ADVANCED
FINANCE
Prof: Kris Boudt, David Ardia, and Steven Vanduffel
Pauline Delphine A Verhelst
VUB | 2021-2022
,TABLE OF CONTENTS
1. BEHAVIORAL FINANCE ............................................................................................................................ 3
1.1. INTRODUCTION........................................................................................................................................... 3
1.2. BASIC FINANCIAL LITERACY REVIEW ................................................................................................................. 5
1.3. EXPLAINING FINANCIAL DECISIONS UNDER UNCERTAINTY: SENSITIVITY TO THE OBJECTIVE FUNCTION OF THE DECISION
MAKER 7
1.3.1. Decision problem (assumptions) ................................................................................................... 7
1.3.2. Decision rules ................................................................................................................................ 8
1.3.3. Prospect theory ........................................................................................................................... 11
1.4. EXPLAINING FINANCIAL DECISIONS OF NORMAL PEOPLE USING PROSPECT THEORY .................................................. 19
1.4.1. Recall: The essentials of prospect theory .................................................................................... 19
1.4.2. Application to investment decisions ............................................................................................ 20
1.4.2.1. Prospect theory and the selling decision ................................................................................................ 20
1.4.2.2. Prospect theory and predicting return and risk by normal people ......................................................... 23
1.4.2.3. Prospect theory and the frequency of trading ........................................................................................ 24
1.4.2.4. Prospect theory and portfolio decisions ................................................................................................. 25
1.4.3. Application to management decisions ........................................................................................ 31
1.4.3.1. Prospect theory and managerial decisions ............................................................................................. 32
1.4.3.2. Conclusion on prospect theory and financial decisions .......................................................................... 35
1.5. EXPLAINING FINANCIAL MARKETS USING BEHAVIORAL FINANCE ........................................................................... 36
1.5.1. Efficient Market Hypothesis ........................................................................................................ 37
1.5.1.1. Strong form EMH: All information, public and private ........................................................................... 38
1.5.1.2. Semi strong form EMH: all publicly available information ...................................................................... 39
1.5.1.3. Weak form EMH: all information included in past price data. ................................................................ 40
1.5.2. Higher level thinking ................................................................................................................... 41
1.5.3. Presence of herding by investors ................................................................................................. 44
1.5.3.1. Cascade models....................................................................................................................................... 45
1.5.3.2. External effects model ............................................................................................................................ 46
1.5.3.3. Reputation .............................................................................................................................................. 46
1.6. SUMMARY ............................................................................................................................................... 48
1.6.1. Financial decision making – course outline ................................................................................. 48
1.6.2. Course evaluation........................................................................................................................ 48
1.6.3. Example and review questions .................................................................................................... 49
2. INTRODUCTION TO DERIVATIVES ......................................................................................................... 56
2.1. PART 1 - FORWARDS AND OPTIONS ............................................................................................................... 56
2.1.1. Derivatives & the financial markets ............................................................................................ 56
2.1.2. Forwards & futures...................................................................................................................... 58
2.1.3. Options ........................................................................................................................................ 61
2.1.4. Strategies with options................................................................................................................ 66
2.1.5. Pricing options ............................................................................................................................. 68
2.1.5.1. Binomial model ....................................................................................................................................... 68
2.2. PART 2 - HEDGING OF CURRENCY RISK ........................................................................................................... 75
2.2.1. Key concepts in foreign exchange markets ................................................................................. 75
2.2.2. Risk management of international operations............................................................................ 78
2.2.2.1. Hedging currency risk with forwards and futures ................................................................................... 79
2.2.2.2. Hedging currency risk with options......................................................................................................... 82
2.2.3. Your turn ..................................................................................................................................... 84
2.3. EXAMPLE QUESTIONS ................................................................................................................................. 87
2.3.1. Part 1 ........................................................................................................................................... 87
2.3.2. Part 2 ........................................................................................................................................... 88
3. PRICING OF FINANCIAL INSTRUMENTS AND PRINCIPLES OF OPTION PRICING....................................... 89
3.1. INTRODUCTION......................................................................................................................................... 89
3.2. INTUITIVE APPROACH TO PRICING PAYOFFS ..................................................................................................... 90
3.3. RISK NEUTRAL PRICING APPROACH TO PRICE PAYOFFS ....................................................................................... 90
3.4. REPLICATING PORTFOLIO APPROACH ............................................................................................................. 91
3.5. THEORETICAL ANALYSIS .............................................................................................................................. 93
3.6. RISK-NEUTRAL PRICING .............................................................................................................................. 94
3.7. IRRELEVANCE OF STOCK’S EXPECTED RETURN .................................................................................................. 96
1
, 3.8. SUMMARY ............................................................................................................................................... 96
4. FINANCIAL DATA ANALYTICS WITH R .................................................................................................... 97
4.1. DATACAMP TASK - LOGBOOK ....................................................................................................................... 97
4.2. FINANCIAL DATA ANALYSIS WITH R TASK – CATERPILLAR ................................................................................. 100
2
, 1. Behavioral finance
1.1. Introduction
- Two major questions
o How to model the decisions of yourself and the others?
