Professional Documents
Culture Documents
Financial Psychology - Complete
Financial Psychology - Complete
STUDY MATERIAL
Semester – III
B.Com
Edition: 2023
#44/4, District Fund Road, Behind Big Bazaar, Jayanagar 9th Block, Bengaluru,
Karnataka 560069
SYLLABUS
Course: B.Com Semester: III
No. of Hours: 45 Hours Credits: 03
Course Objectives:
➢ The course outlines the evolution of Financial Psychology
➢ Helps understand the role of human psychology in financial services.
➢ Understand the concept of the Efficient Markets Hypothesis
➢ It illustrates the key theories involved in Financial Psychology.
Course Outcomes:
SYLLABUS ...............................................................................................................................ii
CONTENTS .............................................................................................................................. iv
Structure
Learning Objectives
All the financial theories that we generally come across in finance depict an idealistic world. It
assumes that all investors have perfect information, i.e., they obtain information at about the
same time. It also assumes that they have the mental faculties required to process this
information in a rational and unbiased manner. However, we all know that this is not how the
world works in reality. Neither do all market participants have access to perfect information,
nor can they rationally process all the information and make informed decisions.
The fact of the matter is that the decisions made by investors in the stock market are based
on emotional factors. There are a wide variety of psychological processes as well as biases at
play that influence how the decision finally gets made.
Financial Psychology is a new emerging science that studies the irrational behaviour of
investors. It holds out the prospect of a better understanding of financial market behaviour and
scope for investors to make better investment decisions based on an understanding of the
potential pitfalls. Advisers can learn to understand their own biases also and act as behavioural
coach to clients in helping them deal with their own biases.
Definition:
“Financial Psychology is the area of finance dealing with the implications of investor reasoning
errors on investment decisions and market prices.”
“Sewell defines Financial Psychology as the study of the influence of psychology on the
behavior of financial practitioners and the subsequent effect on markets Financial Psychology
is of interest because it helps explain why and how markets might be inefficient.”
Financial psychology is just not a part of finance. It is something which is much broader and
wider and includes insights from behavioural economics, psychology and microeconomic
theory.
1. Micro Financial Psychology: This branch deals with the behaviour of individual
investors. In Micro Financial Psychology we compare irrational investors to rational
investors, as observed in the rational/classical economic theory. These rational
investors are also known as “homo economicus” or the rational economic man.
2. Macro Financial Psychology: Unlike Micro Financial Psychology, which deals with
For Private Circulation only ~3~
the behaviour of individuals, Macro Financial Psychology deals with the drawbacks of
the efficient market hypothesis. The efficient market hypothesis is one of the models in
conventional finance that helps us understand the trend of financial markets.
The scope of Financial Psychology can be visualized by examining its role in investment
decision-making if individuals as well as corporate. The scope areas of Financial Psychology
are discussed as follows:
1. To understand the reasons for market anomalies: Though standard finance
theories can justify the stock market to a great extent, still many market anomalies
take place in stock markets, including the creation of bubbles, the effect of any event,
the calendar effect on the stock market trade etc. These market anomalies remain
unanswered in standard finance but Financial Psychology provides explanations and
remedial actions to various market anomalies.
2. To identify an investor’s personality: An exhaustive study of Financial Psychology
helps in identifying the different types of investor personality. Once the biases of the
investor’s actions are identified, by the study of the investor’s personality, various
new financial instruments can be developed to hedge the unwanted biases created in
the financial markets.
3. To enhance the skill set of investment advisors: This can be done by providing a
better understanding of the investor’s goals, maintaining a systematic approach to
advice, earning the expected return and maintaining a win-win situation for both the
client and the advisor.
4. Helps to identify the risks and develop hedging strategies: Because of various
anomalies in the stock markets, investments these days are not only exposed to the
identified risks but also to the uncertainty of the returns which can be explained using
Financial Psychology concepts thus finding ways to hedge such risks arising out of
such uncertainties.
5. Financial Psychology explains various corporate activities: Financial psychology
explains the psychological factors that influence corporate decision-making and
behaviour. It helps understand investor biases, risk perception, consumer behaviour,
and employee motivation. Psychological insights can inform corporate governance
For Private Circulation only ~4~
practices and optimize financial outcomes.
6. Financial Decision-Making: Financial psychology examines the cognitive and
emotional processes that influence how individuals make financial decisions. It
investigates the factors that affect risk tolerance, investment choices, budgeting, and
spending habits.
7. Money Beliefs and Attitudes: Financial psychology explores the beliefs, attitudes,
and values that people hold about money. It examines how these beliefs and attitudes
shape financial behaviours and impact financial well-being.
8. Financial Stress and Anxiety: Financial psychology acknowledges the emotional
aspects of money management. It explores the impact of financial stress, anxiety, and
other psychological factors on financial decision-making and overall well-being.
9. Financial Education and Literacy: Financial psychology recognizes the importance
of financial education and literacy in improving financial well-being. It investigates
the most effective ways to educate individuals about financial concepts and
behaviours, taking into account psychological factors that can enhance or hinder
learning.
10. Consumer Behaviour: Financial psychology examines consumer behaviour and how
it relates to financial choices. It investigates the psychological factors that influence
purchasing decisions, such as the influence of advertising, social norms, and cognitive
biases.
11. Behavioural Economics: Financial psychology aligns with behavioural economics,
which combines principles of economics and psychology to understand how
individuals make economic decisions. It explores the role of cognitive biases,
heuristics, and irrational behaviour in economic choices.
12. Financial Therapy: Financial psychology encompasses the practice of financial
therapy, which integrates therapeutic techniques with financial counselling. It
addresses the emotional and psychological aspects of financial difficulties, helping
individuals overcome financial challenges and improve their financial well-being.
13. Wealth and Happiness: Financial psychology investigates the relationship between
wealth and happiness. It explores how financial factors, such as income, material
possessions, and financial goals, influence subjective well-being and overall life
satisfaction.
Financial psychology explores how an investor’s portfolio performs and gets affected because
of the decisions that are directly linked to or influenced by emotions. Hence, understanding the
Financial psychology and psychological traps may help an investor avoid a bad and influenced
decision.
Understanding the investor’s psychology becomes all the more relevant when discussing
investment decisions. Framing of information and risk perception are the most common factors
that affect the investor’s psychology and behaviour. The psychological studies conducted have
shown the possible outcomes related to the importance of psychology in investment decisions.
Analysts are working on associating and combining these factors with more personal
mediators; such as heuristics and emotional biases to further understand an investor’s
psychology. These are unavoidable psychological and emotional factors that influence the
investment decision process. The investor’s mood and personal sentiments must also be
considered an important regulator while making an investment decision. Analysts believe a
better understanding of these factors will result in a better appreciation of the investors, and
this will potentially help them make a better investment decision. The following points will
help us understand the importance of Financial Psychology.
1.6 Objectives
1.7 History
Behavioural finance has informal origins dating back to Selden's 1912 Psychology of the Stock
Market, as well as Fessinger's 1956 study of cognitive dissonance and Pratt's 1964 discussion
Kahneman and Tversky were shortly thereafter joined by a third so-called founding father,
Richard Thaler. In 1980, Thaler published a paper about investors' propensity towards mental
accounting, a phenomenon wherein they tended to view their money as being in separate and
disparate pools depending on function (retirement fund, vs. emergency fund vs. college fund,
etc.). Together, Thaler, Kahneman, and Tversky began a robust body of literature on how
people make financial decisions, using psychology to bridge the gap between real life and
classic economic theory.
The work of the three "founding fathers" is frequently referred to as the "biases literature," the
study of all the behavioural biases
Other researchers have since attempted to explain additional anomalies found in the markets,
providing counter-evidence to the notion of market efficiency. Such areas of study include the
equity risk premium (Benartzi and Thaler, 1995; Asness, 2000), the abnormally high first-day
returns of IPOs (Loughran and Ritter, 2002), the limits of arbitrage (Barberis and Thaler, 2003),
and situations under which informational efficiency is maximized (Grossman and Stiglitz,
1980; Shiller, 1981). Additional research focuses on recreating bubbles and mispricing in a
laboratory setting (Smith, Suchanek, and Williams, 1988). In a way, these works on market
anomalies serve as the macroeconomic foil to the microeconomic study of investor biases and
individual decision-making processes.
1. Personal Finance and Investing: Financial Psychology can help individuals recognize
1.10 Psychology
Psychology is the scientific study of the mind and behaviour. Psychologists are actively
involved in studying and understanding mental processes, brain functions, and behaviour.
Psychology is defined formally as a science that studies mental processes, experiences and
behaviours in different contexts.
The word, “psychology” is derived from two Greek words, “psyche” and “logos”. Psyche
means “soul” and logos means “science”. Thus, psychology was first defined as the “science
of the soul”.
Psychology is concerned with all aspects of behaviour and with the thoughts, feelings, and
motivations underlying that behaviour. It keeps its importance both as an academic discipline
and a vital professional practice.
➢ Market Psychology refers to the patterns and movements that occur within a market,
stemming from the emotional state of the participants or investors. In other words,
market psychology is the idea that market movements are influenced and also reflect
investors' emotional states.
➢ Thus, market psychology is not necessarily the dominance of a single sentiment but
rather a response to the aggregated or average market sentiment.
➢ Bullish market runs are the result of positive sentiment, while a bear run is linked to
negative investor emotions. With bullish runs, the upward trend results in increased
demand, reducing supply and driving prices high.
