💳Behavioral Finance Unit 2 – Foundations of Traditional Finance

Key Concepts in Traditional Finance

• Traditional finance assumes investors are rational, self-interested, and aim to maximize their utility
• Investors make decisions based on all available information and are not influenced by emotions or biases
• Financial markets are efficient, meaning asset prices reflect all available information (Efficient Market Hypothesis)
• Risk and return are positively correlated, with higher risk investments offering higher expected returns
• Diversification reduces unsystematic risk by spreading investments across different assets and sectors
• Time value of money concepts, such as present value and future value, are used to evaluate investments and make financial decisions
• Capital structure refers to the mix of debt and equity financing used by a company to fund its operations and growth
• Asset pricing models, like the Capital Asset Pricing Model (CAPM), are used to determine the expected return of an asset based on its risk

Financial Markets and Institutions

• Financial markets facilitate the exchange of financial assets, such as stocks, bonds, and derivatives
• Primary markets involve the issuance of new securities (Initial Public Offerings), while secondary markets allow for the trading of existing securities (stock exchanges)
• Financial institutions, such as banks, insurance companies, and investment firms, act as intermediaries between savers and borrowers
• Commercial banks accept deposits and provide loans to individuals and businesses
• Investment banks assist companies in raising capital through the issuance of securities and provide advisory services for mergers and acquisitions
• Central banks, like the Federal Reserve, manage monetary policy and regulate the banking system to maintain financial stability
• Mutual funds pool money from multiple investors to invest in a diversified portfolio of securities, providing access to professional management and diversification benefits

Time Value of Money

• The time value of money is the concept that a dollar today is worth more than a dollar in the future due to its potential to earn interest
• Present value (PV) is the current worth of a future sum of money or stream of cash flows given a specified rate of return
  • PV is calculated using the formula: $PV = \frac{FV}{(1+r)^n}$, where FV is the future value, r is the discount rate, and n is the number of periods
• Future value (FV) is the value of an asset or cash flow at a specified date in the future, assuming a certain rate of growth or interest
  • FV is calculated using the formula: $FV = PV(1+r)^n$
• Net present value (NPV) is used to evaluate the profitability of an investment by discounting all future cash inflows and outflows to the present
  • A positive NPV indicates that the investment is expected to be profitable, while a negative NPV suggests that the investment should be rejected
• Internal rate of return (IRR) is the discount rate that makes the NPV of an investment equal to zero
  • IRR is used to compare the profitability of different investments, with a higher IRR indicating a more attractive investment

Risk and Return

• Risk refers to the uncertainty of future returns and the potential for financial loss
• Systematic risk, also known as market risk, affects the entire market and cannot be diversified away (economic downturns, interest rate changes)
• Unsystematic risk, or firm-specific risk, is unique to a particular company or industry and can be reduced through diversification (management changes, labor strikes)
• Return is the gain or loss on an investment, typically expressed as a percentage of the initial investment
• Expected return is the average return an investor anticipates receiving based on the probability of different outcomes
  • Expected return is calculated using the formula: $E(R) = \sum_{i=1}^{n} p_i R_i$, where $p_i$ is the probability of outcome i, and $R_i$ is the return associated with outcome i
• Standard deviation measures the dispersion of returns around the expected return and is used as a measure of risk
• The risk-return tradeoff suggests that investors must accept higher levels of risk to achieve higher expected returns

Asset Pricing Models

• Asset pricing models are used to determine the theoretical fair price of an asset based on its risk and expected return
• The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for an asset
  • The CAPM formula is: $E(R_i) = R_f + \beta_i(E(R_m) - R_f)$, where $E(R_i)$ is the expected return of the asset, $R_f$ is the risk-free rate, $\beta_i$ is the asset's beta (sensitivity to market risk), and $E(R_m)$ is the expected return of the market
• Beta measures an asset's sensitivity to systematic risk, with a beta greater than 1 indicating higher volatility than the market and a beta less than 1 suggesting lower volatility
• The Arbitrage Pricing Theory (APT) is a multi-factor model that explains an asset's expected return based on its exposure to various macroeconomic factors (inflation, GDP growth)
• The Fama-French Three-Factor Model expands on the CAPM by adding size and value factors to explain stock returns

Portfolio Theory

• Modern Portfolio Theory (MPT), developed by Harry Markowitz, suggests that investors can construct portfolios to maximize expected return for a given level of risk
• Diversification is a key concept in MPT, as it helps to reduce unsystematic risk by investing in a variety of assets with low or negative correlations
• The efficient frontier represents the set of optimal portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given expected return
• Investors can choose a portfolio along the efficient frontier based on their risk tolerance and investment objectives
• The Sharpe ratio measures the risk-adjusted return of a portfolio by comparing its excess return (return above the risk-free rate) to its standard deviation
  • A higher Sharpe ratio indicates a better risk-adjusted return
• Rebalancing involves periodically adjusting the weights of assets in a portfolio to maintain the desired risk and return characteristics

Capital Structure and Corporate Finance

• Capital structure refers to the mix of debt and equity financing used by a company to fund its operations and growth
• Debt financing involves borrowing money that must be repaid with interest (bonds, loans), while equity financing involves selling ownership stakes in the company (stocks)
• The Modigliani-Miller theorem states that, under perfect market conditions, the value of a firm is unaffected by its capital structure
  • In reality, factors such as taxes, bankruptcy costs, and agency costs can make capital structure decisions relevant
• The weighted average cost of capital (WACC) is the average cost of a company's debt and equity financing, weighted by their respective proportions in the capital structure
  • WACC is used as a discount rate for evaluating corporate investments and determining the value of a company
• Capital budgeting involves evaluating and selecting long-term investments, such as new projects or expansions, based on their expected cash flows and profitability
• Dividend policy refers to the decisions a company makes regarding the distribution of its earnings to shareholders, such as the amount and frequency of dividend payments

Efficient Market Hypothesis

• The Efficient Market Hypothesis (EMH) states that asset prices fully reflect all available information, making it impossible to consistently outperform the market
• The weak form of EMH suggests that current stock prices reflect all historical price and volume data, making technical analysis ineffective
• The semi-strong form of EMH asserts that stock prices quickly adjust to new public information, such as earnings announcements or economic reports, making fundamental analysis less useful
• The strong form of EMH contends that stock prices reflect all public and private information, including insider information, making it impossible for any investor to have an advantage
• Empirical evidence provides mixed support for EMH, with some studies finding market anomalies and inefficiencies that can be exploited by investors
• Behavioral finance challenges EMH by arguing that investors are not always rational and that psychological biases can lead to market inefficiencies and mispricing