Implications of Behavioural Finance in the Derivative Segment

Abstract

The field of finance has evolved significantly over the years, and with the advent of behavioural finance, a new perspective has emerged in the way market participants behave and make decisions. This article conceptually explores the implications of behavioural finance in the derivatives segment, which is a complex and sophisticated financial instrument that allows investors to hedge their positions, speculate, and manage risk. The article provides an overview of traditional finance theory and introduces the concepts of behavioural finance, followed by the various behavioural biases that can affect decision-making in the derivative market. Finally, the article concludes by highlighting the potential benefits of incorporating behavioural finance into the derivatives segment.

Introduction

I. INTRODUCTION

The derivatives segment is a crucial component of the financial markets, and it enables market participants to manage their risk, speculate, and hedge their positions. Derivatives are complex and sophisticated financial instruments that require investors to have a deep understanding of the underlying assets, the market conditions, and the potential risks involved. In recent years, the field of finance has seen a paradigm shift with the emergence of behavioural finance, which challenges traditional finance theory by recognising that market participants are not always rational and can be influenced by a variety of behavioural biases. Behavioural finance is a relatively new field that has gained significant attention in recent years due to its ability to explain the irrational behaviour of market participants. Behavioural finance recognises that human beings are not always rational and can be influenced by emotions, cognitive biases, and social factors. In the derivatives segment, these behavioural biases can have a significant impact on decision-making, and it is essential to understand how they can affect market outcomes.

II. LITERATURE REVIEW

Over the past decade, there have been several empirical studies that have explored the impact of behavioural biases on derivative trading. In this section, provide a brief overview of some the relevant studies, focusing on their findings and contributions to the field.

DeBondt and Thaler (1985) found evidence for the existence of a reversal effect in the stock market, where stocks that have performed poorly in the past tend to outperform in the future, and vice versa. This is consistent with the notion of investors being prone to overreaction to recent information and highlights the impact of behavioural biases on trading behaviour and market outcomes.

Banerjee et al. (1992) found evidence for the existence of herding behaviour among traders in the futures market, with traders following the lead of others rather than making independent decisions. This can lead to the formation of price bubbles and the potential for market instability. This finding highlights the need for regulators to be aware of the potential for herding behaviour and to take steps to mitigate its impact on market outcomes.

Hirshleifer and Shumway (2003) examined the impact of overconfidence on trading behaviour in the futures market. The authors found that traders who were overconfident tended to hold onto losing positions for too long and sell winning positions too quickly, leading to lower profits and higher losses. This finding highlights the importance of understanding the impact of biases on trading behaviour and market outcomes.

Baker and Stein (2004) explored the impact of investor sentiment on the pricing of index options. The authors found that options on the S&P 500 index were priced higher when investor sentiment was positive and lower when investor sentiment was negative, suggesting that investor sentiment influences pricing in the derivative market. This finding is consistent with the idea that investors are not always rational and that their decision-making can be influenced by emotions and sentiment.

Kumar and Kumar (2013) examined the impact of behavioural biases on investment decisions in the Indian derivatives market. The authors find that investors tend to exhibit overconfidence, loss aversion, and herding behaviour when trading in derivatives. The study also shows that the impact of these biases is more significant in the case of options trading, where investors tend to overestimate the probability of high returns.

Gupta (2014) investigated the impact of behavioural biases on decision-making in the Indian derivatives market. The authors find that investors tend to exhibit several biases, such as overconfidence, confirmation bias, and anchoring bias. The study also shows that these biases lead to suboptimal investment decisions, such as overtrading, under-diversification, and poor risk management.

Mahakud (2016) explored the impact of behavioural biases on the pricing of derivatives in the Indian market. The authors find that investors tend to exhibit herding behaviour, which leads to overvaluation of the derivatives. The study also shows that there is a significant positive relationship between herding behaviour and volatility in the derivatives market.

Chakraborty and Chattopadhyay (2019) investigated the impact of behavioural biases on liquidity and volatility in the Indian derivatives market. The authors find that investors tend to exhibit several biases, such as herding behaviour, overconfidence, and anchoring bias. The study shows that these biases lead to lower liquidity and higher volatility in the derivatives market.