➢ Rather, market psychology knowledge can help investors identify the point in a bearish
market run where the time is right for early investment in potentially rewarding assets.
➢ It is thus important to understand how emotions affect traders, often turning the most
logical thinkers into irrational investors. The market is always changing, and external
events often affect the market outlook. How investors deal with it will strongly continue
to be a matter of sentiment, no matter what.
Investor psychology is the study of the emotional and cognitive factors that influence the
decision-making process of investors. It refers to the mental and emotional factors that
influence an investor's decision-making process when it comes to buying, holding, or selling
investments.
Let’s look at some known emotional traits and behaviours that directly affect investor’s choices
and provide a picture of how emotion may intervene in investing:
1. Fear of Regret theory: It states that people anticipate regret if they make the wrong
choice, and they consider this anticipation when making decisions. Fear of regret can
play a significant role in dissuading someone from taking action or motivating a person
to take action. Regret theory can impact an investor's rational behaviour, impairing their
ability to make investment decisions that would benefit them as opposed to harming
them.
2. Mental Accounting Behaviours: They place their money into separate parts on a
variety of subjective criteria, like the source of money, and intent of each account,
which has an often irrational and detrimental effect on their consumption decision and
other behaviours. This is also observable in people investing in the stock market. They
3. Prospect theory and loss aversion: People feel more strongly about the pain from loss
than the pleasure from equal gain. Given a choice of equal probability, individuals
would choose to preserve their existing wealth, rather than risk the chance to increase
wealth.
4. Over and Under-Reacting: Investors get optimistic when the market goes up,
assuming it will continue to do so. Conversely, investors become extremely pessimistic
during downturns. A consequence of anchoring, or placing too much importance on
recent events while ignoring historical data, is an over- or under-reaction to market
events, which results in prices falling too much on bad news and rising too much on
good news. At the peak of optimism, investor greed moves stocks beyond their intrinsic
values.
5. Anchoring Trap: First, there is the so-called anchoring trap, which refers to an over-
reliance on what one originally thinks. For instance, if you think of a certain company
as successful, you may be too confident that its stocks are a good bet. This
preconception may be incorrect in the prevailing situation or at some point in the future.
To avoid this trap, you need to remain flexible in your thinking and open to new sources
of information, while understanding the reality that any company can be here today and
gone tomorrow. Any manager can disappear too, for that matter.
2. Boom and Bust Cycles: Boom and bust cycles are very prominent in financial markets.
Howard Raffia provided an approach to strategize against market uncertainty while decision-
making in 1968. The strategy proposed by him can be divided into three approaches as follows:
➢ Normative analysis: Normative analysis refers to the process of making
recommendations about what action should be taken or taking a particular
viewpoint on a topic. What should be the ideal outcome of a decision that has been
made?
➢ Descriptive analysis: Descriptive analytics is the process of using current and
historical data to identify trends and relationships. It’s sometimes called the
simplest form of data analysis because it describes trends and relationships but
doesn’t dig deeper. Which factors should be considered?
➢ Prescriptive analysis: Application of practical tools to minimize the gap between
expected and actual outcomes Prescriptive analytics is the use of advanced
processes and tools to analyze data and content to recommend the optimal course
of action or strategy moving forward. Simply put, it seeks to answer the question,
“What should we do?”
1.17 Summary
Web Links:
➢ What Is Financial Psychology? URL: https://www.morningstar.com/financial-
advice/what-is-financial-psychology
➢ Behavioral Finance: Biases, Emotions and Financial Behaviour. URL:
https://www.investopedia.com/terms/b/behavioralfinance.asp
➢ Difference Between Financial Psychology and Behavioral Finance? URL:
https://datapoints.com/2021/11/18/financial-psychology-behavioral-finance/
Structure
Learning Objectives
Expected utility theory explains how rational individuals make choices when faced with
uncertainty. It was developed by economists and mathematicians to understand and predict
human behaviour in situations where the outcomes and probabilities of different choices are
not known with certainty.
At the core of expected utility theory is the concept of utility, which represents an individual's
subjective preference or value assigned to different outcomes. Utility is a way to quantify the
desirability or satisfaction that a person derives from various outcomes. The theory assumes
that individuals make decisions to maximize their expected utility, which is the weighted
For Private Circulation only ~ 18 ~
average of the utilities of all possible outcomes, taking into account their associated
probabilities.
Based on these components, the decision-maker evaluates the expected utility of each
alternative by multiplying the utility of each outcome by its probability and summing them up.
The alternative with the highest expected utility is considered the rational choice.
Expected utility theory also incorporates the concept of risk aversion. It assumes that
individuals generally prefer certainty over uncertainty and are risk-averse when making
decisions under uncertainty. This means that individuals may be willing to accept a lower
expected utility in exchange for a more certain outcome. This theory advises selecting an event
or action with maximum expected utility. The decision to select an action will depend on an
entity’s risk appetite. This concept also helps in explaining the reason for individuals taking
According to him, determining when individuals must leave for the airport to catch their flight
involves an exchange or a trade-off. The earlier one shows up at the airport, the more likely the
person is to catch a flight. However, if individuals show up early, they have to bear the cost of
the time lost at the airport waiting for their flight. After all, one can utilize that time elsewhere
for something productive.
The concept of utility helps in quantifying this. For example, suppose every hour at an airport
cost 5 utils (unit of utility). On the other hand, let us say that the cost of missing a flight is 25
utils. So, simply put, missing a flight is 5 times more annoying to an individual than the total
inconvenience of spending one hour at an airport. This allows one to determine the expected
utility loss based on when one arrives at the airport.
However, the expected utility theory has been subject to criticism and limitations. One of the
main criticisms is that individuals often deviate from the assumptions of rationality, such as
having consistent preferences or accurately assessing probabilities. Prospect theory, developed
by Daniel Kahneman and Amos Tversky, is an alternative framework that seeks to explain
decision-making behaviour under uncertainty by considering how individuals perceive and
evaluate potential gains and losses.
Financial Psychology is a field of study that combines elements of psychology and economics
to understand how individuals make financial decisions. It explores how cognitive biases and
emotional factors influence decision-making, particularly in situations involving risk and
uncertainty.
When it comes to decision-making under risk, individuals are aware of the probabilities
associated with different outcomes. However, Financial Psychology suggests that people do
Here are some key concepts in Financial Psychology related to decision-making under risk and
uncertainty:
2. Cognitive Biases: Behavioural finance identifies various cognitive biases that can
impact decision-making under risk and uncertainty. These biases are systematic errors
in thinking that can lead to irrational or suboptimal decisions. Examples include:
a. Loss aversion: Loss aversion is a cognitive bias that describes why, for
individuals, the pain of losing is psychologically twice as powerful as the
pleasure of gaining. The loss felt from money, or any other valuable object can
feel worse than gaining that same thing. Loss aversion refers to an individual’s
tendency to prefer avoiding losses to acquiring equivalent gains. Simply put,
it’s better not to lose $20 than to find $20.
b. Overconfidence: The tendency to overestimate one's abilities or the accuracy
of one's judgments.
c. Anchoring and adjustment: The tendency to rely heavily on the first piece of
information encountered (the anchor) and insufficiently adjust from it when
making decisions.
d. Availability bias: The tendency to give greater weight to information that is
easily retrievable from memory, leading to overestimating the likelihood of
such events occurring.
e. Framing effect: The way information is presented or framed can influence
decision-making. People may make different choices depending on whether a
For Private Circulation only ~ 21 ~
situation is presented as a potential gain or a potential loss.
3. Herding and Social Influence: People are often influenced by the behaviour and
decisions of others, particularly in uncertain situations. Herding refers to the tendency
to follow the actions and decisions of a larger group, even if it goes against one's
judgment. This behaviour can lead to market bubbles or crashes when individuals
collectively make suboptimal decisions based on social influence rather than
independent analysis.
4. Regret aversion: Individuals often try to avoid feelings of regret that may arise from
making a wrong decision. This can lead to decision paralysis or a tendency to stick with
the status quo, even when it is not the best option.
Financial Psychology highlights that individuals' decision-making processes are complex and
can be influenced by psychological factors that deviate from the assumptions of rationality in
traditional economic models. By understanding these biases and behaviours, Financial
Psychology provides insights into how individuals make financial decisions under risk and
uncertainty and offers alternative models to explain observed behaviour in financial markets.
Expected utility theory provides a rational framework for decision-making under uncertainty
based on the concept of expected utility. According to expected utility theory, individuals make
decisions by considering the expected value and the subjective utility associated with different
outcomes.
The key steps in decision-making using expected utility theory are as follows:
1. Identify decision alternatives: Determine the available choices or actions that can be
taken in a given situation.
2. Assess outcomes: Identify the potential outcomes or consequences associated with
each decision alternative. These outcomes can be positive (gains, benefits) or negative
(losses, costs).
However, it is important to note that expected utility theory relies on several assumptions,
including rationality, consistent preferences, and accurate assessments of probabilities and
utilities. In practice, individuals may deviate from these assumptions due to cognitive biases,
emotional factors, or limited information. Financial Psychology has emerged as a field that
explores these deviations from rational decision-making and offers alternative models to
explain observed behaviour in real-world settings.
Several decision-making theories are based on the concept of expected utility. Here are some
prominent theories that build upon the expected utility framework:
4. Regret Theory: Regret theory focuses on the emotional impact of regret on decision-
making. It suggests that individuals anticipate regret associated with the outcomes of
their choices and incorporate this anticipation into their decision-making process.
