Behavior Finance

Assignment 1

1. It is harder to get a cab in bad weather because in rainy days the demand of taxis increase so this leads to higher income for the taxi drivers. Usually the taxi drivers have a daily target earning,  as they get more customers than usual on bad weather, they reach their target earnings earlier in the day and stop working. For example the taxi driver wants to earn $200 a day, usually it takes him 8 hours to earn this amount but on a rainy day, because of the high demand he gets $200 in 4 hours, so he stops working even though there is a high demand for it with no supply. This is an example of narrow framing mental accounting, where the taxi drivers are only thinking about today without taking into count how they can earn more in their total wealth by taking advantage of the high demand. Therefore as they reached their target, they are overlooking the opportunity to earn higher.

1. a) Prospect 1 and 2 is risk averse as the Expected utility is smaller than the Utility of the expected value. Prospect 3 is risk neutral as the Utility of the expected value is equal to the expected utility.

b) The certainty equivalent is when an individual agrees to take certain amount of money with guarantee rather than having risky probability of getting higher returns. For example a risk averse person would be indifference between taking $100 or 50% of $75 and 50% of $150.    

c) x0.5 = 38.1721

   x = 38.17212 = 1457.1092
 Therefore the certainty equivalent is $1457.1092. 

1. In prospect A, most individual would choose option i.“a sure gain of $240”, which is a risk averse choice. However, when the same individual has to choose in prospect B, they would choose option ii. “75% chance to lose $1000 and 25% chance to lose $0”, which is risk seeking option. This violates the expected utility theory because according to the excepted utility theory, an individual’s choice should be consistent when conformed with decisions, therefore if an individual is risk averse they should always choose risk averse options and vis-versa if they are risk-seeking. However in these prospects, most individual would change their risk attitude. This is because people do not behave rationally all the time, this is explained by the prospect theory’s value function, it says that individuals are risk averse when they have a gaining option and risk seekers when they have a losing options. In other words, people likes a confirm gain and are ready to gamble when they have to loose.  

1.  a)         The four‐fold pattern of risk attitudes are, most of the time (especially when probability is high), an individual is risk averse for gains and risk seeking for losses, but when the probability of loss is low than the individual becomes risk averse and when the probability of gain is low the individual become a risk seeker. The principal reason of this behavior is because individual overweight the probability of the “low probabilities”, therefore he thinks there is a higher chance of the event to occur than reality and underweight the probability of “high probability” therefore they thinks they is a less chance of the event to occur than reality.

          b) The fourfold pattern of risk attitudes explains perfectly how some individual buys lottery the same individual also buys car insurance. Which actually means the individual is risk seeking when he/she is buying the lottery (gain) as there is very little chance of him winning the lottery, but risk averse when he is buying insurance for his car, even though they might be very little chance of him using it (loss). This is actually the contrast of what the prospect theory’ value function states. This is mainly because, individuals tends to overweight low probability. Therefore, the individual thinks he has a higher probability to win the lottery than the actual probability, so he decide to take the risk. On the other hand even though there is very low chance that he might get into a car accident and need the insurance, he will overweight the probability of the accident and will prefer to be covered by insurance to be safe (risk adverse) and pay a fix amount (loss).