Hhere are the lecture slides for the last lecture on Friday, and I’ll set up office hours next week.

Thanks to everyone for making this an interesting class to teach!

Neurofinance is a fusion of behavioural economics and neuroeconomics.

I know that’s not too helpful yet. Behavioural economics in its modern incarnation looks at persistent deviations from the basic description of the hyper rational homo economicus. Proponents of the theory argue that these deviations aren’t deviations at all: they are, in fact, features of human behaviour we’d like to take as primal to any description of human behaviour. Practitioners use game theory to model how boundedly rational (that is, agents don’t know everything, and can’t process information they receive quickly enough to make sense of the entire world simultaneously) agents might react given an investment decision, and then test the predictions of the game against people’s actual responses. Only instead of looking at revealed behaviours and choices made, neurofinance specialists will look at actual brain responses, and try to figure out what neurological basis there is for such a decision. This area of research is still very much in its infancy, but it is definitely worth a lecture to expose you to the cutting edge of this type of research.

Here’s a 3 slide handout (with many thanks to Dr Liam Delaney for the slides).

Readings/Links

Peter Bossaert’s Lab at Caltech

Neuroeconomics Studies

Kerstin Preuschoff, Peter Bossaerts, and Steven R. Quartz Neural Differentiation of Expected Reward and Risk in Human Subcortical Structures Neuron 51, 381–390, August 3, 2006

Colin Camerer, George Loewenstein, Drazen Prelec, “Neuroeconomics: How neuroscience can inform economics“, Journal of Economic Literature, 2005
Paul J. Zak The Neurobiology of Trust Scientific American, June 2008

The IMF released it’s World Economic Outlook report, which has some interesting things to say about the international economic situation. Pay particular attention to page 105, where they contrast today’s economic outlook with the Great Depression. This report resonates well with the recent work of O’Rourke and Eichengreen, too.  

“We have an irrational tendency to be less willing to gamble with profits than with losses..”

––Tvede (1999)

In these lectures, we’ll build on the insights of the Efficient and Adaptive Markets hypotheses, and have a go at puling them down at the same time. This might sound contradictory, but it’s not. All science (even a pseudo-science like modern economics) advances through sustained and successful criticism. It’s ok to tear down the existing theory, but if you do, try to make sure there’s something to replace it with.

Stated baldly, Behavioural Finance is the study of the inefficiency of real world markets. Most of the time, behavioural finance theorists will borrow concepts from psychology or sociology to make their claims more realistic. The behavioural economics movement is closely aligned with the Neuroeconomics movement currently en vogue in academic economic circles. Dr. Liam Delaney of UCD’s Geary institute retains a bibliography of neuroeconomics readings, if you’re interested.

To the theory-proper. In previous lectures, we worked on the Efficient Markets Hypothesis: markets price traded assets to remove the possibility of arbitrage, making risk-less profits harder and harder to come by.

Nobellist Daniel Kahneman and his colleague Amos Tversky studied decision making under uncertainty over a long period of time (their most famous article is here). They found three heuristics people use to help them make judgements under uncertainty:

1. Representativeness. When possibly erroneous commonality between objects of similar appearance is assumed.

2. Availability. We base our predictions of the frequency of events or the proportion within a population based on how easily an example can be brought to mind.

3. Anchoring and Adjustment. We overly rely, on specific information or a specific value and then adjust to that value to account for other elements of the circumstance. Usually once the anchor is set, there is a bias toward that value.

In this lecture, we’ll look at Prospect theory and asset pricing, and compare Kahneman’s and Tversky’s theory to the data. We’ll also see how various famous behavioural economists (Profs. Shiller, Thaler, and Camerer).

In lecture 19, we’ll move on to consider Thaler’s ‘Anomalies’: holes he and co-authors have found in the existing body of theory, as they apply to Financial Economics. Here is a 3 slide per page handout.

Slides

Links

Thaler’s Anomalies page, get the papers here.

Camerer, C. and G. Loewenstein (2003). “Behavioral Economics: Past, Present, Future,”

Sewell, M. (2008) “Introduction to Behavioural Finance” ⁃
Shiller, R. (2002), “From Efficient Markets to Behavioural Finance.“

She asked me:

What does the economy do?

In your opinion, what does the economy do? Answers either by email or in the comments.

Here’s a 3 slide handout, and here are the slides.

Readings

Liang and Weisbenner,Investor Behavior and the Purchase of Company Stock in 401(k) Plans – The Importance of Plan Design

National Pension Reserve

Blinder,A. Central Banking in Theory and Practice, MIT Press, Cambridge, Mass, 1998.

Scheller, The ECB, History, Role, and Functions, 2004

OECD, Private Pensions Outlook, 2008.

Attacks on pension relief short-sighted and reckless, Irish Times, 2/04/09

ec4024_2009_PS2.pdf

Data

Dollar Euro.xls

Ryanair vs’ Bank of Ireland.xls

Sterling Euro.xls

Here is a 3 slides per page handout, below are the slides themselves.

Readings

Hyman Minsky page at HET, his big book “Stabilizing an Unstable Economy” (Hyman Minsky)

Stephen Kinsella, Financial Fragility and Corporate Governance in Ireland, in Ronan Keane and Ailbhe O’Neal, (eds), Corporate Governance: An Irish Perspective, Roundhall Press, 2009 pgs. 147-170. Draft version here.