Regret theory emphasizes the idea of "anticipated regret" as a factor that influences
choices and preferences.
These theories extend and modify the basic principles of expected utility theory to capture
various behavioural and psychological factors that influence decision-making under
uncertainty. They provide alternative explanations for observed decision patterns and
deviations from traditional economic models.
Investor rationality and market efficiency are concepts frequently discussed in finance and
investment theory. Let's examine each concept individually:
Under the assumption of investor rationality, investors would act under the principles
of expected utility theory. They would incorporate all relevant information, consider
the probabilities and payoffs associated with various investment outcomes, and select
investments that offer the highest expected returns given their risk tolerance.
However, it is important to note that in practice, investors may deviate from perfect
rationality due to cognitive biases, emotional factors, or limited information. Financial
2. Market Efficiency: Market efficiency refers to the degree to which market prices
reflect all available information. In an efficient market, prices are assumed to accurately
reflect the fundamental value of securities, and it is difficult for investors to consistently
outperform the market based on publicly available information.
However, the degree of market efficiency is a subject of ongoing debate. Critics argue
that markets may not be perfectly efficient due to factors such as market frictions,
information asymmetry, or the presence of irrational investors. Financial Psychology
also highlights the impact of psychological biases on market efficiency.
2.8 Summary
➢ Expected Utility Theory (EUT) estimates the likely utility of an action – when there is
uncertainty about the outcome. It suggests the rational choice is to choose an action
with the highest expected utility.
➢ Expected utility theory provides a rational framework for decision-making under
uncertainty based on the concept of expected utility. According to expected utility
theory, individuals make decisions by considering the expected value and the subjective
utility associated with different outcomes.
➢ According to prospect theory, given a choice of equal probability, individuals would
choose to preserve their existing wealth, rather than risk the chance to increase wealth.
This means that people often place greater importance on avoiding losses than on
maximizing gains
➢ Cumulative prospect theory incorporates the notion of diminishing sensitivity to gains
and losses, as well as probability weighting, which reflects the tendency of individuals
to overweight or underweight probabilities compared to their objective values.
➢ Regret theory focuses on the emotional impact of regret on decision-making. It suggests
that individuals anticipate regret associated with the outcomes of their choices and
incorporate this anticipation into their decision-making process.
Web Links:
Structure
Learning Objectives
The efficient market hypothesis (EMH) maintains that all stocks are perfectly priced according
to their inherent investment properties, the knowledge of which all market participants possess
equally. The theory assumes it would be impossible to outperform the market and that all
investors interpret available information the same way.
The efficient market hypothesis (EMH) maintains that all stocks are perfectly priced according
to their inherent investment properties, the knowledge of which all market participants possess
equally.
Market efficiency refers to how well prices reflect all available information. The efficient
markets hypothesis (EMH) argues that markets are efficient, leaving no room to make excess
profits by investing since everything is already fairly and accurately priced. This implies that
there is little hope of beating the market, although you can match market returns through
passive index investing.
The validity of the EMH has been questioned on both theoretical and empirical grounds. There
are investors who have beaten the market, such as Warren Buffett, whose investment strategy
focused on undervalued stocks made billions and set an example for numerous followers. There
are portfolio managers who have better track records than others, and there are investment
houses with more renowned research analysis than others.
➢ Strong efficiency - Accepting the EMH in its purest (strong) form may be difficult as
it states that all information in a market, whether public or private, is accounted for in
a stock's price. However, modifications of EMH exist to reflect the degree to which it
can be applied to markets:
➢ Semi-strong efficiency - This form of EMH implies all public (but not non-public)
information is calculated into a stock's current share price. Neither fundamental nor
technical analysis can be used to achieve superior gains.
➢ Weak efficiency - This type of EMH claims that all past prices of a stock are reflected
in today's stock price. Therefore, technical analysis cannot be used to predict and beat
the market.
1. The different methods for analyzing and valuing stocks: It pose some problems for
the validity of the EMH. If one investor looks for undervalued market opportunities
Fundamental analysis allows you to see what the market value for a company should be. Many
investors only look at the price a stock is currently trading at and what it has traded at instead
of analysing what lies behind the stock. A stock is issued by a company, so its overall
performance is related to the financial performance of the company.
Fundamental analysis uses publicly available financial information and reports to determine
whether a stock and the issuing company are valued correctly by the market.
Analysts use many tools. Some examples are financial reports, ratios from the reports,
spreadsheets, charts, graphs, infographics, government agency reports on industries and the
economy, and market reports.
Fundamental analysis is a valuation tool used by stock analysts to determine whether a stock
is over- or undervalued by the market. It considers the economic, market, industry, and sector
conditions a company operates in and its financial performance.
Fundamental analysts study anything that can affect the security's value, from macroeconomic
factors such as the state of the economy and industry conditions to microeconomic factors like
the effectiveness of the company's management.
The end goal is to determine a number that an investor can compare with a security's current
price to see whether the security is undervalued or overvalued by other investors.
Financial markets move on the basis of data. If one party consistently receives information
faster than the others, then the said party is statistically likely to consistently make more money
as compared to other parties because of this data advantage.
There are several pieces of data that are important while trading in the stock market. There are
some pieces of data like the company’s balance sheet and profit and loss account. This data
makes it possible to conduct a fundamental analysis of any given company. On the other hand,
there is another type of data called market data. In simple words, market data means
information relating to prices and volumes of a particular stock or bond which are being traded
on the market. This data provides more clarity about the behaviour of the stock on a financial
market. Hence, it is called market data. In this article, we will understand what market data is
and why it is important in the financial markets.
➢ Market data is used to execute, buy, and sell orders in real-time. Investors make their
decisions regarding buying and sell orders based on price data, which is being generated
and communicated to them.
➢ Automated trading orders such as stop-loss are also triggered based on market data.
Hence, real-time transmission of prices is inevitable for traders following any sort of
strategy in the open market.
➢ The market data generated can be used to conduct an analysis of the volatility of a
particular stock. Different metrics of volatility such as beta which are used to predict
The bottom line is that market data is an important component of the financial system. There
are a lot of services and activities which would become redundant in the absence of timely
availability of market data.
Stock market prediction is the act of trying to determine the future value of a company stock
or other financial instrument traded on an exchange. The successful prediction of a stock's
future price could yield significant profit.
As more and more data become available, we face new challenges in acquiring and processing
the data to extract knowledge and analyse it’s effect on stock prices.
3.9.1 Arbitrage
Arbitrage is the simultaneous purchase and sale of an asset to profit from an imbalance in the
price. It is a trade that profits by exploiting the price differences of identical or similar financial
instruments on different markets or in different forms. Arbitrage exists as a result of
market inefficiencies and would therefore not exist if all markets were perfectly efficient.
The behavioral economists argue that the arbitrage can be limited due to the fundamental risk,
implementation cost and model risk. Arbitrage may be restricted because it is costly precisely
when it would be useful in removing pricing inefficiencies. For example, because of marking-
Limits to arbitrage theory states that in the real-world arbitrageurs such as financial institutions
have limited access to funds, due to information or agency problems. If there is a supply shock
because of emergency sale of stocks by an investor, it causes the price of stock to drop and
generate an opportunity for the arbitrageur. If the arbitrator has ample supply of money they
would buy the stock and stabilize the price. But in lack of substantial money, the shock may
not be well observed and pricing difference may Sustain for longer period.
Investors may be subject to fundamental risk, noise trader risk, resale risk and implementation
costs. Therefore researchers explained that even if investors know that prices are not correct,
they may not be able to exploit the mispricing to drive prices to their fundamental values. There
is also strong evidence that arbitrage is limited.
A key argument in behavioural finance is that the existence of behavioural biases among
investors (noise traders) will affect asset prices and returns on a sustained basis only if limits
to arbitrage also exist that prevent rational investors from exploiting short-term mispricing and,
by doing so, returning prices to equilibrium value.
While investing in the stock market, it is essential for investors to know certain tools that will
help them make informed decisions. Fundamental analysis and technical analysis are two such
tools to approach the market, although they differ. Fundamental analysis looks at the intrinsic
value of a security to determine its worth, while technical analysis focuses on market trends
and utilizes past data to predict future performance. Let us understand the difference between
fundamental and technical analysis.
The goal of fundamental analysis is to determine the intrinsic value of a company and its stock
based on its financial performance, growth potential, and overall health.
As mentioned, the fundamental analysis also includes examining macroeconomic factors such
as interest rates, GDP growth, inflation, and consumer confidence to assess the overall health
of the economy and how it might affect the company’s future prospects, and ultimately its stock
prices.
Intrinsic value: the true economic worth of the share is its intrinsic value. The fundamental
analysts find out the intrinsic value of a share by using the following formula
a) Economic analysis: The level of economic activity has an impact on investment in many
ways. If the economy grows rapidly, the industry can also be expected to show rapid growth &
vice versa. The analysis of the macro-economic environment is essential to understand the
behaviour of the stock prices. The commonly analysed macro-economic factors are as follows
1. Gross domestic product (GDP)
2. Savings & investment
3. Inflation
4. Interest rates
5. Budget
6. The tax structure
For Private Circulation only ~ 40 ~
7. The balance of payment
8. Monson and agriculture
9. Infrastructure facilities
10. Demographic factors
Forecasting techniques
1. Economic indicators
2. Diffusion indexes
3. Econometric model building
Economic indicators: these are factors that indicate the present status, progress or slowdown
of the economy. They are a capital investment, business profits, money supply, GDP, interest
rate, unemployment rate etc. The economic indicators are grouped into leading, coincidental &
lagging indicators.
b) Industry analysis: An industry is a group of firms that have a similar technological structure
of production and produce similar products. Companies are distinctly classified to give a clear
picture of their manufacturing process & products. Each industry is different from the other.