o How to take advantage of the behavior of others
§ Gain profit out of the mistakes of others
- How to model the decisions of yourself and the others?
o When we make decisions, we will make mistakes
o How do people make financial decisions?
§ Making assumptions
§ Economic textbook
• Economies start by making assumptions
¨ People behave like ‘economic man’, very rational
¨ People notice all the relative aspects of the environment,
notices everyone and can make the most optimal decision
¨ Able to calculate the outcome of each possible decision and
then take the best on
¨ Based on the preferences of this person
§ Compare assumptions with reality
• Bounded rationality
¨ Risk of calculation mistakes
§ Even if you try to be rational, it cannot be rational
because of mistakes
¨
§ Information imperfection: not everyone has the
same amount of information
§ Cognitive limitation: limited by skills
§ Time constraint: decisions have to be made on the
spot
¨ à impossible to be fully rational and having optimal
decisions
¨ Computation skills
§ Does not make any cognitive mistakes
§ But people do make mistakes
§ Example: there are three cards in a hat
• 1 is red on both sides
• 1 is green on both sides
• 1 is red on one side and green on the other
• What is probability that you pick red?
• Take a long time to find the answer
3
FINANCE
Prof: Kris Boudt, David Ardia, and Steven Vanduffel
Pauline Delphine A Verhelst
VUB | 2021-2022
,TABLE OF CONTENTS
1. BEHAVIORAL FINANCE ............................................................................................................................ 3
1.1. INTRODUCTION........................................................................................................................................... 3
1.2. BASIC FINANCIAL LITERACY REVIEW ................................................................................................................. 5
1.3. EXPLAINING FINANCIAL DECISIONS UNDER UNCERTAINTY: SENSITIVITY TO THE OBJECTIVE FUNCTION OF THE DECISION
MAKER 7
1.3.1. Decision problem (assumptions) ................................................................................................... 7
1.3.2. Decision rules ................................................................................................................................ 8
1.3.3. Prospect theory ........................................................................................................................... 11
1.4. EXPLAINING FINANCIAL DECISIONS OF NORMAL PEOPLE USING PROSPECT THEORY .................................................. 19
1.4.1. Recall: The essentials of prospect theory .................................................................................... 19
1.4.2. Application to investment decisions ............................................................................................ 20
1.4.2.1. Prospect theory and the selling decision ................................................................................................ 20
1.4.2.2. Prospect theory and predicting return and risk by normal people ......................................................... 23
1.4.2.3. Prospect theory and the frequency of trading ........................................................................................ 24
1.4.2.4. Prospect theory and portfolio decisions ................................................................................................. 25
1.4.3. Application to management decisions ........................................................................................ 31
1.4.3.1. Prospect theory and managerial decisions ............................................................................................. 32
1.4.3.2. Conclusion on prospect theory and financial decisions .......................................................................... 35
1.5. EXPLAINING FINANCIAL MARKETS USING BEHAVIORAL FINANCE ........................................................................... 36
1.5.1. Efficient Market Hypothesis ........................................................................................................ 37
1.5.1.1. Strong form EMH: All information, public and private ........................................................................... 38
1.5.1.2. Semi strong form EMH: all publicly available information ...................................................................... 39
1.5.1.3. Weak form EMH: all information included in past price data. ................................................................ 40
1.5.2. Higher level thinking ................................................................................................................... 41
1.5.3. Presence of herding by investors ................................................................................................. 44
1.5.3.1. Cascade models....................................................................................................................................... 45
1.5.3.2. External effects model ............................................................................................................................ 46
1.5.3.3. Reputation .............................................................................................................................................. 46
1.6. SUMMARY ............................................................................................................................................... 48
1.6.1. Financial decision making – course outline ................................................................................. 48
1.6.2. Course evaluation........................................................................................................................ 48
