Directorate of Distance Education UNIVERSITY OF JAMMU JAMMU SELF LEARNING MATERIAL OF BEHAVIOURAL FINANCE COURSE NO : FE-316 UNIT : I-IV M.COM. IIIRD SEMESTER LESSON NO. : 1-20 PROF. SANDEEP KOUR TANDON CO-ORDINATOR M. COM. Room No. 111, Ist Floor Directorate of Distance Education, University of Jammu, Jammu. http:/www.distanceeducationju.in Printed and Published on behalf of the Directorate of Distance Education, University of Jammu, Jammu by the Director, DDE, University of Jammu, Jammu. M.COM. IIIRD SEMESTER Lesson Writers : Edited by : Mr. Ashok Kumar Dr. Rupa Mahajan & Teacher Incharge M. Com. Ms. Nikita Gupta Room No. 205, IInd Floor, PG Dept. of Commerce Directorate of Distance Education, University of Jammu University of Jammu, Jammu. © Directorate of Distance Education , University of Jammu, Jammu 2020 • All rights reserved . No part of this work may be reproduced in any form , by mimeograph or any other means, without permission in writing from the DDE , University of Jammu. • The script writer shall be responsible for the lesson / script submitted to the DDE. Printed at : Rohini Printers 20/400 DIRECTORATE OF DISTANCE EDUCATION UNIVERSITY OF JAMMU M.Com. Third Semester (NCBS) Behavioural Finance Course : M.Com.-FE 316 Max. Marks : 100 Marks Credit : 4 External : 80 Marks Time : 3.00 Hrs. Internal : 20 Marks (Syllabus for the examinations to be held in Dec. 2020, 2021, 2022) OBJECTIVE : The purpose of this course is to introduce the student to the new field of behavioural finance. Students will deal with major implications of human psychology for financial decision-makers and for financial markets. Upon completion of this course, students will be able to have a good understanding of the major concepts and topics of behavioural finance. UNIT-I : RATIONAL MARKETS HYPOTHESIS AND PAGE NO. THE CHALLENGE OF BEHAVIOURALISTS 6-71 Introduction to behavioural finance; Intellectual underpinnings; The rise of the rational markets hypothesis; Impact on wall street and the corporate; The challenges of behaviouralists; Synthesis and future horizons. UNIT-II : FOUNDATION OF RATIONAL FINANCE 72-138 Expected utility theory, Modern portfolio theory, Capital asset pricing model (CAPM); Efficient markets hypothesis; Agency theory; The influence of psychology. UNIT-III : FOUNDATIONS OF BEHAVIOURAL FINANCE 139-217 (Heuristics and Biases) How the human mind works-the two systems; Familiarity and related heuristics; Representativeness and related biases; Anchoring; Irrationality and adaptation; Hyperbolic discounting. UNIT-IV : PROSPECT THEORY AND MENTAL ACCOUNTING 218-284 Error in Bernoulli’s theory; Prospect theory; SPA theory, Framing; Mental Accounting; Emotional factors and social forces-substance of emotion, theories of emotion, evolutionary perspective on emotions, types and dimensions of emotions, emotional style, emotions and investing, social inlfuence, social influence on investment and consumption. BOOKS RECOMMENDED 1. Chandra, P. (2017), Behavioural Finance, Tata Mc Graw Hill Education, Chennai (India). 2. Ackert, Lucy, Richard Deaves (2010), Behavioural Finance; Psychology, Decision Making and Markets, Cengage Learning. 3. Forbes, William (2009), Behavioural Finance, Wiley. 4. Kahneman, D. and Tversky, A. (2000). Choices, values and frames. New York : Cambridge Univ. Press. 5. Shefrin, H. (2002), Beyond Greed and Fear; Understanding Behavioural Finance and Psychology of investing. New York; Oxford University Press. 6. Shleifer, A. (2000). Inefficient markets; An introduction to Behavioural Finance. Oxford Univ. Press. 7. Thaler, R. (1993). Advances in Behavioral Finance. Vol. I. New York, Russell Sage Foundation. 8. Thaler, R. (2005). Advances in Behavioural Finance. Vol. II. New York; Princeton University Press. NOTE FOR PAPER SETTING The paper consists of two sections. Each section will cover the whole of the syllabus without repeating the question in the entire paper. Section A : It will consist of eight short answer questions, selecting two from each unit. A candidate has to attempt any six and answer to each question shall be within 200 words. Each question carries four marks and total weightage to this section shall be 24 marks. Section B : It will consist of six essay type questions with answer to each question within 800 words. One question will be set atleast from each unit and the candidate has to attempt four. Each question will carry 14 marks and total weightage shall be 56 marks. MODEL QUESTION PAPER BEHAVIOURAL FINANCE Duration of examination : 3hours M. Marks: 80 SECTION A Attempt any six questions. Each question carries 4 marks. Answer to each question should be within 200 words. 1. Discuss the concept of Behavioural Finance. 2. Explain various challenges being faced by behaviouralists. 