The textile industry is entirely different from the steel industry can the power industry in its
product & process.
These industries can be classified on the basis of the business cycle, i.e classified according to
their reactions to the different phases of the business cycle. They are classified into growth,
cyclical, defensive and cyclical growth industry.
For Private Circulation only ~ 41 ~
1. Growth industry: it has special features of the high rate of earnings & growth in
expansion, independent of the business cycle. The expansion of the industry mainly
depends on technological change.
2. Cyclical industry: the growth & the profitability of the industry move along with the
business cycle. During the boom period, they enjoy growth & during the depression,
they refer to a setback.
3. Defensive industry: it defines the movement of the business cycle. The stock of the
defensive industries can be held by the investor for income-earning purpose. They
expand & earn income in the depression period too.
4. Cyclical growth industry: this is a new type of industry that is cyclical & at the same
time growing. Ex: The automobile industry experience periods of stagnation decline
but they grow tremendously.
Industry life cycle: the life cycle of the industry is separated into four well-defined stages such
as
1. Pioneering stage: the demand for the product attracts many producers to produce a
particular product. There would be severe completion & only fittest companies survive this
stage. The producers try to develop brand name to differentiate the product & create a
product image
2. Rapid growth stage: the company that has withstood the competition grow strongly in
market share & financial performance. The technology of the production would have
improved resulting in low cost of production & good quality products. The companies have
a stable growth rate in this stage & they declare a dividend to the shareholders. It is
advisable to invest in the shares of these companies.
3. Maturity & stabilisation stage: the growth rate tends to moderate & the rate of growth
would be more or less equal to the industry growth rate (or) the gross domestic product
For Private Circulation only ~ 42 ~
growth rate. Symptoms of obsolescence may appear in the technology. To keep going,
technological innovations in the production process & products should be introduced.
4. Declining stage: in this stage demand for the particular product & the earnings of the
companies in the industry decline. The specific feature of the declining stage is that even
in the boom period, the growth of the industry would low. It is better to avoid investing in
the share of this industry.
c) Company analysis: in the company analysis the investor assimilates the several bits of
information related to the company & evaluates the present & future values of the stock. The
risk & return associated with the purchase of the stock is analysed to take better investment
decisions. The present & future values are offered by a number of factors & they are given in
Factors Share values
Competitive edge earnings Historic price of stocks
Capital structure P/E ratio
Management Economic condition
Operating efficiency Stock market condition
Financial performance
❖ Capital structure
➢ Preference shares
➢ Debt
❖ Management
➢ Ability to get along with people
➢ Leadership
➢ Analytical competence
➢ Judgement
❖ Operating efficiency
❖ Financial analysis
➢ Balance sheet
➢ Fund flow statement
➢ P & L account
➢ Cash flow statement
➢ Ratio analysis
➢ Comparative financial statement
The underlying premise of technical analysis is that stock prices move in trends and these trends
tend to repeat themselves over time. By identifying these trends and patterns, future price
Under this approach, analysts do not attempt to measure a stock’s intrinsic value. Instead, they
try to determine the future price based on historic data and patterns and ultimately identify the
right entry and exit points. Various technical indicators are used here to plot crucial price points
on the chart, such as support and resistance levels, which are key to identifying trading
opportunities.
Fundamental analysis and technical analysis are two different schools of thought in the terms
of investing in the markets. While both are used to predict future stock prices, both have a very
different approach. The key differences between fundamental analysis and technical analysis
are as follows:
➢ Meaning: Fundamental analysis considers the most basic and fundamental aspects of
a business whereas technical analysis comprises considering historical chart data and
metrics like the price and volume of a stock.
➢ Assumption: The principle behind fundamental analysis is that after studying a
company’s fundamentals, you can forecast its growth and success potential. Technical
analysis assumes that the current share price has all the relevant information priced in.
➢ Objective: The objective of fundamental analysis is to determine the intrinsic value of
a company or a stock. Technical analysis aims to predict the future price trend of the
share.
➢ Data: Fundamental analysis relies on financial statements and economic data, while
technical analysis relies on historical share price and volume data.
➢ Time Horizon: Fundamental analysis is typically used for long-term investing, while
technical analysis is often used for short-term trading.
➢ Interpretation: As per fundamental analysis, if a company is undervalued, investors
can buy the stock as it shows growth potential and if it is overvalued then investors
should sell the stock. On the other hand, technical analysis involves analysing price
trends on the charts using different indicators and arriving at entry and exit points.
For Private Circulation only ~ 45 ~
➢ Indicators: Fundamental analysis uses a company’s financial indicators like net profit,
revenue, assets, liabilities and financial ratios, among others. While technical analysis
uses technical indicators like RSI, Moving Averages, MACD, etc, on the price charts
to identify key price levels and determine entry and exit points.
Fundamental analysis and technical analysis help you trade better and understand how the stock
market functions. While investors can use fundamental analysis to determine and select stocks
with high growth potential, technical analysis can be used to identify the right entry and exit
points. It is important to perform all types of research on the stocks to make an informed
decision.
The use of Candle Stick charts originated in JAPAN when RICE was the medium of exchange.
Munehisa Homma is considered as the father of Candle Sticks.
Candlestick charts are much more visually appealing than a standard two-dimensional bar
chart. As in a standard bar chart, there are four elements necessary to construct a candlestick
chart, the OPEN, HIGH, LOW and CLOSING price for a given time period. The sticks are two
types. White stick or Green stick and Black stick or Red stick.
Real Body: It is the rectangle portion of the Candle that represents the range between the
Opening and Closing Price.
White (Green) Real Body: It represents Close being higher than Open.
Black (Red) Real Body: It represents Close being lower than Open.
Shadow: It is the Vertical line that extends above and below the real body called Upper and
Lower Shadows.
For Private Circulation only ~ 46 ~
The Top of the Upper shadow is the sessions high and the Bottom is the sessions low.
SUPPORT: It is an area or level on the chart where buying interest is sufficiently strong to
overcome selling pressure i.e. Demand > Supply. In short, the troughs or reaction lows are
called Support.
RESISTANCE: It is an area or level on the chart where Selling pressure is sufficiently strong
enough to overcome buying interest i.e. Supply > Demand. In short, the peaks or reaction highs
are called as Resistance.
V formation: It (V) indicates that the stock prices have a long sharp decline and fast recovery.
It occurs because of quick changes in market interest rates. In the case of inverted “˄” indicates
that the stock prices have a long sharp increase and fast decline.
Days
Tops and bottoms: The investor has to buy after uptrend has started and exit before the top is
reached. Generally, tops and bottoms are formed at the beginning or end of the new trends. The
reversal from the tops and bottoms indicate sell and buy signals.
Double top and bottom: The double top is formed when a stock price rises to a certain level,
falls rapidly, again raises to the same height or more, and turns down. The pattern forms the
letter “M”. The double top may indicate the bear market.
The double bottom is formed when a stock price falls to a certain level, rise rapidly, again falls
to the same down or more, and turns up. The pattern forms the letter “W”. The double top may
indicate the bull market.
Double top
Price
Days
Price
Double bottom
Days
Inverted head and shoulders: In this pattern, three rallies are resembling the left shoulder, a
head and a right shoulder. A neckline is drawn connecting the top of the inverted head and
shoulders. When the stock price cuts the neckline from below, it signals the bull market.
Neck Line
Neck Line
Triangles
Symmetric triangle: This pattern is made up of a series of fluctuations, each fluctuation
smaller than the previous one. Tops do not attain the height of the previous tops and bottoms
are higher than the previous bottoms. Connecting the lower tops that are slanting downward
forms a symmetrical triangle. It will not signal the bull or bear market.
Ascending triangle: In this, the upper trend line is almost a horizontal trend line connecting
the tops and the lower trend line is connecting the rising bottoms. The pattern indicates that the
bull operations are more powerful than the bear operations.
Flags: These patterns form before a fall or rise in the value of the scripts. These patterns show
the market corrections of the overbought or oversold situations. The bullish flag is formed by
two trend lines that stoop downwards. The break out would occur on the upper side of the trend
line. The bearish flag is formed by two trend lines that stoop upwards. The break out would
occur on the downside of the trend line.
Pennant: It looks like a symmetrical triangle. In the bullish pennant, the lower tops from the
upper trend line and the lower trend line connects the rising bottoms. The bullish trend occurs
when the value of the script moves above the upward trend line. The bearish trend occurs when
the value of the script falls below the lower trend line.
➢ The efficient market hypothesis (EMH) maintains that all stocks are perfectly priced
according to their inherent investment properties, the knowledge of which all market
participants possess equally. The theory assumes it would be impossible to outperform
the market and that all investors interpret available information the same way.
➢ Market data is data relating to the behaviour of a particular stock or bond in the financial
market. This data is collated and analysed in order to fully understand the risks which
an investor may have to take if they invest in a particular security.
