Asset Pricing and Investor Irrationality

This diploma thesis is inspired by theoretical models in subject area of behavioral finance. Nevertheless, it also focuses on real-life issues related to a limitation of arbitrageurs, who are assumed to be hedge fund managers, in bringing stock prices towards fundamental values promoting market efficiency thereby. The limitation arises from irrationality of wealthy investors that tend to withdraw money from a hedge fund exactly when expected return is the highest. Although a lot of research has been done so far in this topic, there are still open questions about influence of performance-independent external funds and fundamental risk on arbitrageur’s behavior. Based on already developed model, I try to expand its logic by refining a basic specification and simulating it together with the modifications using R programming language where necessary. My prime results are that allowing for arbitrageur to exploit external debt cannot improve his efficiency as previously thought, while fundamental risk influence is, in contrast, favorable. Remember about arbitrageur risk-neutrality assumption. In addition, there exists a principal-agent problem that acts as a source of investor irrationality. A resolution of information asymmetry eliminates alleged irrationality triggered by noise traders’ sentiments regarding asset value and restores arbitrageur price correction power. The methods of doing this are stated and critically evaluated. Besides, there is also an attempt to establish a link between arbitrageurs and predatory traders in financial markets and explain how their interaction affects overall economic stability. My reasoning, if correct, justifies strong government and self- regulation of financial markets.