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Risk Management

By Torben Juul Andersen (eds.)

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Additional info for Contemporary Challenges in Risk Management: Dealing with Risk, Uncertainty and the Unknown

Example text

1 contrasts BW and expected return (averaged over all stocks that were part of the exercise). 1 only displays data through the end of 2010, as the BW series is only available until December 2010. 017). 72). The value of BW that is matched to an expected return is the one closest in time to the date the exercise was undertaken. One of the most intriguing issues that Baker and Wurgler address is the extent to which sentiment affects the relationship between realized returns and characteristics such as size and B/M.

In truth, however, one can’t tell whether the problem is bad pricing or a bad asset pricing model. A stock’s price can always be expressed as the present value of expected future cash flows discounted at the expected return on the stock (Campbell and Shiller, 1989; Vuolteenaho, 2002). It follows that if two stocks have the same price, the one with higher expected cash flows must have a higher expected return. This holds true whether pricing is rational or irrational. Thus, when one observes a positive relation between expected Distinguishing Rationality and Bias in Prices 13 cash flows and expected returns that is left unexplained by the CAPM or the three-factor model, one can’t tell whether it is the result of irrational pricing or a mis-specified asset pricing model” (p.

Therefore, investors relying on representativeness are induced to make judgments about expected return and perceived risk in a manner that leads the correlation for these variables to be negative. That is, investors’ judgments suggest that they expect higher returns from safer stocks. 6 summarizes the relevant correlation coefficients for my sample. 64 In Shefrin (2001), I noted that before seeing the analysis of their judgments, virtually all participants indicate that in principle they believe that risk and return are positively correlated.

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