➢ Limits to arbitrage theory states that in the real-world arbitrageurs such as financial
institutions have limited access to funds, due to information or agency problems.
➢ Fundamental analysis and technical analysis are two such tools to approach the market,
although they differ. Fundamental analysis looks at the intrinsic value of a security to
determine its worth, while technical analysis focuses on market trends and utilizes past
data to predict future performance.
1. State Fundamental analysis. Also explain the concept of Economic analysis with
suitable illustrations.
2. Describe the different chart patterns with neat sketches.
Web Links:
Structure
Learning Objectives
Corporate decisions on capital structure and dividend policy are crucial aspects of financial
management that directly impact a company's financing and distribution of profits to its
shareholders. Let's explore into each of these decisions separately:
1. Capital Structure Decisions: Capital structure refers to the mix of debt and equity used by
a company to finance its operations and investments. It involves determining the proportion of
debt and equity in the company's long-term financing. Key considerations for capital structure
decisions include:
➢ Risk Tolerance: Companies with a higher risk tolerance may opt for higher leverage
(more debt) to amplify returns, while risk-averse companies may prefer a conservative
capital structure with lower debt levels to reduce financial risk.
➢ Cost of Capital: Evaluating the cost of debt and equity financing is essential in
determining the optimal capital structure. Companies strive to minimize the weighted
average cost of capital (WACC) to maximize shareholder value.
➢ Cash Flow Stability: Companies with stable and predictable cash flows may be more
comfortable with higher debt levels, as they can service their debt obligations reliably.
➢ Regulatory and Tax Considerations: Regulatory restrictions and tax implications can
influence capital structure decisions. Interest payments on debt are typically tax-
deductible, providing an advantage over equity financing.
➢ Cash Flow: A stable and consistent cash flow is essential to support regular dividend
payments. Companies must ensure they have adequate cash reserves to meet dividend
obligations.
➢ Growth Prospects: Companies with high growth prospects may choose to reinvest
earnings into the business to fuel expansion rather than paying dividends.
➢ Legal and Regulatory Requirements: Companies must adhere to legal and regulatory
requirements when making dividend payments.
It's important to note that capital structure and dividend policy decisions are interrelated. A
company's choice of capital structure can affect its ability to pay dividends, while dividend
policy can also influence investors' perceptions of the company's financial health and
attractiveness as an investment. Corporate decisions in these areas should align with the
company's long-term financial objectives, risk tolerance, growth opportunities, and the
expectations of its stakeholders, including shareholders and creditors. Regular reviews and
adjustments based on changing business conditions and external factors are essential to
ensuring the company's financial health and sustainable growth.
For Private Circulation only ~ 56 ~
4.2 Behavioural factors and Corporate Decisions on Capital Structure
The capital structure of a corporation refers to the way a company finances its overall
operations and growth by using a combination of different sources of funds, such as equity and
debt. It plays a critical role in determining a company's financial health, risk profile, and
potential for growth. Corporate decisions on capital structure are influenced by various factors,
including both financial and non-financial or behavioural factors. Here, we'll focus on the
behavioural factors that can influence corporate decisions on capital structure:
1. Risk Appetite: The risk appetite of a company's management and shareholders can
significantly impact capital structure decisions. Some companies may be more
conservative and prefer lower levels of debt to reduce financial risk, while others may
have a higher risk appetite and be more willing to take on debt to finance growth
opportunities.
2. Peers' Behavior: Companies often compare their capital structures to those of their
industry peers. If competitors or other companies in the same sector have high debt
levels and seem to be performing well, it may influence a company to adopt a similar
capital structure to remain competitive or to avoid being at a disadvantage.
4. Market Sentiment and Timing: Market conditions and sentiment can impact a
company's capital structure choices. In times of favorable market conditions, when
interest rates are low, companies may be more inclined to use debt financing to take
advantage of cheaper borrowing costs. Conversely, during economic downturns or
uncertain times, companies may opt for more equity financing to avoid excessive debt
burden and reduce financial risks.
6. Corporate Culture: The overall corporate culture can influence decisions on capital
structure. Conservative cultures may lean towards lower levels of debt, while more
aggressive cultures may favor higher leverage.
8. Short-term vs. Long-term Thinking: Companies with a short-term focus may be more
inclined to use debt to fund immediate growth or acquisitions, while companies with a
long-term perspective might prioritize equity financing to strengthen their balance
sheets and ensure stability over time.
It's important to note that these behavioural factors are just some of the many considerations
that can influence capital structure decisions. In practice, companies often take into account a
combination of financial, strategic, and behavioural factors to arrive at an optimal capital
structure that aligns with their objectives and risk tolerance.
Corporate dividend policy refers to the decisions made by a company's management regarding
the payment of dividends to its shareholders. Dividends are the portion of a company's profits
distributed to shareholders as a return on their investment. Behavioural factors can also play a
significant role in shaping a company's dividend policy. Here are some behavioural factors that
can influence corporate decisions on dividend policy:
3. Herding Behavior: Companies might feel pressure to follow industry norms or mimic
the dividend policies of other successful firms in the same sector. This herding behavior
can lead to companies adopting similar dividend policies, even if it may not be the most
optimal decision for their specific financial situation.
4. Loss Aversion: Shareholders may exhibit loss aversion, which means they feel the pain
of a loss more than they value an equivalent gain. Companies might be reluctant to
reduce or eliminate dividends, even if it makes financial sense, as shareholders could
react negatively to the perceived loss of income stability.
6. Status Quo Bias: Companies might adhere to the status quo in dividend policy,
maintaining a stable or increasing dividend payment pattern year after year, even if
changes in the business environment or financial position warrant a different approach.
It's important to note that while behavioral factors can influence dividend decisions, these
decisions are also influenced by various other factors, including the company's financial
performance, cash flow position, growth prospects, and overall corporate strategy.
Additionally, regulatory and tax considerations also play a role in shaping dividend policy.
Companies need to strike a balance between shareholder expectations, financial needs, and
long-term growth objectives when determining their dividend policy.
Capital structure decisions of a company can be influenced by market timing, which refers to
the notion that the prevailing market conditions and investor sentiment can affect the cost and
availability of different sources of financing (equity and debt). Companies might adjust their
capital structure depending on their perceptions of market conditions and their expectations for
future changes. Here's how market timing can influence capital structure decisions:
1. Cost of Capital: Market timing can affect the cost of capital for both equity and debt
financing. During periods of favorable market conditions, such as a booming economy
or low-interest-rate environments, companies may find it more attractive to issue debt
2. Investor Sentiment: Investor sentiment plays a vital role in the demand for a
company's securities. When investor sentiment is positive and there is a strong appetite
for stocks, companies might choose to issue equity to take advantage of the higher stock
prices and raise funds. Conversely, during periods of negative investor sentiment,
companies may be hesitant to issue new equity, fearing a lower valuation and dilution
of existing shareholders.
4. Perceived Risk and Stability: Market timing can influence a company's perception of
market risk and overall market stability. During times of economic uncertainty or
financial market turbulence, companies may become more conservative in their capital
structure decisions, preferring to maintain a lower debt-to-equity ratio to reduce
financial risks.
6. M&A and Investment Opportunities: Market timing can also impact a company's
approach to mergers and acquisitions (M&A) and investment decisions. When the
market is buoyant, a company may choose to fund acquisitions using more equity to
For Private Circulation only ~ 61 ~
take advantage of high stock prices, while during a downturn, they may rely on debt
financing to pursue strategic opportunities.
It's essential to emphasize that while market timing can influence capital structure decisions,
companies should not base their decisions solely on short-term market conditions. The capital
structure should align with the company's long-term financial and strategic objectives,
considering factors such as business risk, growth prospects, tax implications, and the cost of
capital over the entire lifecycle of the company. Market timing can be unpredictable, and overly
aggressive attempts to time the market could expose companies to unnecessary risks. A prudent
approach to capital structure management involves a careful analysis of both market conditions
and the company's unique financial situation and objectives.
1. Awareness and Education: The first step is to create awareness among decision-
makers, executives, and employees about various behavioral biases and their potential
impact on decision-making. Conduct workshops, training sessions, or seminars to
educate the team about common biases like overconfidence, confirmation bias,
anchoring, and others.
2. Identify Relevant Biases: Examine past decisions and identify instances where
behavioral biases may have influenced the outcome. By recognizing patterns and biases
in historical decision-making, the organization can develop an understanding of how
these factors play a role in shaping choices.
5. Use Data and Analytics: Rely on data and analytics to inform decisions rather than
solely depending on intuition or gut feelings. Data-driven decision-making can help
mitigate the impact of behavioral biases by providing objective and quantifiable
information.
7. Implement Decision Support Tools: Introduce decision support tools or software that
can identify and mitigate behavioral biases. These tools can analyze decisions and alert
decision-makers to potential biases that might be influencing the outcome.
External factors can have a significant impact on a company's capital structure and dividend
policy decisions. These factors are beyond the company's direct control and are influenced by
the broader economic, market, regulatory, and competitive environment. Some of the key
external factors that influence capital structure and dividend policy include:
1. Economic Conditions: The overall state of the economy, including factors such as
economic growth, inflation rates, and interest rates, can influence capital structure
decisions. During economic downturns, companies may be more conservative and opt
for lower leverage to mitigate financial risks. Conversely, in periods of economic
growth and low-interest-rate environments, companies may be more willing to use debt
financing to take advantage of lower borrowing costs.
