Behavioral Risk Management: Managing the Psychology That Drives Decisions and Influences Operational Risk

529 Pages·2016·3.732 MB·English

by  Shefrin, Hersh

Behavioral Risk Management

Behavioral Risk
Management
Managing the Psychology
That Drives Decisions and
Influences Operational Risk
H S
ERSH HEFRIN
BEHAVIORAL RISK MANAGEMENT
Copyright © Hersh Shefrin 2016
Softcover reprint of the hardcover 1st edition 2016 978-1-137-44560-5
All rights reserved. No reproduction, copy or transmission of this publication
may be made without written permission. No portion of this publication
may be reproduced, copied or transmitted save with written permission. In
accordance with the provisions of the Copyright, Designs and Patents Act
1988, or under the terms of any licence permitting limited copying issued by
the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London
EC1N 8TS.
Any person who does any unauthorized act in relation to this publication may
be liable to criminal prosecution and civil claims for damages.
First published 2016 by
PALGRAVE MACMILLAN
The author has asserted their right to be identified as the author of this work
in accordance with the Copyright, Designs and Patents Act 1988.
Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited,
registered in England, company number 785998, of Houndmills, Basingstoke,
Hampshire, RG21 6XS.
Palgrave Macmillan in the US is a division of Nature America, Inc., One
New York Plaza, Suite 4500, New York, NY 10004-1562.
Palgrave Macmillan is the global academic imprint of the above companies
and has companies and representatives throughout the world.
ISBN: 978–1–349–55420-1
E-PDF ISBN: 978–1–137–44562–9
DOI: 10.1057/9781137445629
Distribution in the UK, Europe and the rest of the world is by Palgrave
Macmillan®, a division of Macmillan Publishers Limited, registered in England,
company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS.
Library of Congress Cataloging-in-Publication Data
Shefrin, Hersh, 1948–
Behavioral risk management : managing the psychology that drives
decisions and infl uences operational risk / Hersh Shefrin.
pages cm
Includes index.
1. Risk management—Psychological aspects. 2. Risk perception.
3. Decision making—Psychological aspects. I. Title.
HD61.S4435 2015
658.4903019—dc23 2015021834
A catalogue record for the book is available from the British Library.
Printed in the United States of America.
Contents
Figures and Tables vii
Preface xiii
1. Introduction 1
Part I
2. SP/A Theory’s Focus on Three Key Emotions 19
3. Prospect Theory’s Focus on Gains, Losses, and Framing 37
4. Biases and Risk 53
5. Personality and Risk 71
Part II
6. Process, Pitfalls, and Culture 85
7. Minsky, the Financial Instability Hypothesis, and
Risk Management 105
8. Aspirational Pitfalls at UBS and Merrill Lynch 125
9. Cheating Issues at S&P and Moody’s 141
10. Groupthink at Fannie, Freddie, and AIG 157
11. The Winner’s Curse Strikes at RBS, Fortis, and ABN AMRO 173
12. Behavioral Dimension of Systemic Risk 191
13. Financial Regulation and Psychology 211
1 4. R isk of Fraud, Madoff, and the SEC 2 29
15. R isk, Return, and Individual Stocks 249
16. How Psychology Brought Down MF Global 267
vi Contents
17. JPMorgan’s Whale of a Risk Management Failure 281
1 8. R isk Management Profiles: Con Ed, BP, and MMS 2 99
19. Information Sharing Failures at Southwest Airlines,
General Motors, and the Agencies That Regulate Them 319
20. Conclusion 335
Erratum to : Behavioral Risk Management E1
Appendix A: A Deeper Dive into SP/A Theory 347
Appendix B: A Deeper Dive into Prospect Theory 369
Appendix C: Integrating SP/A Theory and Prospect Theory 385
Appendix D: A Deeper Dive into Heuristics and Biases 409
Appendix E: A Formal Model of Organizational Risk 435
Appendix F: Modelling FIH Issues 445
Appendix G: Empirical Proxies of Sentiment 453
Appendix H: A Formal Model for Identifying Failing Banks 459
Appendix I: FIH Issues in China and Europe 4 61
Notes 469
Index 509
The original version of this book was revised. An erratum to this book can be
found at DOI: 10.1057/9781137445629_21
Figures and Tables
Figures
2.1 Probability density functions for the future value of
the positions PK and RF 22
2.2 Valuations elicited from a participant Jeff in a risk choice and
valuation experiment involving undergraduates 32
2.3 Valuations elicited from a participant Tom in the same risk
choice and valuation experiment involving business managers 33
4.1 Coin-flip histograms for two groups of participants in
an experiment 60
6.1 Conceptual framework underlying RMP 94
7.1 Hedge finance 110
7.2 Speculative finance 111
7.3 Ponzi finance 112
7.4 Ponzi finance with short-term financing being used
for longer-term assets 114
12.1 Time series of the VIX between January 2000 and
