A Behavioral Approach to Asset Pricing (Academic Press Advanced Finance Series)
by Hersh Shefrin (Author)

Hardcover: 496 pages

Publisher: Academic Press; Har/Cdr edition (January 21, 2005)

Language: English

Review
"Students and researchers interested in this important and burgeoning field of finance should read [this book]."
- Financial Analysts Journal

"I highly recommend Shefrin's book to anyone who wants to probe into the implications of behavioral finance for asset pricing. Shefrin builds rigorous theoretical models that integrate investor heterogeneity and psychological biases into the traditional stochastic discount factor framework. The text contains a wealth of original ideas, and provides new modeling tools. The results are convincing and thought provoking. I believe Shefrin's book will help revolutionize our thinking about asset pricing and stimulate more work along its line."
-Bing Han, Assistant Professor of Finance, the Ohio State University

Book Description
A Behavioral Approach to Asset Pricing Theory examines the reigning assumptions of asset pricing theory and reconstructs them to incorporate findings from behavioral finance. It constructs a solid, intact structure that challenges classic assumptions and at the same time provides a strong theory and efficient empirical tools.

Building on the models developed by both traditional asset pricing theorists and behavioral asset pricing theorists, this book takes the discussion to the next step. The author provides a general behaviorally based intertemporal treatment of asset pricing theory that extends to the discussion of derivatives, fixed income securities, mean-variance efficient portfolios, and the market portfolio.

The book develops a series of examples to illustrate the theoretical results. The CD-ROM contains most of the examples, worked out as Excel spreadsheets, so that a diligent reader can follow them through.
Instructors might also want to use the examples to assign class exercises, asking students to modify the numbers and see what happens.

* The first book to focus completely on how behavioral finance principles affect asset pricing
* Hersh Shefrin is a recognized expert in behavioral finance
* Behavioral finance is a growth area in finance scholarship and moving more and more into practice

