Title Details

Preface xv

Acknowledgements xvii

1 Introduction 1

1.1 Illustration and Structure 2

1.2 Finance Theory as an Engine not a Camera 3

1.3 Rebuilding on New Foundations 7

1.4 Challenging the Classical Assumptions of Finance 9

1.5 Modelling Behavioural Aspects of Finance 11

1.6 The Structure of the Book 12

Appendix: A Financial Tsunami 14

Notes 14

References 14

Part I FOUNDATIONS 17

2 Financial Decision Making 19

2.1 Illustration and Structure 19

2.2 The Expected Utility Rule 20

2.3 Expected Utility Theory: Simple But Untrue? 26

2.4 Frames for Actions, Contingencies and Outcomes 31

2.5 Conclusion and Summary 35

Questions 35

Notes 36

References 36

3 Discounting 39

3.1 Illustration and Structure 40

3.2 The Discounted Utility Model 40

3.3 How and Why Discount Rates Vary 44

3.4 Investment Behaviour When Discount Rates are Declining: Investing in a ‘Golden Egg’ 47

3.5 Hyperbolic Discount Factors 49

3.6 Valuation by Using the Matching Law 51

3.7 How Investment Decisions are Made When Discount Factors Decline Over Time 54

3.8 Conclusion and Summary 59

Appendix: Timely Choice: Euler Equations – Dynamics and Inter-Temporal

Choice 60

Questions 61

Notes 62

References 62

4 Learning 65

4.1 Illustration and Structure 65

4.2 Rational Learning 66

4.3 Do We Learn the Bayesian Way? 72

4.4 Over Inference and the Law of Small Numbers 76

4.5 Disagreement, Tastes and the Capital Asset Pricing Model 77

4.6 Conclusion and Summary 79

Appendix: Case Study – Baseball the Bayesian Way 80

Questions 87

Notes 88

References 88

5 Bubbles 89

5.1 Illustration and Structure 90

5.2 Tulipmania and the Didactic Value of Bubbles 91

5.3 The Regulatory Origins of the Most Recent Bubble 92

5.4 Bubbles: Past, Present and Future 101

5.5 The 1929 Stock-Market Crash 104

5.6 Should Government Burst the Bubble? 108

5.7 Conclusion and Summary 109

Appendix: Tulips as Assets and Art 110

Questions 114

Notes 114

References 114

Part II ASSET PRICING 117

6 Noise Traders 119

6.1 Illustration and Structure 120

6.2 The De Long, Shleifer, Summers and Waldmann Model 121

6.3 Can Investors Get Emotional? 133

6.4 Conclusion and Summary 138

Questions 138

Notes 139

References 139

7 Overconfidence and Optimism 141

7.1 Illustration and Structure 142

7.2 A Model of Trading Amongst Optimistic Investors 142

7.3 Do Investors Trade Too Much? 150

7.4 Conclusion and Summary 154

Appendix A: Hubris at Work: The AOL–Time Warner Merger 155

Appendix B: Derivation of Results in Odean’s Model 161

Questions 163

Notes 163

References 163

8 Asset Pricing under Prospect Theory 165

8.1 Illustration and Structure 165

8.2 The Basics of Prospect Theory 166

8.3 Does Prospect Theory Work? 172

8.4 The Cumulative Probability Version of Prospect Theory 176

8.5 Does Cumulative Prospect Theory Work? 177

8.6 Conclusion and Summary 181

Appendix: CARA Utility 181

Questions 182

Note 182

References 183

9 Overreaction and/or Underreaction 185

9.1 Illustration and Structure 185

9.2 The DHS Model 186

9.3 No News Is . . .? 194

9.4 Conclusion and Summary 199

Questions 199

Note 199

References 200

10 Momentum 201

10.1 Illustration and Structure 201

10.2 Grinblatt and Han’s (2005) Model 203

10.3 What Drives Stock-Market Momentum? 208

10.4 What Causes PEAD? 212

10.5 Conclusion and Summary 217

Questions 217

Note 218

References 218

11 Herding 221

11.1 Illustration and Structure 221

11.2 The FSS Model 222

11.3 Conformity as a Force for Social Good and Evil 228

11.4 Conclusion and Summary 233

Appendix: The United States vs. Microsoft 234

Questions 236

Note 237

References 237

12 Insider Trading 239

12.1 Illustration and Structure 240

12.2 Insider Trading Here for Better or Worse 241

12.3 The Hirshleifer, Subrahmanyam and Titman Model 245

12.4 Insider Trading, Stock Options and the Construction of Earnings 255

12.5 Insider Trading and its Consequence for Outsiders 257

12.6 Conclusion and Summary 258

Appendix A: Why Don’t Later Informed Traders Trade in Period 1 in the HST Model? 258

Appendix B: Deriving Investor Demands as Linear Functions of the Random Variables Underpinning the Model 262

Questions 265

Notes 265

References 266

13 Equity Premium Puzzle 269

13.1 Illustration and Structure 269

13.2 The Puzzle 270

13.3 Loss Aversion in a Reference-Dependent Utility Model 276

13.4 Conclusion and Summary 280

Questions 281

References 281

Part III CORPORATE FINANCE 283

14 Incorporation 285

14.1 Illustration and Structure 285

14.2 Companies: Where did They Come from and Where will They Go? 286

14.3 Agency, Monitoring and Incorporation 289

14.4 Lions Led by Donkeys. Some Common Failings in Managerial Making 296

14.5 Conclusion and Summary 300

Appendix: Emperor Eisner – A Case Study in the Power of Personal Control in a

Corporation 300

Questions 313

Notes 313

References 314

15 The Market for Information, Noise and Deception 317

15.1 Illustration and Structure 318

15.2 The Boundaries of the Market for Corporate Information 318

15.3 What Do Analysts Do? 321

15.4 Valuing Investment Advice 325

15.5 Conclusion and Summary 333

Questions 334

Notes 334

References 334

16 Dividends 337

16.1 Illustration and Structure 337

16.2 The Irrelevance of Dividends to Value 338

16.3 A Prospect Theory Explanation of Dividend Payments 340

16.4 Who Pays Dividends and Why? 346

16.5 Conclusion and Summary 350

Questions 350

Note 351

References 351

17 Entrepreneurship 353

17.1 Illustration and Structure 354

17.2 The BT Model 355

17.3 Is Deluding Yourself Worth it? 362

17.4 Conclusion and Summary 364

Appendix: Entrepreneurs and the BT Model – Some Case Studies 364

Questions 370

Notes 370

References 371

Part IV THE PROFESSIONS 373

18 Analysts’ Conflicts of Interest 375

18.1 Illustration and Structure 376

18.2 Evidence of Conflicts of Interest from Empirical Studies 377

18.3 Regulating Conflicts of Interest 380

18.4 Conclusion and Summary 385

Questions 386

Notes 386

References 386

19 Accounting Reform 389

19.1 Illustration and Structure 389

19.2 The Onward March of ‘Fair-Value’ Accounting 390

19.3 An Accounting-Based Valuation Model 392

19.4 Behavioural Bias in Estimates of the Ohlson Model 404

19.5 Conclusion and Summary 407

Appendix A: Mark-to-Market Accounting at Enron – A Case Study 407

Appendix B: Solving for Price in Terms of Abnormal Earnings and Non-Accounting

Information only (Equation (19.7)) 423

Questions 425

Notes 425

References 426

20 Conclusion 427

Index 431