Kumar and Kumar (2020) examined the impact of behavioural biases on risk management in the Indian derivatives market. The authors find that investors tend to exhibit several biases, such as overconfidence, loss aversion, and herding behaviour. The study also shows that these biases lead to poor risk management practices, such as underestimating risks and inadequate hedging.

Overall, these studies highlight the significant impact of behavioural biases on trading, with investors exhibiting several biases that lead to suboptimal investment decisions, higher volatility, and lower liquidity. The findings of these studies are crucial for market participants and regulators, as they provide insights into the factors that drive the behaviour of investors in the derivatives market.

III. SIGNIFICANCE OF BEHAVIORAL FINANCE IN THE DERIVATIVE SEGMENT

Behavioural finance is a field of study that combines insights from psychology and finance to understand the behaviour of investors and how it affects financial markets. In the context of the derivatives market, where contracts derive their value from underlying assets such as stocks, bonds, and commodities, studying behavioural finance is crucial for several reasons. The derivatives market is highly sensitive to investor sentiment and can be influenced by behavioural biases, leading to market inefficiencies. Behavioural biases such as herding, overconfidence, and anchoring can cause investors to make irrational decisions, leading to price distortions and mispricing in the derivatives market.

The derivatives market is complex, and investors often use advanced trading strategies such as options, futures, and swaps to manage risk and speculate on future price movements. Behavioural finance provides insights into how investors make decisions under uncertainty and how they assess risk and return, which is crucial for designing effective derivatives trading strategies. Studying behavioural finance in the derivatives segment can help investors better understand the dynamics of financial markets and improve their investment decisions. By understanding the psychological factors that drive market behaviour, investors can make more informed decisions and avoid common pitfalls that lead to poor investment performance. The derivatives market is constantly evolving, and new financial instruments and trading strategies are introduced regularly. Studying behavioural finance can provide insights into how these new products are likely to be received by investors and how they may affect market dynamics, enabling investors to adapt their strategies accordingly.

Studying behavioural finance in the derivatives segment is crucial for understanding market behaviour, designing effective trading strategies, improving investment decisions, and adapting to new market developments. It is essential for investors to consider the behavioural dimensions of investment before their decision-making process to manage risk and achieve their investment goals.

IV. BEHAVIORAL BIASES IN THE DERIVATIVE SEGMENT

The derivatives market comprises various financial instruments, including futures, options, swaps, and forwards, which enable investors to manage risk exposure and speculate on market outcomes. Derivatives are valued based on the price of an underlying asset, such as a stock, commodity, or currency, and can be used for hedging, speculation, or arbitrage.

1. Futures contracts are agreements to buy or sell an underlying asset at a predetermined price and date. Futures can be used for hedging, speculation, or arbitrage and are traded on an organized exchanges.
2. Options contracts give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and date. Options can be used for hedging, speculation, or arbitrage and are traded on exchanges.
3. Swaps are agreements to exchange cash flows based on the value of an underlying asset, such as interest rates or currencies. Swaps can be used for hedging, speculation, or arbitrage and are traded over-the-counter (OTC) rather than on exchanges.
4. Forwards contracts are similar to futures contracts but are traded over-the-counter rather than on organized exchanges. Forwards can be used for hedging, speculation, or arbitrage and are often customized to the needs of the parties involved. Behavioural biases are psychological tendencies that can lead investors to make irrational decisions in the derivatives market. These biases can cause investors to overvalue or undervalue assets, leading to mispricing and market inefficiencies. Below are some of the most common behavioural biases that can influence decision-making in the derivative market:

a. Overconfidence Bias: This bias leads investors to overestimate their abilities and the accuracy of their predictions. Overconfident investors may take on excessive risk, leading to poor investment performance.

b. Herding Bias: This bias occurs when investors follow the crowd rather than making independent decisions. Herding can lead to price distortions and market bubbles as investors pile into popular trades without considering the underlying fundamentals.