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Contents
Preface xvii
1 Introduction 1
1.1 Why Read This Book? . . . . . . . . . . . . . . . . . . . . 2
1.2 Organization: How the Ideas in This Book Tie Together . . 6
1.3 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
I Heuristics and Representativeness:
Experimental Evidence 13
2 Representativeness and Bayes Rule: Psychological
Perspective 15
2.1 Explaining Representativeness . . . . . . . . . . . . . . . . 16
2.2 Implications for Bayes Rule . . . . . . . . . . . . . . . . . . 16
2.3 Experiment . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.4 Representativeness and Prediction . . . . . . . . . . . . . . 19
2.4.5 How Regressive? . . . . . . . . . . . . . . . . . . . . 22
2.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3 Representativeness and Bayes Rule: Economics
Perspective 25
3.1 The Grether Experiment . . . . . . . . . . . . . . . . . . . 25
3.2 Representativeness . . . . . . . . . . . . . . . . . . . . . . 28
3.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
3.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
4 A Simple Asset Pricing Model Featuring
Representativeness 33
4.1 First Stage, Modified Experimental Structure . . . . . . . . 34
4.2 Expected Utility Model . . . . . . . . . . . . . . . . . . . . 34
4.3 Equilibrium Prices . . . . . . . . . . . . . . . . . . . . . . . 37
4.4 Representativeness . . . . . . . . . . . . . . . . . . . . . . 38
4.5 Second Stage: Signal-Based Market Structure . . . . . . . . 39
4.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5 Heterogeneous Judgments in Experiments 43
5.1 Grether Experiment . . . . . . . . . . . . . . . . . . . . . . 43
5.2 Heterogeneity in Predictions of GPA . . . . . . . . . . . . . 44
Contents vii
5.3 The De Bondt Experiment . . . . . . . . . . . . . . . . . . 46
5.4 Why Some Bet on Trends and Others Commit
Gambler’s Fallacy . . . . . . . . . . . . . . . . . . . . . . . 55
5.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
II Heuristics and Representativeness: Investor
Expectations 59
6 Representativeness and Heterogeneous Beliefs Among
Individual Investors, Financial Executives, and
Academics 61
6.1 Individual Investors . . . . . . . . . . . . . . . . . . . . . . 61
6.2 The Expectations of Academic Economists . . . . . . . . . 69
6.3 Financial Executives . . . . . . . . . . . . . . . . . . . . . 73
6.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
7 Representativeness and Heterogeneity in the Judgments
of Professional Investors 75
7.1 Contrasting Predictions: How Valid? . . . . . . . . . . . . . 75
7.2 Update to Livingston Survey . . . . . . . . . . . . . . . . . 76
7.3 Individual Forecasting Records . . . . . . . . . . . . . . . . 80
7.4 Gambler’s Fallacy . . . . . . . . . . . . . . . . . . . . . . . 88
7.5 Why Heterogeneity Is Time Varying . . . . . . . . . . . . . 93
7.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
III Developing Behavioral Asset Pricing Models 97
8 A Simple Asset Pricing Model with Heterogeneous
Beliefs 99
8.1 A Simple Model with Two Investors . . . . . . . . . . . . . 99
8.2 Equilibrium Prices . . . . . . . . . . . . . . . . . . . . . . . 102
8.3 Fixed Optimism and Pessimism . . . . . . . . . . . . . . . 104
8.3.1 Impact of Heterogeneity . . . . . . . . . . . . . . . . 107
8.4 Incorporating Representativeness . . . . . . . . . . . . . . . 107
8.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
9 Heterogeneous Beliefs and Inefficient Markets 111
9.1 Defining Market Efficiency . . . . . . . . . . . . . . . . . . 111
9.2 Market Efficiency and Logarithmic Utility . . . . . . . . . . 115
9.2.1 Example of Market Inefficiency . . . . . . . . . . . . 115
9.3 Equilibrium Prices as Aggregators . . . . . . . . . . . . . . 116
9.4 Market Efficiency: Necessary and Sufficient Condition . . . 117
9.5 Interpreting the Efficiency Condition . . . . . . . . . . . . . 119
9.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
10 A Simple Market Model of Prices and Trading Volume 123
10.2 Analysis of Returns . . . . . . . . . . . . . . . . . . . . . . 126
10.3 Analysis of Trading Volume . . . . . . . . . . . . . . . . . . 127
10.4 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Asymmetric Volatility . . . . . . . . . . . . . . . . . 137
10.5 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
10.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
11 Efficiency and Entropy: Long-Run Dynamics 141
11.2 Entropy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
11.3 Numerical Illustration . . . . . . . . . . . . . . . . . . . . . 148
11.4 Markov Beliefs . . . . . . . . . . . . . . . . . . . . . . . . . 149
11.5 Heterogeneous Time Preference, Entropy, and Efficiency . . 150
11.6 Entropy and Market Efficiency . . . . . . . . . . . . . . . . 154
11.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
IV Heterogeneity in Risk Tolerance and
Time Discounting 159
12 CRRA and CARA Utility Functions 161
12.1 Arrow–Pratt Measure . . . . . . . . . . . . . . . . . . . . . 161
