Question

1. Differentiate the following terms/concepts:

a. Certainty equivalent and a gamble b. Loss aversion and myopic loss aversion

c. Speculative price bubble and ex post rational stock price

d. Greater fool theory and speculation

Answer 1

1:

Certainity equivalent is a guranteed return that a person will obtain now rather than him taking a higher risky chance later.

Gambling is opposite to certainity equivalent. It is an event with highly uncertain outcome with an aim of obtaining money or goods.

2:

A speculative price bubble is exaggerated increase in price of a commodity or security that happens due to unexplained expectation of growth for that commodity/security. Due to this the asset could increase in price value untill it burst. eg: Dotcom bubble, Bitcoin bubble

Expost is another term for actual returns. Expost rationale stock price is the generally used to find out wheteher the stock market movements are rationale and can be explained by the underlying events or not. This is more scientific approach compared to speculation.

3:

Greater fool theory states that price of an asset is not always represents its intrinsic value whereas its relative demand of the asset. It states that it is possible to make money of an overvalued asset because there will be always someone who is willing to buy it at higher price.

Speculation in finance is the trading practice without any base or evidence on the future outcome. It is an believe trading which hopes an asset once purchased will appreciate without any major underlying reason.