September 2015 195
12.2 Trajectories for estimates of excessive optimism and
overconfidence between 2002 and 2009 196
12.3 Econometric estimate of the crash probability 197
12.4 Left tail sentiment measure 197
12.5 Long-term trajectory of the Baker-Wurgler
sentiment series BW 198
12.6 CAPE, Campbell and Shiller’s cyclically adjusted P/E for
US stocks 199
12.7 Trajectory of the Yale/Shiller crash confidence indices 200
12.8 Trajectory of the Gilchrist-Zakrajšek credit spread 200
12.9 SRISK% and leverage, at the end of March 2007 203
12.10 SRISK% and leverage, at the end of September 2007 204
12.11 SRISK% and MES, at the end of March 2008 205
12.12 SRISK% and leverage, at the end of March 2008 206
viii Figures and Tables
12.13 MES trajectories for select financial institutions for
the period May through October of 2008 207
12.14 Absolute values of correlations between excessive
optimism and MES and optimism for the period
March 2007 through October 2009 208
13.1 Equation ROE = [(EBIT – iD)(1−t)]/E 215
13.2 Bell-shaped density function and corresponding
cumulative distribution function 216
13.3 Patterns of default rates over time for double-A and
B-rated bonds 217
13.4 Two density functions, one for a standard normal
(N(0,1)), and the other for a power law 218
13.5 A vulnerability classification heuristic as a sequence of
cue-defined hurdles 225
14.1 Gross value of the split-strike conversion strategy on
the expiration date 232
14.2 Trajectory of cumulative monthly returns for
Fairfield Sentry and for the S&P 500 234
14.3 Monthly return series for the S&P 500 235
14.4 Monthly return series for Fairfield Sentry 236
14.5 Return histograms for the monthly returns associated
with Fairfield Sentry and the S&P 500 respectively 236
15.1 Linear structure associated with both the capital
market line and the securities market line 250
15.2 Tim Hellman’s correlations for variables expected return and
risk with beta, size, B/M, and past returns 259
15.3 Correlations for variables expected return and risk with beta,
size, B/M, and past returns for the group of analysts to
which Tim Hellman belonged 259
15.4 Two views of the relationship between BW and
expected return 262
17.1 A stylized depiction of the contingent payoffs for long
positions in the two CDX contracts 284
17.2 A stylized depiction of a short HY position 285
17.3 The tripling in position size of SCP during the first three
months of 2012 291
17.4 Magnitude of the losses to the portfolio during
the first six months of 2012 292
A.1 Shapes of the six probability density functions (pdfs)
Lopes used in her experiments 350
A.2 Illustrative pdf function p(x) and its associated
decumulative distribution function D(x) 352
Figures and Tables ix
A.3 How fear operates on PK 354
A.4 Functions h, h , and h 354
s p
A.5 The probability of achieving at least $1,100 from each of
the six alternatives SS, PK, U, BM, LS, RF 358
A.6 Valuations of a subject Pamela 359
A.7 Valuations of a subject Jack 359
A.8 Valuations of a subject Bill 361
A.9 Group mean valuations for WTA and WTP, for the
six risky alternatives 363
A.10 Allocations and ratings scaled down by one-tenth, for
the six risky alternatives 363
B.1 Shapes of three utility functions 371
B.2 Shape of the prospect theory value function 374
B.3 π-function in original prospect theory 375
B.4 w-weighting function in cumulative prospect theory 379
C.1 A graphical depiction of the information in Table C.2 388
C.2 The decumulative distributions for returns associated with
Risk A and Risk B in Zeisberger’s experiment 392
C.3 Graph of the SP/A L –function 399
D.1 A “fault tree” describing possible ways in which a once
profitable restaurant might go out of business 410
D.2 A “fault tree” describing possible ways in which a once
profitable restaurant might go out of business 412
D.3 Histogram response for subject hit rates to overconfidence
trivia quiz 425
D.4 Histogram response for hit rates per question to
overconfidence trivia quiz 426
D.5 Histogram response rates for Question D6 in Appendix D 426
D.6 Histogram of responses for both the prior probability and
posterior probability for Question D10, the bag of chips
problem, associated with the responses of a group of
risk managers 433
D.7 Histogram of responses for both the prior probability and
posterior probability for Question D10, the bag of chips
problem, associated with the responses of a group of
undergraduate finance majors 433
E.1 Elliptical confidence region for a bivariate distribution
for random variables x and y 436
E.2 Impact associated with increasing the value of xCrit 438
G.1 Three pdfs associated with the future gross returns for
the market at some specific date 455
G.2 Two different pricing kernels, one objective and one subjective 456