Merging New Paradigm In Finance Essay Example Pdf

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Academic finance has transformed significantly from the days where most academics and practitioners believed that markets were efficient. Traditionalists argue that the market prices assets at their fair value, assuming that all relevant information pertinent and relevant to an asset is known by all market participants-in reality however there is an information asymmetry. In addition to this financial and economic theory have assumed that all economic agents behave in a two way rational manner-the principles of expected utility theory and unbiased prediction of the future thus their decisions and actions must be rational as well. However, events in the last decade such as, the dotcom bubble and the crash of 2008, suggest that in reality markets do not behave as theory suggested but in fact other factors must be taken into account: i.e. human behavior. Traditional finance paradigms have yet to explain the behavior of markets during bubbles and times of uncertainty, even when there is no changes in the fundamentals of a stock the price may plummet or rise. The same principle is applicable to commodities and the foreign exchange market. Traditionally human psychology has not been an integral part of the study of finance despite the fact that financial markets are operated by humans. Behavioral finance is a field that studies the influence of investor psychology and the effect on the markets; it seeks to explain why markets are inefficient and the irrational behavior of investors in other words, if EHM were true then in theory premiums or discounts of financial instruments should not exist. However, in the reality such is not the case but the question really is why? Selden (1912) in his book Psychology of the Stock Market proposed that the movements of prices on financial markets are influenced in large part by the attitudes and behavior of the market participants. Also it is important to consider that as markets became more globalized the number of participants increased.

1.3 Justification

The study of behavioral finance represents an opportunity to revaluate our perceptions of financial theory and adds another dimension to the study of financial markets, a shift occurs from the traditional view of markets as being efficient, extremely analytical and normative into a more realistic view of what actually occurs. By adding the dimension of behavior it is then possible to identify certain patterns of individual and collective behavior that may affect the function of the markets, for example traditional finance has been unable to explain the bubbles in Taiwan, Japan and the United States. Behavioral finance provides a previously non existing bridge between psychology and finance. Both are social sciences but in finance, before behavioral finance, there was little importance placed on individual decision making processes and finance like its mother discipline economics treated decision making as a black box. Finance acknowledges the existence of mental models of choice but it is more concerned with prediction rather than description or explanation. In terms of research Olsen points the fact that financial researchers have almost always found it necessary to offer ex post behavioral explanations for numerical results indicates that behavior has always been important and worthy of study in the field of finance.(Olsen,

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