2. Industry Characteristics: Different industries have varying levels of financial risk and
capital intensity, which can influence their preferred capital structures. Capital-
intensive industries, such as utilities or infrastructure, may rely more on debt financing
to fund their investments, while high-growth industries might prefer equity financing
to fuel expansion.
4. Access to Capital Markets: The availability and cost of different sources of financing,
such as equity and debt, depend on the company's credit rating and perceived risk.
Companies with strong credit ratings may have better access to debt markets at
favorable terms, allowing them to use debt as a primary source of financing.
6. Taxation Policies: Taxation policies can affect the attractiveness of dividend payments
versus share buybacks or capital gains. For instance, in some jurisdictions, dividends
may be subject to higher tax rates than capital gains, which could influence a company's
dividend policy.
7. Competitive Landscape: The competitive landscape in an industry can affect the level
of financial risk a company is willing to take. If competitors are highly leveraged, a
company may feel pressured to match their capital structure to remain competitive.
It's important to note that companies need to consider a combination of internal and external
factors when determining their optimal capital structure and dividend policy. The goal is to
strike a balance between the company's financial needs, risk tolerance, growth prospects, and
the expectations of its various stakeholders. Flexibility and adaptability are crucial, as external
factors can change over time, necessitating adjustments to the capital structure and dividend
policy.
Investor behaviour can be influenced by a wide range of external factors that shape their
perceptions, decisions, and actions in financial markets. These factors can be economic, social,
political, or related to market conditions. Understanding these external factors is essential for
companies, financial institutions, and policymakers as they impact investment decisions and
market dynamics. Some key external factors influencing investor behaviour include:
4. Global Events and Geopolitical Risks: Geopolitical events, such as wars, trade
disputes, and political instability, can create uncertainty and affect investor sentiment.
Global events can lead to increased market volatility and a flight to safe-haven assets.
5. Media and social media: Media coverage and social media play a significant role in
shaping investor perceptions and emotions. News and social media platforms can
amplify market news, rumors, and sentiment, influencing investor behavior and herd
mentality.
8. Demographics: Demographic factors, such as age, income level, and risk tolerance,
play a role in shaping investor behavior. Different generations may have varying
investment preferences and objectives.
9. Cultural and Social Norms: Cultural and social norms can influence investment
behavior in different regions and countries. For example, in some cultures, there may
be a preference for traditional assets like gold or real estate.
It's important to recognize that these external factors interact and evolve over time, influencing
investor behaviour in complex ways. Investors' decisions are often driven by a combination of
rational analysis, emotions, and cognitive biases. Understanding these external factors can help
market participants make informed decisions and navigate the dynamics of financial markets
more effectively.
4.8 Summary
➢ Corporate decisions on capital structure and dividend policy are crucial aspects of
financial management that directly impact a company's financing and distribution of
profits to its shareholders.
➢ A company's choice of capital structure can affect its ability to pay dividends, while
dividend policy can also influence investors' perceptions of the company's financial
health and attractiveness as an investment.
➢ Corporate decisions in these areas should align with the company's long-term financial
objectives, risk tolerance, growth opportunities, and the expectations of its
stakeholders, including shareholders and creditors.
➢ It plays a critical role in determining a company's financial health, risk profile, and
potential for growth.
➢ Corporate decisions on capital structure are influenced by various factors, including
both financial and non-financial or behavioural factors.
➢ Corporate dividend policy refers to the decisions made by a company's management
regarding the payment of dividends to its shareholders.
➢ Behavioural factors can also play a significant role in shaping a company's dividend
policy.
➢ Companies need to strike a balance between shareholder expectations, financial needs,
and long-term growth objectives when determining their dividend policy.
➢ The capital structure should align with the company's long-term financial and strategic
objectives, considering factors such as business risk, growth prospects, tax
implications, and the cost of capital over the entire lifecycle of the company.
For Private Circulation only ~ 68 ~
➢ By adopting a systematic approach that incorporates behavioural factors into corporate
decision-making, organizations can make more informed and balanced choices,
mitigate the impact of biases, and improve overall decision-making quality.
➢ It's essential to create a culture that values self-awareness, learning, and adaptability to
ensure that the organization remains resilient and agile in its decision-making
processes.
➢ The goal is to strike a balance between the company's financial needs, risk tolerance,
growth prospects, and the expectations of its various stakeholders.
➢ Understanding these external factors is essential for companies, financial institutions,
and policymakers as they impact investment decisions and market dynamics.
➢ It's important to recognize that these external factors interact and evolve over time,
influencing investor behaviour in complex ways.
➢ Investors' decisions are often driven by a combination of rational analysis, emotions,
and cognitive biases.
➢ Understanding these external factors can help market participants make informed
decisions and navigate the dynamics of financial markets more effectively.
1. Explain the External Factors Influencing Capital Structure and Dividend Policy
Web Links:
Structure
Learning Objectives
5.1 Introduction
Ethics in Finance talks about financial behaviour or activities that are ethically right or wrong.
Business ethics that are followed by financial institutions, financial services, or financial
markets are the integral parts of ethics in finance. The ethics in finance incorporate truthfulness,
integrity, honesty, justice, and fairness in all sorts of financial activities. Financial ethics or
business ethics are actually subsets of general ethics. It is crucial for maintaining harmony and
stability in financial services where people interact with one another and do any sort of financial
or monetary transactions.
Finance ethics is highly crucial because of the countless scandals and ethical issues of the
financial industry. Ethics in the finance sector mainly revolves around the handling of material
non-public information and reporting of the unethical act. Upholding ethical standards in
finance-related activities by being aware, educated, and holding high moral standards in
economic, corporate, business or finance activities. It resolves all sorts of unethical act and
interests.
Now that we have discussed the basics of the ethics and finance terms, let us discuss the needs
of ethics in the financial and service industry while handling the ethics-related crisis.
1. Acting with honesty and integrity while handling dilemmas of the world of finances.
2. Not associating with any real/clear conflicts of interest in personal, or company
relationships.
3. Providing information that is full, accurate, fair, complete, relevant, objective,
understandable, and timely in and for different documents and reports.
4. Acting in accordance with all the applicable rules, laws, and regulations of governments
along with other relevant public/private regulatory agencies.
5. Acting responsibly and in good faith with due care, carefulness, and competence
without any sort of misrepresentation of material facts.
For Private Circulation only ~ 73 ~
6. Respecting the confidentiality of information which is acquired in the business course
and such information should not be used for the personal benefit.
7. Promoting ethical behavior among all the associates and stakeholders of a company.
8. Adhering and promoting a code of ethics in the company.
➢ To deal with ethical problems in finances like those ranging from ethical codes in place
for financial professionals to the replacement of the egoistic theory, there are a large
variety of domains covered in business ethics.
➢ These are kept in place to ensure ethically and morally responsible behaviour from the
various operatives that operate in the financial market.
➢ Example of ethical violations in the financial market includes insider trading, investor
management, campaign financing, and stockholder interest vs stakeholder interest.
➢ Businesses in both financial and general markets have to be wary of loyalty and trust
violations in both private and public dealings.
➢ Over the years, there have been multiple cases of whistleblowing in the world. People
have been involved in cases where just the knowledge of such practices landed them in
problems. No one prefers to blow a whistle on their fellow worker or the organization.
➢ Still, it is also an essential and ethical duty to ensure that fair practices are being
followed in the financial industry or society.
➢ For instance, take the example of Harshad Mehta in the 20th century. It was the morally
responsible ethics of a news reporter to make sure such practices were reported.
➢ Over these years, these professionals’ involvement in countless various allegiances and
scandals has given these professionals a black eye and completely rocked the industry.
Standard neoclassical economics assumes that all companies in the market want to maximize
profits. Therefore, all decisions are driven solely by the question “Will it be profitable?”
However, ethical decisions are driven by a different set of questions, such as:
• Is it a breach of trust?
• Is it respectful?
• Is it responsible?
• Is it fair?
• Is it compassionate?
• Is it civil?
Trust
• The company should act in a way that inspires trust and positively impacts its
reputation.
• The company should act with integrity and honesty.
• The company should be reliable.
• The company should behave in a stable and consistent manner.
• The company should keep its promises and take its reputation seriously.
Respect
• The company should respect its customers.
• The company should respect its workers.
• The company should respect its competitors.
• The company should deal with disagreements and conflict in a respectful manner.
• The company should be tolerant of different beliefs and ideologies.
For Private Circulation only ~ 76 ~
• The company should actively try to promote good moral behavior through its business
decisions.
Responsible
• The company should be considerate.
• The company should be accountable.
• The company should be thoughtful and realize that actions come with consequences.
• The company is disciplined and does not behave in a rash and erratic manner.
Fair
• The company is stoic.
• The company accepts that it will not always get its way.
• The company takes success with humility.
• The company takes defeat with grace.
• The company is open-minded and does not react adversely to change.
Care
• The company cares about its customers.
• The company cares about its workers.
• The company cares about its own reputation.
• The company cares about more than just profits.
• The company does not hold grudges and forgives easily.
• The company is compassionate.
• The company is altruistic.
Civil
• The company exhibits a sense of civic duty.
• The company treats its surroundings with care and respect.
• The company protects the local environment.
• The company recognizes its debt to the public.
• The company respects the law.