3. What do you understand by Expected Utility Theory? 4. Briefly discuss agency theory and agency cost. 5. Give a brief note on hyperbolic discounting. 6. Describe how human mind works with the two systems. 7. What are errors in Bernoulli’s theory? 8. Discuss the concepts of mental accounting and mental budgeting. SECTION B Attempt any four questions. Each question carries 14 marks. Answer to each question should be within 800 words. 1. Explain the nature, scope and applications of behavioural finance. Also, discuss the evolution of rational markets. 2. Discuss modern portfolio theory and its assumption. Also, explain the importance of MPT for risk management. 3. Elucidate CAPM in detail. State its components and implications. 4. Explain the concept of representativeness and anchoring. Also, discuss the biases related with representatives. 5. Discuss in detail the key tenets of prospect theory. 6. What are emotions? Discuss in detail the theories and dimensions of emotions. UNIT–I M.COM IIIRD SEMESTER COURSE NO. FE-316 LESSON NO. 1 RATIONAL MARKETS HYPOTHESIS AND THE CHALLENGE OF BEHAVIOURALISTS INTRODUCTION TO BEHAVIOURAL FINANCE STRUCTURE 1.1 Introduction 1.2 Objective 1.3 Concept of Behavioural Finance 1.4 Nature of Behavioural Finance 1.5 Scope of Behavioural Finance 1.6 Objectives of Behavioural Finance 1.7 Application of Behavioural Finance 1.7.1 Behavioural Biases that Influence Investment Decisions 1.8 Approaches to Decision-Making in Behavioural Finance 1.9 Traditional Finance and Behavioural Finance 1.10 Summary 1.11 Glossary 1.12 Self Assessment Questions 1.13 Lesson End Exercises 1.14 Suggested Readings / References 1.1 INTRODUCTION Since the mid-1950s, the field of finance has been dominated by the traditional finance model developed by the economists of the University of Chicago. The Central assumption of the traditional finance model is that the people are rational. Standard Finance theories are based on the premise that investor behaves rationally and stock and bond markets are efficient. As the financial economists were assuming that people (investors) behaved rationally while making financial decisions, psychologists have found that economic decisions are made in an irrational manner, so they challenge this assumption of standard finance. Cognitive error and extreme emotional bias can cause investors to make bad investment decisions, thereby acting in irrational manner. Since the past few decade, field of Behavioural finance has evolved to consider how personal and social psychology influence financial decisions and behaviour of investors in general. The finance field was reluctant to accept the view of psychologists who had proposed the Behavioural finance model. Behavioural finance was considered first by the psychologist Daniel Kahneman and economist Vernon Smith, who were awarded the Nobel Prize in Economics in 2002.This was the time when financial economist started believing that the investor behaves irrationally. Human brains process information using shortcuts and emotional filters even in investment decisions. It is an attempt to explain how the psychological dimensions influence investment decisions of individual investor, how perception influences the mutual funds market as a whole. It is worth exploring whether field of psychology helps investor to make more reasonable investment decisions. Behavioural finance is a concept developed with the inputs taken from the field of psychology and finance. It tries to understand the various puzzling factors in stock markets to offer better explanations for the same. These factors or abnormalities were initially termed as market anomalies, as they could not be explained in the Neo-classical framework. To answer the increased number and types of market anomalies, a new approach to financial markets had emerged- the Behavioural finance. Behavioural finance is defined as the study of the influence of socio-psychological factors on an asset’s price. It focuses on investor behaviour and their investment decision-making process. 1.2 OBJECTIVE After studying this lesson, you will be able to understand : • the concept of Behavioural finance • the scope of Behavioural finance • the application of Behavioural finance • objectives of Behavioural finance 1.3 CONCEPT OF BEHAVIOURAL FINANCE Behavioural Finance (BF) is the study of investors’ psychology while making financial decisions. It is the study of the influence of psychology and sociology on the behaviour of financial practitioners and the subsequent effect on market. According to Behavioural finance, investors’ market behaviour derives from psychological principles of decision-making to explain why people buy or sell stock. Behavioural finance focuses upon how investor interprets and acts on information to take