By Richard H. Thaler

This booklet deals a definitive and wide-ranging evaluate of advancements in behavioral finance during the last ten years. In 1993, the 1st quantity supplied the traditional connection with this new technique in finance--an technique that, as editor Richard Thaler positioned it, "entertains the chance that the various brokers within the economic climate behave below totally rationally the various time." a lot has replaced seeing that then. no longer least, the bursting of the net bubble and the next marketplace decline additional established that monetary markets usually fail to act as they might if buying and selling have been really ruled through the totally rational traders who populate monetary theories. Behavioral finance has made an indelible mark on parts from asset pricing to person investor habit to company finance, and maintains to work out intriguing empirical and theoretical advances.

Advances in Behavioral Finance, quantity II constitutes the fundamental new source within the box. It offers twenty fresh papers via best experts that illustrate the abiding energy of behavioral finance--of how particular departures from absolutely rational choice making by way of person industry brokers provides causes of another way difficult marketplace phenomena. As with the 1st quantity, it reaches past the area of finance to signify, powerfully, the significance of pursuing behavioral ways to different parts of monetary life.

The participants are Brad M. Barber, Nicholas Barberis, Shlomo Benartzi, John Y. Campbell, Emil M. Dabora, Daniel Kent, François Degeorge, Kenneth A. Froot, J. B. Heaton, David Hirshleifer, Harrison Hong, Ming Huang, Narasimhan Jegadeesh, Josef Lakonishok, Owen A. Lamont, Roni Michaely, Terrance Odean, Jayendu Patel, Tano Santos, Andrei Shleifer, Robert J. Shiller, Jeremy C. Stein, Avanidhar Subrahmanyam, Richard H. Thaler, Sheridan Titman, Robert W. Vishny, Kent L. Womack, and Richard Zeckhauser.

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7 For example, in a recent extension and test of the underinvestment hypothesis developed below, Malmendier and Tate (2001) use option exercise behavior and stock purchases to proxy for chief executive optimism. 6 MANAGERIAL OPTIMISM 677 no additional cost of external financing since by assumption there is no informational asymmetry and prices are efficient. Faced with a new project that requires investment of i where i > y1, the managers’ decision rule (see Assumption 2) is: invest if: do not invest if: EM(r) − i − CM(E) > 0 EM(r) − i − CM(E) ≤ 0 When ET(r) − i > 0, but EM(r) − i − CM(E) ≤ 0, the manager passes up a positive NPV project because he believes the cost of external financing is too high, despite the fact that he believes the project has a positive NPV (he must believe this since by Definition 1, EM(r) > ET(r)).

The result for risky debt is analogous. Any issue of risky debt is equivalent to a weighted average of risk-free debt and equity. The managers are indifferent between this weighted average (risky debt) and the individual components. Letting “w” denote the amount raised by risk-free debt, the cost of any combination of risk-free debt and equity is: w  K − w   K − w   EM (y2 ) − w  +    K  K   ET (y2 ) − w   K − w  w  K − w   EM (y2 ) − w  = +   >1 K  K   ET (y2 ) − w  for any w < K since EM(y2) > ET(y2).

I rule out “sidebets” on these events. Modeling managerial risk aversion in the model would alleviate this possibility, but add nothing to the intuition of the model. Put another way, I assume that the existence of optimism is not enough to create “money pump” opportunities against managers (for example, Rabin and Thaler 2001). At date t = 2, the firm’s operations are wrapped up and cash flows are distributed to security holders according to the rights of their particular security. The following set of securities may be issued by the firm (when feasible) MANAGERIAL OPTIMISM 673 in any combination: (1) risk-free debt, (2) risky debt, and (3) equity.

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