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14.127BehavioralEconomics. Lecture 13 Xavier Gabaix May6, 2004

14.127BehavioralEconomics. Lecture 13 Xavier Gabaix May6, 2004. 0.1 Prospect TheoryandAsset Pricing • Barberis, Huang, Santos, QJE 2001. • S t — dollar amount invested in stocks • x t +1 = s t R t −R rf where R t stock return, R rf -risk-free rate

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14.127BehavioralEconomics. Lecture 13 Xavier Gabaix May6, 2004

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  1. 14.127BehavioralEconomics. Lecture 13 • Xavier Gabaix • May6, 2004

  2. 0.1 Prospect TheoryandAsset Pricing • • Barberis, Huang, Santos, QJE 2001 • St — dollar amount invested in stocks • xt+1 = st Rt−Rrf where Rt stock return, Rrf -risk-free rate • Zt — historical benchmark level for risky assets,

  3. • the agent is “in the domain of gains” iff zt < 1 • in order to have same rate of growth for both terms in the parentheses

  4. • Dynamics • If z >1then with increasing in

  5. • Dividend and consumptions • State variable to be determined • Solution

  6. • To get Euler equation vary Since • and

  7. • Perturbation with risky asset Since so and

  8. • Thus is decreasing in z • Problem: make this tractable (like Veronesi and Santos made tractable version of Campbell-Cochrane) • See tables 3,4,6 of the paper [separate file]

  9. 1 Data(see handout) • • Fama and French disprove CAPM (see handout) — Propose a rational three factor (n =3) model where is risk premium on factor — beta of asset i on factor k — One of the factors HML = high minus low book to market — Half of the finance papers have now their factors in the regressions • Fama and French on momentum (see handout) — this arbitrage requires constant rebalancing of portfolio and may be killed by transaction costs; it also involves small illiquid stocks

  10. • Forward discount puzzle but if you run the regression you get negative values (st is foreign exchange rate) • Same puzzle for bonds • Warning: after many puzzles are discovered the effects become usually much less strong: — so either they are arbitraged away — or they were due to data mining. • Some puzzles are robust, e.g. the bond yield puzzle

  11. 2 Bubbles • • Kindleberger “Manias, Panics and Crashes” • • Bubble feeds on inflow of less and less sophisticated investors • • People who predict crash are repeatedly disconfirmed, hence public trusts • more those that correctly predicted growth • • Limits to arbitrage: • — even rational looking hedge funds did ride the bubble.

  12. — some hedge funds did short but if they did it (or move out of the market) too early they were closed — other hedge funds were doing much better • No good quantitative analysis of bubbles in behavioral finance • P/E ratios increased after introduction of 401k accounts. 401k increased demand for stocks • Persistence of very high growth rates • See slides [a listing of bubbles, graph of NASDAQ, bubble in 1998-1999, and CISCO’s three year annualized growth in EPS]

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