12.2 Proportional Risk . . . . . . . . . . . . . . . . . . . . . . . 162
12.3 Constant Relative Risk Aversion . . . . . . . . . . . . . . . 162
12.4 Logarithmic Utility . . . . . . . . . . . . . . . . . . . . . . 164
12.5 CRRA Demand Function . . . . . . . . . . . . . . . . . . . 165
12.6 Representative Investor . . . . . . . . . . . . . . . . . . . . 166
12.7 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
12.8 CARA Utility . . . . . . . . . . . . . . . . . . . . . . . . . 170
12.9 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
13 Heterogeneous Risk Tolerance and Time Preference 175
13.1 Survey Evidence . . . . . . . . . . . . . . . . . . . . . . . . 175
13.2 Extended Survey . . . . . . . . . . . . . . . . . . . . . . . 179
13.3 Time Preference . . . . . . . . . . . . . . . . . . . . . . . . 182
13.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
14 Representative Investors in a Heterogeneous
CRRA Model 185
14.1 Relationship to Representative Investor Literature . . . . . 186
14.2 Modeling Preliminaries . . . . . . . . . . . . . . . . . . . . 189
14.3 Efficient Prices . . . . . . . . . . . . . . . . . . . . . . . . . 190
14.4 Representative Investor Characterization Theorem . . . . . 191
14.5 Comparison Example . . . . . . . . . . . . . . . . . . . . . 195
14.6 Pitfall: The Representative Investor Theorem Is False . . . 198
14.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
V Sentiment and Behavioral SDF 201
15 Sentiment 203
15.1 Intuition: Kahneman’s Perspective . . . . . . . . . . . . . . 203
15.2 Sentiment . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
15.3 Example Featuring Heterogeneous Risk Tolerance . . . . . . 207
15.4 Example Featuring Log-Utility . . . . . . . . . . . . . . . . 209
15.5 Sentiment as a Stochastic Process . . . . . . . . . . . . . . 218
15.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
16 Behavioral SDF and the Sentiment Premium 221
16.1 The SDF . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
16.2 Sentiment and the SDF . . . . . . . . . . . . . . . . . . . . 223
16.3 Pitfalls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
16.4 Sentiment and Expected Returns . . . . . . . . . . . . . . . 230
16.4.1 Interpretation and Discussion . . . . . . . . . . . . . 232
16.4.2 Example Illustrating Theorem 16.2 . . . . . . . . . . 233
16.5 Entropy and Long-Run Efficiency . . . . . . . . . . . . . . 234
16.5.1 Formal Argument . . . . . . . . . . . . . . . . . . . 235
16.6 Learning: Bayesian and Non-Bayesian . . . . . . . . . . . . 236
16.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
VI Applications of Behavioral SDF 239
17 Behavioral Betas and Mean-Variance Portfolios 241
17.1 Mean-Variance Efficiency and Market Efficiency . . . . . . 241
17.2 Characterizing Mean-variance Efficient Portfolios . . . . . . 242
17.3 The Shape of Mean-Variance Returns . . . . . . . . . . . . 244
17.4 The Market Portfolio . . . . . . . . . . . . . . . . . . . . . 247
17.5 Behavioral Beta: Decomposition Result . . . . . . . . . . . 249
17.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
18 Cross-section of Return Expectations 255
18.1 Literature Review . . . . . . . . . . . . . . . . . . . . . . . 256
18.2 Factor Models and Risk . . . . . . . . . . . . . . . . . . . . 261
18.3 Differentiating Fundamental Risk and Investor Error . . . . 262
18.4 Implications for the Broad Debate . . . . . . . . . . . . . . 267
18.5 Analysts’ Return Expectations . . . . . . . . . . . . . . . . 268
18.6 How Consciously Aware Are Investors When Forming
Judgments? . . . . . . . . . . . . . . . . . . . . . . . . . . 269
18.7 How Reliable Is the Evidence on Expected Returns? . . . . 270
18.8 Alternative Theories . . . . . . . . . . . . . . . . . . . . . . 272
18.9 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
19 Testing for a Sentiment Premium 279
19.1 Diether–Malloy–Scherbina: Returns Are Negatively
Related to Dispersion . . . . . . . . . . . . . . . . . . . . . 280
19.2 Ghysels–Juergens: Dispersion Factor . . . . . . . . . . . . . 282
19.3 Estimating a Structural SDF-Based Model . . . . . . . . . 286
19.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
20 A Behavioral Approach to the Term Structure
of Interest Rates 289
20.1 The Term Structure of Interest Rates . . . . . . . . . . . . 289
20.2 Pitfall: The Bond Pricing Equation in Theorem 20.1
Is False . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
20.3 Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
20.3.1 Heterogeneous Risk Tolerance . . . . . . . . . . . . 295
20.4 Expectations Hypothesis . . . . . . . . . . . . . . . . . . . 296
20.4.1 Example . . . . . . . . . . . . . . . . . . . . . . . . 298
20.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
21 Behavioral Black–Scholes 301
21.1 Call and Put Options . . . . . . . . . . . . . . . . . . . . . 301
21.2 Risk-Neutral Densities and Option Pricing . . . . . . . . . 302
21.3 Option Pricing Examples . . . . . . . . . . . . . . . . . . . 305
21.4 Smile Patterns . . . . . . . . . . . . . . . . . . . . . . . . . 311
