Finance and the Behavioral Prospect: Risk, Exuberance, and Abnormal Markets

350 Pages·2016·4.93 MB·English

by  James Ming Chen (auth.)

FINANCE AND
THE BEHAVIORAL
PROSPECT
Risk, Exuberance, and Abnormal Markets
JAMES MING CHEN
Quantitative Perspectives on Behavioral
Economics and Finance
Series Editor
James Ming   Chen
College of Law
Michigan State University
East Lansing ,   Michigan, USA
Aims of the Series
The economic enterprise has fi rmly established itself as one of evaluating
human responses to scarcity not as a rigidly rational game of optimiza-
tion, but as a holistic behavioral phenomenon. The full spectrum of social
sciences that inform economics, ranging from game theory to evolution-
ary psychology, has revealed the extent to which economic decisions and
their consequences hinge on psychological, social, cognitive, and emo-
tional factors beyond the reach of classical and neoclassical approaches
to economics. Bounded rational decisions generate prices, returns, and
resource allocation decisions that no purely rational approach to optimiza-
tion would predict, let alone prescribe.
Behavioral considerations hold the key to longstanding problems in
economics and fi nance. Market imperfections such as bubbles and crashes,
herd behavior, and the equity premium puzzle represent merely a few
of the phenomena whose principal causes arise from the comprehensi-
ble mysteries of human perception and behavior. Within the heterodox,
broad-ranging fi elds of behavioral economics, a distinct branch of behav-
ioral fi nance has arisen.
Finance has established itself as a distinct branch of economics by apply-
ing the full arsenal of mathematical learning on questions of risk manage-
ment. Mathematical fi nance has become so specialized that its practitioners
often divide themselves into distinct subfi elds. Whereas the P branch of
mathematical fi nance seeks to model the future by managing portfolios
through multivariate statistics, the Q world attempts to extrapolate the
present and guide risk-neutral management through the use of partial dif-
ferential equations to compute the proper price of derivatives.
The emerging fi eld of behavioral fi nance, worthy of designation by the
Greek letter psi (ψ), has identifi ed deep psychological limitations on the
claims of the more traditional P and Q branches of mathematical fi nance.
From Markowitz’s original exercises in mean-variance optimization to the
Black-Scholes pricing model, the foundations of mathematical fi nance
rest on a seductively beautiful Gaussian edifi ce of symmetrical models and
crisp quantitative modeling. When these models fail, the results are often
catastrophic.
The ψ branch of behavioral fi nance, along with other “postmodern”
critiques of traditional fi nancial wisdom, can guide theorists and practi-
tioners alike toward a more complete understanding of the behavior of
capital markets. It will no longer suffi ce to extrapolate prices and forecast
market trends without validating these techniques according to the full
range of economic theories and empirical data. Superior modeling and
data-gathering have made it not only possible, but also imperative to har-
monize mathematical fi nance with other branches of economics.
Likewise, if behavioral fi nance wishes to fulfi ll its promise of transcend-
ing mere critique and providing a more comprehensive account of fi nan-
cial markets, behavioralists must engage the full mathematical apparatus
known in all other branches of fi nance. In a world that simultaneously lauds
Eugene Fama’s effi ciency hypotheses and heeds Robert Shiller’s warnings
against irrational exuberance, progress lies in Lars Peter Hansen’s com-
mitment to quantitative rigor. Theory and empiricism, one and indivisible,
now and forever.
More information about this series at
http://www.springer.com/series/14524

James Ming   Chen
Finance and the
Behavioral Prospect
Risk, Exuberance, and Abnormal Markets
James Ming   Chen
College of Law
Michigan State University
East Lansing, Michigan, USA
Quantitative Perspectives on Behavioral Economics and Finance
ISBN 978-3-319-32710-5 ISBN 978-3-319-32711-2 (eBook)
DOI 10.1007/978-3-319-32711-2
Library of Congress Control Number: 2016950218
© The Editor(s) (if applicable) and The Author(s) 2 016
The author(s) has/have asserted their right(s) to be identifi ed as the author(s) of this work
in accordance with the Copyright, Designs and Patents Act 1988.
This work is subject to copyright. All rights are solely and exclusively licensed by the
Publisher, whether the whole or part of the material is concerned, specifi cally the rights of
translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on
microfi lms or in any other physical way, and transmission or information storage and retrieval,
electronic adaptation, computer software, or by similar or dissimilar methodology now
known or hereafter developed.
The use of general descriptive names, registered names, trademarks, service marks, etc. in this
publication does not imply, even in the absence of a specifi c statement, that such names are
exempt from the relevant protective laws and regulations and therefore free for general use.
The publisher, the authors and the editors are safe to assume that the advice and information
in this book are believed to be true and accurate at the date of publication. Neither the
publisher nor the authors or the editors give a warranty, express or implied, with respect to
the material contained herein or for any errors or omissions that may have been made.
Cover illustration © TongRo Images / Alamy Stock Photo
Printed on acid-free paper
This Palgrave Macmillan imprint is published by Springer Nature
The registered company is Macmillan Publishers Ltd. London
To Heather Elaine Worland Chen, with all my love

A
CKNOWLEDGMENTS
This book incorporates ideas from papers I have presented at the University
of Cincinnati, Florida State University, Georgetown University, Michigan
State University, the University of Pennsylvania, the University of Virginia,
and the Faculty of Economics of the University of Zagreb (Ekonomski
Fakultet, Sveučilište u Zagrebu). The International Atlantic Economic
Society and the ACRN Oxford Academic Research Network have pro-
vided multiple platforms for the work underlying this book. Along the
way, I have benefi ted from scholarly and professional interactions with
Anna Agrapetidou, Abdel Razzaq Al Rababa’a, Moisa Altar, Christopher
J. Brummer, Irene Maria Buso, Adam Candeub, Seth J. Chandler, Felix
B. Chang, Tendai Charasika, César Crousillat, David Dixon, Robert
Dubois, John F.  Duffy, Daniel A.  Farber, Christopher C.  French,
Santanu K.  Ganguli, Tomislav Gelo, Periklis Gogas, Gil Grantmore,
Andy Greenberg, Losbichler Heimo, Hemantha Herath, Jesper Lyng
Jensen, Jagoda Kaszowska, Daniel Martin Katz, Yuri Katz, Imre Kondor,
Carolina Laureti, Cordell Lawrence Jr., Cordell Lawrence Sr., Matthew
Lee, Othmar Lehner, Heimo Losbichler, Gerry Mahar, Milivoj Marković,
L. Thorne McCarty, Steven C. Michael, Ludmila Mitkova, José María
Montero Lorenzo, Kevin Lynch, Laura Muro, Vivian Okere, Merav
Ozair, Elizabeth Porter, Mobeen Ur Rehman, Carol Royal, Bob Schmidt,
Jeffrey A. Sexton, Galen Sher, Ted Sichelman, Jurica Šimurina, Nika Sokol
Šimurina, Robert Sonora, Lisa Grow Sun, Elvira Takli, Peter Urbani,
Robert R.M. Verchick, Benjamin Walther, Karen Wendt, Gal Zahavi, and
Johanna F. Ziegel. Christian Diego Alcocer Argüello of Michigan State
University’s Department of Economics provided very capable research
ix