vs. growthb) Momentumc) Long-run reversald) Biases in brokerage recommendationsSuggested Readings• Lakonishok, Josef, Andrei Shleifer and Robert W. Vishny (1994). Contrarianinvestment, extrapolation, and risk, Journal of Finance49:1541-78• Jegadeesh, Narasimhan, and Sheridan Titman. Momentum, in Thaler R. (ed.), Advancesin Behavioral Finance, New York: Russell Sage Foundation.• Daniel, Kent, David Hirshleifer, and Avanidhar Subrahmanyam (1998). Investorpsychology and security market under- and overreaction, Journal of finance 53: 1939-85• De Bondt, Werner F.M., and Richard Thaler (1985). Does the stock market overreact?Journal of Finance 40: 793-8055 Investor Behaviora) Disposition effectb) Naïve diversificationc) Excessive tradingSuggested Readings• Shefrin, Hersh M., and Meir Statman (1985). The disposition to sell winners too earlyand ride losses too long: theory and evidence, Journal of Finance 40:777-790• Odean, Terrance (1998). Are investors reluctant to realize their losses? Journal ofFinance 53: 1775-1798• Odean, Terrance (1999). Do investors trade too much? American Economic Review 89:1279-1298

6 Limits to Arbitragea) Noise trader riskb) Efficiency-reducing arbitragec) Short sale constraintsSuggested Readings• Chapter 2, 4, and 6 of Shleifer (2000)• Froot, Kenneth and Emil M. Dabora (1999). How are stock prices affected by thelocation of trade? Journal of Financial Economics, 53: 189-216• Lamont, Owen A., and Richard H. Thaler (2003). Can the market add and subtract?Mispricing in tech price care-outs, Journal of Political Economy 111: 227-268• Brunnermeier, Markus K., and Stefan Nagel (2004). Hedge funds and the technologybubble, Journal of Finance 59: 2013-2040