A framework for ethical decision making in finance is based on the premise that, when firms
instill ethical decision making into all employees’ decisions, a strong ethical culture will ensue,
resulting in increased trust from investors, enhanced financial markets, and an overall benefit
to society. The ethical decision-making framework helps the decision maker see the situation
from multiple perspectives with a longer-range view that is less self-centered, thereby
benefiting shareholders.
1. Identify important facts and other information: Identify important facts and other
information that may still be needed while separating fact from opinion. Identify
stakeholders and responsibility to them, along with relevant laws and regulations and
any conflicts of interest.
4. Assess the outcome: Assess the outcome by reflecting on whether or not it occured as
anticipated and why. This is an applying an ethical decision-making framework can
help to view a situation from multiple perspectives, thereby allowing the best decision
to be made avoiding the negative consequences of making a poorly conceived decision.
We discussed the different steps of an ethical decision-making framework that is typically used
by finance professionals.
For Private Circulation only ~ 78 ~
5.10 Character-Based Decision-Making Model
The Golden Rule – “Help when you can and avoid harm when you can.”
Ethical principles are morally superior to non-ethical principles and should be used as a guide
for all decisions. The company should violate an ethical principle if it means it can promote a
greater ethical principle. However, this is an extremely subtle rule and can be abused. In
general, the company should make decisions that promote the greatest amount of moral
justness.
PLUS Ethical Decision-Making Model is one of the most used and widely cited ethical
models.
To create a clear and cohesive approach to implementing a solution to an ethical problem; the
model is set in a way that it gives the leader “ethical filters” to make decisions. It purposely
leaves out anything related to making a profit so that leaders can focus on values instead of a
potential impact on revenue.
The letters in PLUS each stand for a filter that leaders can use for decision-making:
P – Policies and Procedures: Is the decision in line with the policies laid out by the company?
L – Legal: Will this violate any legal parameters or regulations?
U – Universal: How does this relate to the values and principles established for the
organization to operate? Is it in tune with core values and the company culture?
S – Self: Does it meet my standards of fairness and justice? This particular lens fits well with
the virtue approach that is a part of the five common standards mentioned above.
These filters can even be applied to the process, so leaders have a clear ethical framework all
along the way. Defining the problem automatically requires leaders to see if it is violating any
of the PLUS ethical filters. It should also be used to assess the viability of any decisions that
For Private Circulation only ~ 79 ~
are being considered for implementation and make a decision about whether the one that was
chosen resolved the PLUS considerations questioned in the first step. No model is perfect, but
this is a standard way to consider four vital components that have a substantial ethical
impact.
While this one is not as widely cited as the PLUS Model, it is still worth mentioning. The
Character-Based Decision-Making Model was created by the Josephson Institute of Ethics,
and it has three main components leaders can use to make an ethical decision.
1. All decisions must consider the impact to all stakeholders – This is very similar to
the Utilitarian approach discussed earlier. This step seeks to do good for most, and
hopefully avoid harming others.
2. Ethics always takes priority over non-ethical values – A decision should not be
rationalized if it in any way violates ethical principles. In business, this can show up
through deciding between increasing productivity or profit and keeping an employee’s
best interest at heart.
3. It is okay to violate another ethical principle if it advances a better ethical climate
for others – Leaders may find themselves in the unenviable position of having to
prioritize ethical decisions. They may have to choose between competing ethical
choices, and this model advises that leaders should always want the one that creates the
most good for as many people as possible.
Insider trading is a subject of much criticism since it unfairly disadvantages those individuals
who do not possess proprietary knowledge about a particular corporation. People who don’t
have access to information that hasn’t been made public lose faith in the organization. As a
result, insider trading causes many companies to lose potential investors. Insider trading is
occasionally acceptable but can also be unethical.
Insider trading refers to both legal and unlawful activity and has multiple meanings and
connotations. The trading of a business’s stock, securities, bonds, and stock options by
individuals who may have access to sensitive information about the firm is also referred to as
insider trading. Insider trading is still permitted to occur every day, provided that it does not
involve the use of non-public information and complies with the policies and regulations of the
company in question. This includes trading by corporate insiders like officers, directors,
employees, and large shareholders who wish to buy or sell stock in their own companies.
However, the term “insider trading” is typically used to refer to a practice in which an insider
party engages in trading based on material non-public information obtained while carrying out
their duties as insiders at the company, in contravention of other relationships of faith and
assurance, or in other situations when the non-public information was stolen from the
corporation.
An insider is a person who has access to sensitive information about a business or organization
that could be used to manipulate stock prices or investment choices. Furthermore, it is obvious
that the majority of business executives are knowledgeable about the organization. For
instance, the sales manager is aware of the company’s sales volume, and in the event of a rally,
the projections are shared with investors.
Additionally, other employees of the business also have access to crucial information. For
example, the accountants and auditors who create spreadsheets for sales forecasts and the
administrative assistants who write press releases are both insiders.
Employees of publicly traded corporations frequently buy or sell their stocks, making them
examples of legal traders who are insiders with familiarity with the business. Insiders are
Contrarily, illegal traders are individuals that exchange valuable knowledge with the general
public wherever in the world, even though the information they exchange and the methods used
to impart it is very different. However, it is the SEC’s responsibility to ensure that all
shareholders are basing their decisions on comparable facts. Insider trading may also be
prohibited because it undermines all options and investor confidence in the company.
Ethical Arguments for insider trading
Proponents of insider trading argue that when corporate insiders have access to information not
available to the general public, they can use this knowledge to their advantage by buying or
selling stocks at opportune moments. This could result in more efficient pricing and the ability
to find undervalued stocks. Additionally, it can provide incentives for management to make
decisions that increase shareholder value, as executives could profit from successful
investments made using insider information.
Supporters of insider trading also argue that it can increase the liquidity of certain stocks, which
leads to lower transaction costs for traders. This increased liquidity can make it easier for small
investors to purchase and sell stocks without incurring high costs. Moreover, allowing
corporate insiders to use their information may encourage greater transparency and disclosure
of company information, as executives may want to show potential investors that their
investments are based on sound information.
Insider trading puts individuals with privileged access to inside information at an advantage,
which goes against the fundamental principles of a fair and open market system. It can also
damage confidence in the stock market, as investors become aware that others are privy to
information that they are not.
Furthermore, insider trading affects corporate governance, as it gives an incentive for corporate
insiders to manipulate financial results or otherwise take advantage of their positions for
For Private Circulation only ~ 82 ~
personal gain. This undermines trust between a company and its shareholders and can lead to
severe legal and financial penalties for those involved.
Finally, insider trading can cause a misallocation of resources, as money flows from less-
informed to more-informed investors. This creates an unfair playing field where those with
access to insider information can reap the rewards of their knowledge without providing any
additional value.
In short, corporate insider trading has serious ethical implications and should be avoided at all
costs. Fairness and transparency should be the core principles behind any stock market trading
activities.
Corporate insiders have access to material, non-public information regarding the financial
performance and potential developments of the company. As such, they are not allowed to use
this information to buy or sell securities of the company, as this is considered illegal insider
trading.
The Securities and Exchange Commission (SEC) enforces regulations that make it illegal for
corporate insiders to use their privileged access to gain an unfair advantage over other
investors. Those found guilty of insider trading can face fines, civil damages, and even jail
time.
In order to combat insider trading, the SEC has set up rules that require corporate insiders to
disclose their trades in the company’s securities. Companies must also put into place systems
and controls to ensure that their corporate insiders are not using their privileged access to obtain
an unfair advantage.
It’s important for investors to be aware of the legal aspects of insider trading, as it can have a
significant impact on business ethics. Insider trading erodes public confidence in the markets
and undermines the fairness of stock prices. It is important for investors to be vigilant when it
When it comes to business ethics, the implications of insider trading are clear: it creates an
unfair advantage and goes against the basic principles of fairness, transparency, and trust.
Corporate insiders who engage in insider trading are taking advantage of privileged access to
information to make a financial gain that other investors do not have.
Moreover, insider trading violates the trust between company insiders and shareholders.
Companies rely on the trust of their shareholders to remain financially viable and act
responsibly with their money. When corporate insiders take advantage of confidential
information for their own gain, it undermines this trust and puts the company at risk of being
seen as acting unethically.
Insider trading has far-reaching implications, and it is important to recognize how serious an
offense it is. Companies must ensure they have robust policies in place that prohibit any type
of insider trading while at the same time encouraging transparency and fair competition in the
market.
Employees, contractors, and anyone else with privileged access to non-public information can
be guilty of insider trading if they use that information for financial gain. It is important for
companies to be aware of this potential risk and take measures to protect confidential
information from any misuse.
Corporate insider trading is the illegal practice of using confidential information for personal
gain in the stock market. This unethical behavior has a serious impact on businesses, both in
terms of reputation and financial losses.
Insider trading can also lead to significant financial losses. Companies may be required to pay
fines or other monetary damages related to insider trading investigations, which can have a
major impact on a business’s bottom line. It can also lead to lawsuits from shareholders who
feel they have been defrauded.
In addition to these tangible impacts, corporate insider trading can also damage employee
morale. When employees learn that company insiders are engaged in unethical activity, it can
create a hostile work environment and have a negative effect on job satisfaction.
In short, corporate insider trading is an illegal activity that can cause serious harm to businesses.
Companies must take steps to prevent insider trading and protect their reputation, finances, and
workforce.
Meaning: A hostile takeover, in mergers and acquisitions (M&A), is the acquisition of a target
company by another company (referred to as the acquirer) by going directly to the target
company’s shareholders, either by making a tender offer or through a proxy vote. The
difference between a hostile and a friendly takeover is that, in a hostile takeover, the target
company’s board of directors do not approve of the transaction.
