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This topic has been prompted by the following question:

Measuring Behavioral Finance Effects in Fund/Portfolio Manager Analysis

After reading it and the comments below I started thinking whether behavioral finance could be incorporated into pricing paradigms used by quants.

  • Couldn't option pricing to at least some extent benefit from it? E.g. with american options pricing - when pricing one mostly uses the continuation value to analyse whether the holder would exercise or not.
  • Does literature on the interfacing of behavioural finance and pricing exit?
  • How relevant is it in portfolio optimization ?
  • What about an application to credit risk modeling ? Or Risk-Management in general. In Basel III or Solvency II where the companies assets are projected into the future. This projections also include assumptions on how the management will act in certain situations.
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1 Answer 1

up vote 4 down vote accepted

Behavioral Finance is a wide topic, which I believe is still today underestimated by many financial professionals.

How can it be used by quants?

Well, in portfolio optimization it can be used "as an overlay" in the form of constraints where the optimal portfolio can not be too different from the current portfolio, because clients have behavioral biases which make them will to keep roughly the same allocation. The CFA Level 3 curriculum discusses this topic.

For option pricing it would have to be integrated in the model. The problem is, quants use models to simplify the reality and be able to derive "simple" close-form solutions

"All models are wrong, but some are useful." George Box

Adding behavioral finance in pricing models would essentially make them more complicated and hence more difficult to apply. I have not read a specific article that I remember, but a quick google search pointed me to this study which confirms that people have indeed been looking into this.

The real question to answer is does the addition of the behavioral finance concept to a model provide a big enough payoff from the market to compensate investment managers for the sophistication?

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+1 for the link. I would also give another +1 for the concluding remark. Do you think it would make sense to open up a discussion on that topic ? –  Probilitator Mar 9 at 12:04
    
@Probilitator well my concluding remark was supposed to be my last question... Clearly yes, it's worth opening the topic, but it's been an open question for some time now with no obvious answer apparently... –  SRKX Mar 9 at 21:42
    
@bottom line - it is worth considering but as Long as there is no proven benefit to including it, it is not really relevant –  Probilitator Mar 10 at 13:39

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