1.6.3. Example and review questions .................................................................................................... 49
2. INTRODUCTION TO DERIVATIVES ......................................................................................................... 56
2.1. PART 1 - FORWARDS AND OPTIONS ............................................................................................................... 56
2.1.1. Derivatives & the financial markets ............................................................................................ 56
2.1.2. Forwards & futures...................................................................................................................... 58
2.1.3. Options ........................................................................................................................................ 61
2.1.4. Strategies with options................................................................................................................ 66
2.1.5. Pricing options ............................................................................................................................. 68
2.1.5.1. Binomial model ....................................................................................................................................... 68
2.2. PART 2 - HEDGING OF CURRENCY RISK ........................................................................................................... 75
2.2.1. Key concepts in foreign exchange markets ................................................................................. 75
2.2.2. Risk management of international operations............................................................................ 78
2.2.2.1. Hedging currency risk with forwards and futures ................................................................................... 79
2.2.2.2. Hedging currency risk with options......................................................................................................... 82
2.2.3. Your turn ..................................................................................................................................... 84
2.3. EXAMPLE QUESTIONS ................................................................................................................................. 87
2.3.1. Part 1 ........................................................................................................................................... 87
2.3.2. Part 2 ........................................................................................................................................... 88
3. PRICING OF FINANCIAL INSTRUMENTS AND PRINCIPLES OF OPTION PRICING....................................... 89
3.1. INTRODUCTION......................................................................................................................................... 89
3.2. INTUITIVE APPROACH TO PRICING PAYOFFS ..................................................................................................... 90
3.3. RISK NEUTRAL PRICING APPROACH TO PRICE PAYOFFS ....................................................................................... 90
3.4. REPLICATING PORTFOLIO APPROACH ............................................................................................................. 91
3.5. THEORETICAL ANALYSIS .............................................................................................................................. 93
3.6. RISK-NEUTRAL PRICING .............................................................................................................................. 94
3.7. IRRELEVANCE OF STOCK’S EXPECTED RETURN .................................................................................................. 96
1
, 3.8. SUMMARY ............................................................................................................................................... 96
4. FINANCIAL DATA ANALYTICS WITH R .................................................................................................... 97
4.1. DATACAMP TASK - LOGBOOK ....................................................................................................................... 97
4.2. FINANCIAL DATA ANALYSIS WITH R TASK – CATERPILLAR ................................................................................. 100
2
, 1. Behavioral finance
1.1. Introduction
- Two major questions
o How to model the decisions of yourself and the others?
o How to take advantage of the behavior of others
§ Gain profit out of the mistakes of others
- How to model the decisions of yourself and the others?
o When we make decisions, we will make mistakes
o How do people make financial decisions?
§ Making assumptions
§ Economic textbook
• Economies start by making assumptions
¨ People behave like ‘economic man’, very rational
¨ People notice all the relative aspects of the environment,
notices everyone and can make the most optimal decision
¨ Able to calculate the outcome of each possible decision and
then take the best on
¨ Based on the preferences of this person
§ Compare assumptions with reality
• Bounded rationality
¨ Risk of calculation mistakes
§ Even if you try to be rational, it cannot be rational
because of mistakes
¨
§ Information imperfection: not everyone has the
same amount of information
§ Cognitive limitation: limited by skills
§ Time constraint: decisions have to be made on the
spot
¨ à impossible to be fully rational and having optimal
decisions
¨ Computation skills
§ Does not make any cognitive mistakes
§ But people do make mistakes
§ Example: there are three cards in a hat
• 1 is red on both sides
• 1 is green on both sides
• 1 is red on one side and green on the other
• What is probability that you pick red?
• Take a long time to find the answer
3