Example:
For example, Company A is looking to pursue a corporate-level strategy and expand into a new
geographical market.
In the scenario above, despite the rejection of its bid, Company A is still attempting an
acquisition of Company B. This situation would then be referred to as a hostile takeover
attempt.
There are two commonly-used hostile takeover strategies: a tender offer or a proxy vote.
1. Tender offer: A tender offer is an offer to purchase stock shares from Company B
shareholders at a premium to the market price. For example, if Company B’s current
market price of shares is Rs10, Company A could make a tender offer to purchase shares
of company B at Rs 15 (50% premium). The goal of a tender offer is to acquire enough
voting shares to have a controlling equity interest in the target company. Ordinarily,
this means the acquirer needs to own more than 50% of the voting stock. In fact, most
tender offers are made conditional on the acquirer being able to obtain a specified
amount of shares. If not enough shareholders are willing to sell their stock to Company
A to provide it with a controlling interest, then it will cancel its Rs 15 a share tender
offer.
2. Proxy vote: A proxy vote is the act of the acquirer company persuading existing
shareholders to vote out the management of the target company so it will be easier to
take over. For example, Company A could persuade shareholders of Company B to use
their proxy votes to make changes to the company’s board of directors. The goal of such
a proxy vote is to remove the board members opposing the takeover and to install new
board members who are more receptive to a change in ownership and who, therefore,
will vote to approve the takeover.
In India, takeovers are primarily governed under the Takeover Code- that goes by the name
SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011. The Code defines
an Acquirer as a person who, directly or indirectly, acquires shares or voting rights or control
over a Target Company by himself or through persons acting in concert with him. Further,
Regulation 3 permits such Acquirers to make a public announcement of an open offer in case
they aim to acquire more than 25% of the voting rights of the Target Company. It is easy to
conclude that the Takeover Code provides no legal protection against a hostile takeover.
Furthermore, there is no distinction in the Code between a friendly and hostile takeover. More
so, the Code contains no onerous requirements for hostile takeovers that would undermine the
aim of such a bid. Despite the lack of a legal structure forbidding hostile takeovers, India
appears to be reluctant to engage in shark-bait takeovers. One of the reasons for this reluctance
could be the way our corporate houses have traditionally been constituted, with most Indian
companies being closely controlled by their promoters in contrast to the management-driven
strategy that most corporations in developed nations take.
In the history of Indian business, there have been very few hostile takeovers. Some of them
are:
While these takeovers are legal, they can raise several ethical concerns due to the potentially
negative impacts on various stakeholders. Some of these considerations include:
1. Employee Welfare: Hostile takeovers may result in layoffs, reorganizations, and
changes to the workplace that may be detrimental to worker morale, job security, and
general well-being.
2. Shareholder Interests: In a hostile takeover, the interests of the target company's
shareholders may be compromised since they may not be given a fair chance to weigh
the advantages and dangers of the deal.
Considering these ethical concerns, companies involved in a hostile takeover need to carefully
assess the potential impacts on all stakeholders and strive for transparency, fairness, and
responsible decision-making throughout the process.
Corporate scandals that culminate with the arrests of nefarious executives may garner the
headlines. But the cumulative damages caused by the seemingly small indiscretions that
employees and managers commit every day are just as bad.
Whether it’s a common infraction like misusing company time, mistreating others, lying,
stealing or violating company internet policies, unethical behavior in the workplace is
widespread.
Causes of Unethical Behaviour
For Private Circulation only ~ 89 ~
1. No Code of Ethics: Employees are more likely to do wrong if they don’t know what’s
right. Without a code of ethics, they may be unscrupulous. A code of ethics is a
proactive approach to addressing unethical behavior. It establishes an organization’s
values and sets boundaries for adhering to those values. Everyone is accountable.
2. Fear of Reprisal: When explaining why they don’t report ethical misconduct that they
witness, people often say it is because they worry about the ramifications. They don’t
want to damage their career or incur the wrath of the offender. Or, sometimes, they let
the infraction go because they don’t know how to report it or they feel that their report
may be ignored.
3. Peer Influence: If everyone is doing it, it must be right. Or is it? What’s to stop
someone from padding their expense report when their co-workers do it but don’t get
caught? Too often people lapse into the bad behavior of others. People behave
unethically because they tend to perceive questionable behaviors exhibited by people
who are similar to them – like their co-workers – to be more acceptable than those
exhibited by people who they perceive as dissimilar, researchers say.
4. Slippery Slope: Misconduct starts small, such as the exaggeration of a mileage report.
But the longer it goes unchecked, the worse the offenses become. The few extra dollars
that came from the mileage report may eventually be dwarfed by larger falsified
expenses or perhaps even outright embezzlement. People who are faced with growing
opportunities to behave unethically are more likely to rationalize their misconduct
because unethical behavior becomes habit.
5. Setting a Bad Example: Ethical behavior starts at the top. Employees emulate their
leaders, and the most significant factor in ethical leadership is personal character.
Corporate leaders who employees view as demonstrating personal character are more
likely to be perceived as setting a strong tone, researchers say. If employees see the
boss knocking off early every day, they may do likewise.
When constructing an annual budget, considering ways to prevent unethical behaviour in the
workplace is rarely on anyone’s mind. The Report to the Nations from the Association of
Certified Fraud Examiners (ACFE) found that a typical business could anticipate losing five
percent of its annual revenue to fraudulent activity.
Corruption has routinely been the most pressing concern for larger companies, while smaller
businesses more frequently face issues with check tampering, skimming, and payroll
irregularities. Despite these variances in the method of fraud, the study found that the reported
median loss of $120,000 varied little when accounting for company size.
Surprisingly, there is a strong chance that these small ethical shortcomings could snowball into
larger concerns. According to an article jointly written by three university research teams,
people are more likely to rationalize unethical behaviour if the opportunities for misconduct at
work are presented gradually rather than as an abrupt change. Similarly, those surrounding the
inappropriate behaviour—even those charged with oversight—are more likely to overlook this
creeping employee misconduct.
Organizations who aren’t taking proactive steps to prevent ethics shortcomings are exposed to
lawsuits, regulatory penalties, investigations, intense media scrutiny, and damaged employee
relations.
And without proper oversight, corruption bloomed. Altogether, the bank has fired more than
5,300 employees connected with fraudulent activity.
Just as employees are susceptible to gradual ethical erosion, they are equally open to positive
influences. Research indicates that a “nudge” in the right direction, such as having staff sign
paperwork verifying the authenticity of mileage expenses immediately before actually
submitting the mileage figures, can subconsciously encourage employees to be more honest.
Not surprisingly, the more ethically responsible a business operates, the happier and more loyal
its employees tend to be. And happier employees tend to behave more ethically, creating a
positive cycle for your business.
5.17 Summary
➢ Introduction Ethics in Finance talks about financial behaviour or activities that are
ethically right or wrong.
➢ Finance ethics is highly crucial because of the countless scandals and ethical issues of
the financial industry.
➢ To deal with ethical problems in finances like those ranging from ethical codes in place
for financial professionals to the replacement of the egoistic theory, there are a large
variety of domains covered in business ethics.
➢ Behavioural biases and situational influences: Behavioural biases and situational
influences are identified that can affect thinking and decision-making ability.
➢ In short, corporate insider trading has serious ethical implications and should be
avoided at all costs.
➢ In order to combat insider trading, the SEC has set up rules that require corporate
insiders to disclose their trades in the company's securities.
➢ It's important for investors to be aware of the legal aspects of insider trading, as it can
have a significant impact on business ethics.
➢ In short, corporate insider trading is an illegal activity that can cause serious harm to
businesses.
➢ Companies must take steps to prevent insider trading and protect their reputation,
For Private Circulation only ~ 93 ~
finances, and workforce.
➢ A hostile takeover, in mergers and acquisitions (M&A), is the acquisition of a target
company by another company (referred to as the acquirer) by going directly to the target
company's shareholders, either by making a tender offer or through a proxy vote.
➢ While these takeovers are legal, they can raise several ethical concerns due to the
potentially negative impacts on various stakeholders.
➢ Considering these ethical concerns, companies involved in a hostile takeover need to
carefully assess the potential impacts on all stakeholders and strive for transparency,
fairness, and responsible decision-making throughout the process.
➢ Corruption has routinely been the most pressing concern for larger companies, while
smaller businesses more frequently face issues with check tampering, skimming, and
payroll irregularities.
Web Links:
➢ Ethical Decision-Making.
URL: https://corporatefinanceinstitute.com/resources/esg/ethical-decision-making/
➢ Ethics in Finance URL: https://www.marketing91.com/ethics-in-finance/
➢ Ethical Decision-Making Models. URL: https://status.net/articles/ethical-decision-
making-process-model-framework/
➢ Ethical Issues in Insider Trading: Case Studies. URL:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=538682
➢ URL: https://dealroom.net/blog/hostile-takeovers-the-dark-side-of-m-a
Subject:
Time: 3 Hours Total Marks: 50
SECTION-A
I. Answer any Four of the following questions (4x5 = 20)
SECTION-B
II. Answer any Two of the following questions (2x9 = 18)
SECTION-C
III. Compulsory question (1x12= 12)
1. State Fundamental analysis. Also explain the concept of Economic analysis with suitable
illustrations.