21.5 Heterogeneous Risk Tolerance . . . . . . . . . . . . . . . . 316
21.6 Pitfall: Equation (21.12) Is False . . . . . . . . . . . . . . . 317
21.6.1 Locating the Flaw . . . . . . . . . . . . . . . . . . . 318
21.7 Pitfall: Beliefs Do Not Matter in Black–Scholes . . . . . . . 318
21.8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
22 Irrational Exuberance and Option Smiles 321
22.1 Irrational Exuberance: Brief History . . . . . . . . . . . . . 322
22.1.1 Sentiment . . . . . . . . . . . . . . . . . . . . . . . 324
22.2 Risk-Neutral Densities and Index Option Prices . . . . . . . 326
22.2.1 Butterfly Position Technique . . . . . . . . . . . . . 328
22.3 Continuation, Reversal, and Option Prices . . . . . . . . . . 330
22.4 Price Pressure: Was Arbitrage Fully Carried Out? . . . . . 335
22.5 Heterogeneous Beliefs . . . . . . . . . . . . . . . . . . . . . 337
22.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
23 Empirical Evidence in Support of Behavioral SDF 339
23.1 Bollen–Whaley: Price Pressure Drives Smiles . . . . . . . . 340
23.2 Han: Smile Effects, Sentiment, and Gambler’s Fallacy . . . 344
23.3 David–Veronesi: Gambler’s Fallacy and
Negative Skewness . . . . . . . . . . . . . . . . . . . . . . . 346
23.4 Jackwerth: Estimating Market Risk Aversion . . . . . . . . 348
23.4.1 Behavioral Risk Neutral Density . . . . . . . . . . . 348
23.5 Rosenberg–Engle: Signature of Sentiment in the SDF . . . . 350
23.6 Comparing the Behavioral SDF and Empirical SDF . . . . 352
23.7 Heterogeneous Perspectives . . . . . . . . . . . . . . . . . . 359
23.8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
VII Prospect Theory 363
24 Prospect Theory: Introduction 365
24.1 Experimental Evidence . . . . . . . . . . . . . . . . . . . . 366
24.1.1 Common Ratio Effect . . . . . . . . . . . . . . . . . 366
24.2 Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374
24.2.1 The Weighting Function . . . . . . . . . . . . . . . 374
24.2.2 Value Function . . . . . . . . . . . . . . . . . . . . . 376
24.2.3 Interaction Between Value Function and
Weighting Function . . . . . . . . . . . . . . . . . . 377
24.2.4 Framing . . . . . . . . . . . . . . . . . . . . . . . . 378
24.3 Subtle Aspects Associated with Risk Aversion . . . . . . . 379
24.4 Generalized Utility Theories . . . . . . . . . . . . . . . . . 381
24.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
25 Behavioral Portfolios 383
25.1 Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384
25.1.1 Prospect Theory: Uncertainty Weights . . . . . . . . 384
25.1.2 Utility Function . . . . . . . . . . . . . . . . . . . . 384
25.1.3 Prospect Theory Functional . . . . . . . . . . . . . 385
25.2 Prospect Theory: Indifference Map . . . . . . . . . . . . . . 385
25.3 Portfolio Choice: Single Mental Account . . . . . . . . . . . 386
25.4 Multiple Mental Accounts: Example . . . . . . . . . . . . . 389
25.5 SP/A Theory . . . . . . . . . . . . . . . . . . . . . . . . . . 392
25.6 Real World Portfolios and Securities . . . . . . . . . . . . . 398
25.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
26 Prospect Theory Equilibrium 401
26.1 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 402
26.2 Simple Example . . . . . . . . . . . . . . . . . . . . . . . . 403
26.3 On the Boundary . . . . . . . . . . . . . . . . . . . . . . . 407
26.4 Equilibrium Pricing . . . . . . . . . . . . . . . . . . . . . . 408
26.5 Portfolio Insurance . . . . . . . . . . . . . . . . . . . . . . 410
26.6 Risk and Return: Portfolio Insurance
in a Mean-Variance Example . . . . . . . . . . . . . . . . . 413
26.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417
27 Pricing and Prospect Theory: Empirical Studies 419
27.1 Combining Behavioral Preferences and Beliefs . . . . . . . . 419
27.2 Disposition Effect: The Empirical Evidence . . . . . . . . . 420
27.3 Investor Beliefs . . . . . . . . . . . . . . . . . . . . . . . . 422
27.4 Momentum and the Disposition Effect . . . . . . . . . . . . 426
27.4.1 Theoretical Hypotheses . . . . . . . . . . . . . . . . 426
27.4.2 Empirical Evidence . . . . . . . . . . . . . . . . . . 427
27.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 428
28 Reflections on the Equity Premium Puzzle 429
28.1 Basis for Puzzles in Traditional Framework . . . . . . . . . 429
28.2 Erroneous Beliefs . . . . . . . . . . . . . . . . . . . . . . . 433
28.3 Alternative Rationality-Based Models . . . . . . . . . . . . 437
28.4 Behavioral Preferences and the Equity Premium . . . . . . 440
28.4.1 Myopic Loss Aversion . . . . . . . . . . . . . . . . . 440
28.5 Risks, Small and Large . . . . . . . . . . . . . . . . . . . . 444
28.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
VIII Closure 447
29 Conclusion 449
29.1 Recapitulating the Main Points . . . . . . . . . . . . . . . . 449
29.2 Testable Predictions . . . . . . . . . . . . . . . . . . . . . . 452
29.3 Future Directions . . . . . . . . . . . . . . . . . . . . . . . 453
References 457
Index 473

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