Behavioural Finance

Question 1

The Behavioural Critique:
Describe the Two categories of irrationalities

Answer 1

1. Investors do not always process information correctly.
   - Result: Incorrect probability distributions of future returns.
2. Even when given a probability distribution of returns, investors may make inconsistent or suboptimal decisions.
   - Result: They have behavioral biases.

Question 2

describe the Sources of Limits to Arbitrage: (3 points)

Answer 2

1. Fundamental Risk:
   – Intrinsic value and market value may take too long to converge.
2. Implementation Costs:
   – Transactions costs and restrictions on short selling can limit arbitrage activity.
3. Model Risk:
   – What if you have a bad model and the market value is actually correct?

Question 3

what could be a result of Limits to Arbitrage:

Answer 3

– Violation of Law of One Price – Bubble and Crash