Question 30

Read the following statements and answer the question that follows.
1. Behavioral models in finance most often critique the efficient market hypothesis, which states that if investors behave rationally then prices should reflect all available information about the financial asset in consideration.
2. A number of behavioral models, including feedback models where investors bid up the price, have been used to explain this phenomenon.
3. But asset price bubbles and crashes belie this conclusion.
4. Finance is one of the fields where behavioral models have been used extensively, enough for behavioral finance.
5. This idea of “irrational exuberance” is now widely accepted and used in financial analysis, especially while analyzing asset price bubbles.
Arrange the above five statements in a logical sequence.

Solution

4 is the opening statement as it introduces the idea of using behavioural models in finance. Hence, options B and D are eliminated.

1-3-2 forms a logical sequence as 1 introduces the "efficient market hypothesis", 3 contradicts 1 by giving the example of "asset price bubbles". Statement 2 talks further about the phenomenon.

Statement 5 builds up on 2 by talking about the "irrational exuberance" referring to the "investors bidding up" in 1.

Thus, the required sequence is 4-1-3-2-5.

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