Here’s a 3 slide handout of the lecture, here’s the data handout and the slides are below.

Readings

The collapse of Iceland’s banks: the predictable end of a non-viable business model

Entranced by banking

Iceland faces the music

GDP Growth Rate Calculator for Iceland

Statistics Iceland

Buiter & Sibert: The Banking Crisis and What to Do about it.

“One of the reasons this is so outrageous is that the promise of such bonuses was in fact one of the very factors that caused our current problems, creating incentives for managers of AIG to get out of solid insurance underwriting and into hedge fund gambling. If anyone had supposed that AIG had “learned its lesson”, this report seemed to dash that hope against the wall like a plate of china.”
On a slightly lighter note, here’s MIT’s Ricardo Caballero on more constructive solutions to the crisis.

In tutorials, we’ll be spending time in the Trading Simulation floor from next week, and using this resource well will become part of your second problem set. So, here’s the roadmap:

(today) Lecture 12: Domestic and International Bond Markets. Reading: Pilbeam, cht. 12

Lecture 13: Stabilistation & Growth Pacts, the ECB, and Ireland. Reading: Cournot Institute Working Paper by Solow et al.

Lecture 14: Default Probabilities and Defunct States: Ireland and Iceland. Reading: Buiter & Sibert, http://www.voxeu.org/index.php?q=node/2498

Lecture 15: Financial Fragility in Ireland, Reading: Kinsella, Financial Fragility in Ireland,2009.

Lecture 16: The European Central Bank & Investor Behaviour. Reading: Buiter, W: Why the United Kingdom Should Join the Eurozone

Lecture 17: The Credit Default Swap Market, the Subprime Crisis, and Ireland, 2008-2009. Reading: Shiller, R, The Subprime Solution, chapters 2 and 3.

Lecture 18: Behavioural Finance 1: CAPM and Reality. Reading: course notes

Lecture 19: Behavioural Finance 2: Biases and Trading. Reading: course notes

Lecture 20: Behavioural Finance 3: The Efficient and Adaptive Markets Hypotheses. Reading: Lo (2004)

Lecture 21: Options & Option Pricing, Reading: Pilbeam, Cht 15, and course notes

Lecture 22: Options Pricing 2: Reading, Taleb & Huag.

Lecture 23: Recap lecture. Readings: All of them

I’ve decided to extend the deadline for Problem Set 1 from this Friday to next Friday, the 13th, at the same time.

It’s always OK to email me and let me know what’s going on with your other courses. Sometimes I won’t be able to change deadlines, but, when I can, I will.

I expect better problem set submissions, of course.

Now someone buy Anna and Stuart pints.

There are two schools of thought on how to get credit flowing again. One suggests buying the toxic assets, the other says to recapitalise banks. This column says that both approaches are necessary, though the right balance will vary across nations. The real difficulty is aligning incentives – in both pricing assets and recapitalising banks, bank managers’ interests may thwart governments’ objectives.

Buying assets, recapitalising banks, and getting incentives right

A quick follow-up to Nicolai’s post on the copula function: See also this item on Gary Gorton’s role in the financial crisis, which includes Warren Buffett’s great line: “Beware of geeks . . . bearing formulas.” And items on Knightian uncertainty here and here.

And there’s this passage from Darren Aronofsky’s cult classic Pi:

Restate my assumptions: One, Mathematics is the language of nature. Two, Everything around us can be represented and understood through numbers. Three: If you graph the numbers of any system, patterns emerge. Therefore, there are patterns everywhere in nature. Evidence: The cycling of disease epidemics;the wax and wane of caribou populations; sun spot cycles; the rise and fall of the Nile. So, what about the stock market? The universe of numbers that represents the global economy. Millions of hands at work, billions of minds. A vast network, screaming with life. An organism. A natural organism. My hypothesis: Within the stock market, there is a pattern as well. . . . Right in front of me . . . hiding behind the numbers. Always has been.

This is before the speaker, the mathematician protagonist Max Cohen, goes literally insane. That’s what quantitative financial modeling can do to you.

[From Risk, Uncertainty, and Financial Markets]

Link

Related articles

• Comparing Bank Failures, Then and Now, in Current Dollars (paul.kedrosky.com)
• ‘Real’ inflation falls further – but will pensioners benefit? (telegraph.co.uk)
• Liquidity Trap (wordout.computergeekservices.net)

Extra readings on the topic of crises in financial markets and banking crises especially through history are here, here and here.

You should also read this, and chapter 4 of Pilbeam. Donna will go through Portfolio theory in classes this week, and there are no lectures Friday or Monday, as I’m traveling. We’ll do make up classes at the end of the term.

Click here for the slides, they are up on slideshare below.

This chapter advances a financial fragility hypothesis[1] to explain many of the determinants of the 2009/2010 Irish recessionary period. This chapter gives the context in terms of goshavernance for the poor performance of the Irish economy to date, suggests one theory to explain the changes we have witnessed in Irish economic conditions in 2008 and 2009, and advances an ‘emergent’ theory of corporate governance for the 21st Century to better protect the Irish economy from the inevitable excesses of the financial sector.

Kinsella_Financial Fragility_V0.3