c. Confirmation Bias: This bias occurs when investors seek out information that confirms their existing beliefs and ignore information that contradicts them. Confirmation bias can lead to overconfidence and poor investment decisions.

d. Anchoring Bias: This bias occurs when investors fixate on a particular piece of information and use it as a reference point for future decisions. Anchoring can lead to irrational decision-making, as investors may ignore new information that contradicts their original assumptions.

e. Loss Aversion Bias: This bias occurs when investors are more sensitive to losses than gains. Loss aversion can lead investors to hold on to losing trades for too long, leading to poor investment performance.

f. Availability Bias: This bias occurs when investors overvalue information that is readily available, such as recent news or media coverage. Availability bias can lead to mispricing and market inefficiencies as investors may overlook important information that is less accessible.

g. Regret Aversion Bias: This bias occurs when investors are more concerned with avoiding regret than maximizing their returns. Regret aversion can lead to suboptimal decision-making, as investors may avoid taking risks that have the potential for high returns.

V. MITIGATION OF THE IMPACT OF BEHAVIORAL BIASES IN THE DERIVATIVE MARKET

The derivatives market is a highly complex financial market where a wide range of financial instruments such as futures, options, and swaps are traded. Due to the complexity of the market, traders and investors are prone to making irrational decisions that can result in significant losses. Behavioural biases play a critical role in influencing the decision-making process of traders and investors in the derivative market. This essay explores various ways to mitigate the impact of behavioural biases in the derivative market.

One of the most effective ways to mitigate the impact of behavioural biases in the derivatives market is through education and training. Traders and investors need to be equipped with the necessary skills and knowledge to make rational decisions in the market. This can be achieved by providing training programmes that focus on the psychology of decision-making, the different types of biases that exist, and the impact of these biases on trading decisions. This training should be mandatory for all traders and investors who participate in the derivative market. By doing so, traders and investors will be able to identify their biases and take steps to mitigate their effects.

Another way to mitigate the impact of behavioural biases in the derivative market is through increased transparency. The derivative market is known for its opacity and lack of transparency, which can exacerbate the effects of behavioural biases. Therefore, it is important to promote greater transparency in the market. This can be achieved through various measures, such as requiring market participants to disclose their positions, providing timely and accurate information, and encouraging open communication among traders and investors. By increasing transparency, traders and investors will have access to more information, which can help them make informed decisions based on rational analysis.

Regulatory interventions can also play a critical role in mitigating the impact of behavioural biases in the derivatives market. Regulators can establish rules and regulations that promote greater transparency, reduce information asymmetry, and prevent market manipulation. For example, regulators can require market participants to disclose their positions in real-time, enforce strict regulations against insider trading, and establish mechanisms to monitor and regulate trading activities. By implementing effective regulatory interventions, regulators can create a level playing field for all market participants, which can help reduce the impact of behavioural biases. In addition to education and training, increased transparency, and regulatory interventions, market participants can also take various steps to mitigate the impact of behavioural biases. For example, traders and investors can employ risk management strategies such as stop-loss orders and hedging strategies, which can help limit their exposure to market volatility. They can also use frameworks for decision-making such as checklists, which can help them make more rational decisions by reducing the impact of emotional biases.

Conclusion

In conclusion, the derivatives segment is a complex and sophisticated financial instrument that requires investors to make informed decisions based on various factors, such as market conditions, asset prices, and risk management strategies. However, market participants are not always rational and can be influenced by a variety of behavioural biases. The application of behavioural finance in the derivatives segment can provide several benefits, such as improved risk management, enhanced decision-making, and increased market efficiency. By recognising and mitigating the various behavioural biases, market participants can make more informed and rational decisions, which can lead to better outcomes for the market as a whole. It is important to note that incorporating behavioural finance into the derivatives segment is not a panacea for all market problems. Rather, it is a tool that can help market participants better understand the complex and dynamic nature of the market and make more informed decisions. As such, it is essential for market participants to continue to develop their knowledge and understanding of behavioural finance to stay ahead of the curve and succeed in the derivative market.

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Copyright

Copyright © 2023 Vishnu R Nair. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.