In-class discussion 1

About Presentation and Essay Choose a time slot and fill in the table 10 minutes presentation would have Q & A section Bonus credit for reading + essay

Game 1 – tea auction Take out a piece of paper Write down the highest price you are willing to pay for this tin of tea. Congratulations, you get this tin of tea for free! Write down the lowest price you would accept to sell this tin of tea.

What’s your WTP and WTA Your first price is your WTP. Your second price is your WTA. In traditional finance theory, WTP=WTA=your valuation of this tin of tea. But, look at your numbers… Don’t worry, people behave like you!

WTP<<WTA Experimental economics/finance Why WTP<<WTA? Or what’s wrong with traditional finance theory? Traditional finance assume ‘traders’ in financial markets are ‘rational’. Behavioral finance theory says ‘traders’ have emotional and behavioral patterns.

Behavioral Finance Explanation People hate to loose more than they like to gain. If you get something, you soon become attached to it, and would ‘unrationally’ sell for a higher price than your valuation of it. You trade ‘emotionally’!

Critics about behavioral finance point of view Problematic experiments Old friend – information problem John List sports card trading No experience traders Experienced traders Sell price=WTA Buy price=WTP

Related behavioral finance theories Anchoring effect Prospect theory

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Prospective theory Bought at $50, now trading at $55, but tomorrow there’s half chance it would be $50, half chance price be $ sell now or sell later? Bought at $50, now trading at $45, but tomorrow there’s half chance it would be $40, half chance price be $ sell now or sell later? Situation A: sell now, Situation B: sell later back

Game 2 – portfolio choice List two kinds of soft drinks that you like. How to spend 10 dollars on these two drinks… ‘Simple diversification’ Suppose Ames and Kansas City both issue bonds, you can buy 10 bonds in total, how much you would buy on each? ‘Home basis’ – insufficient diversification ‘conservation’: too much weight on ‘base’ value

Game 3 - psychology Write down how much score you think you could get in the exam next Friday. ‘overconfidence’ excessive trading, trade (esp. buy) too often. When there is a loss, tend to have optimism and wishful thinking and don’t want to ‘stop loss’. stuborn.

Conclusion A revolution of behavioral finance Classical economics => Game theory => Behavioral economics/Finance People on the trading floor are not as ‘rational’ as optimization machines. Emotion, psychology, social effects come into play.