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Roots and effects of financial misperception in a stochastic dominance framework

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  • Rosella Castellano
  • Roy Cerqueti

Abstract

This work deals with the issue of investors’ irrational behavior and financial products’ misperception. The theoretical analysis of the mechanisms driving erroneous assessment of investment performances is explored. The study is supported by the application of Monte Carlo simulations to the remarkable case of structured financial products. Some motivations explaining the popularity of these complex financial instruments among retail investors are also provided. In particular, investors are assumed to compare the performances of different projects through stochastic dominance rules. Unreasonably and in contrast with results obtained by the application of the selected criteria, investors prefer complex securities to standard ones. In this paper, introducing a new definition for stochastic dominance which presents asymmetric property, we provide theoretical and numerical results showing how investors distort stochastic returns and make questionable investment choices. Results are explained in terms of framing and representative effects, which are behavioral finance type arguments showing how decisions may depend on the way the available alternatives are presented to investors. Copyright Springer Science+Business Media B.V. 2013

Suggested Citation

  • Rosella Castellano & Roy Cerqueti, 2013. "Roots and effects of financial misperception in a stochastic dominance framework," Quality & Quantity: International Journal of Methodology, Springer, vol. 47(6), pages 3371-3389, October.
    • Handle: RePEc:spr:qualqt:v:47:y:2013:i:6:p:3371-3389
    DOI: 10.1007/s11135-012-9726-z
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    Cited by:

    1. Hanaki, Nobuyuki, 2022. "Risk misperceptions of structured financial products with worst-of payout characteristics revisited," Journal of Behavioral and Experimental Finance, Elsevier, vol. 33(C).
    2. Rosella Castellano & Marco Mancinelli & Giorgia Ponsi & Gaetano Tieri, 2021. "What if versus probabilistic scenarios: a neuroscientific analysis," Annals of Operations Research, Springer, vol. 299(1), pages 331-347, April.
    3. Doron Sonsino & Yaron Lahav & Yefim Roth, 2022. "Reaching for Returns in Retail Structured Investment," Management Science, INFORMS, vol. 68(1), pages 466-486, January.

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    More about this item

    Keywords

    Stochastic dominance; Behavioral finance; Derivatives pricing; Mispricing; Structured products; C65; D81; G24;
    All these keywords.

    JEL classification:

    • C65 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Miscellaneous Mathematical Tools
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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