BF

Question 1

Present a list with the three Judgment heuristics and define them

Answer 1

Representativeness, availability and anchoring are the three heuristic rules, or “rules of thumb” used to evaluate the likelihood of events.

Representativeness:
The tendency to evaluate the likelihood of an event on the basis of how similar the event is to the stereotype of a parent population. (conjunction fallacy).
How much its features are representative of the overall process by which it was generated.
this might lead to base rate neglect

Availability:
The availability heuristic is a mental shortcut towards an idea about the likelihood of an event. The mental shortcut depends on how easily the event comes to mind. Important factors which strengthen the availability heuristic are Recency, Salience and Imaginability

Anchoring:
As it is called, this is the tendency to anchor beliefs to a reference point. the reference point can be both relevant and irrelevant.
The causes of anchoring are “selective accessibility” or “anchoring and adjusting”.

Question 2

What are the challenges to market efficiency presented in the course?

Answer 2

Excess volatility:
Higher volatility in price compared to the dividends contradicts P_t =D+u_t

Past winners tend to perform badly compared to past losers

Siamese Twins should perform proportionally.
However, Royal dutch and Shell Transport should be similar on a 1.5:1 basis, but there are clear deviations from this ratio in the prices.

There should be no reaction to no news, but 1987 proved otherwise.
Also, the 50 largest price movements since WWII was accompanied by no news.

Question 3

In relation to prospect theory, what is the argument behind the weights that are added to probabilities?

Answer 3

Irrational high weights on low probabilities and low weights on average probabilities.

Question 4

What does prospect theory describe?

Answer 4

prospect theory describes decisions under uncertainty and therefore risk (descriptive model).

Question 5

Prospect theory is modelled through two different steps, the editing phase and the evaluation phase.
What does the editing phase consist of?

Answer 5

Editing phase consist of heuristic rules used to organize, simplify and reformulate choices under uncertainty. Five major operations in editing:

simplification:
Prospect are likely to be rounded off. 49 % is 50 %,
and very small probabilities are discarded

Coding: outcomes are percieved as gains or losses and not as a final state of welfare. This, of course, needs a reference point

Combination:
similiar outcomes will be combined into a higher probability of one outcome.

Segregation:
The riskless outcome is seperated from its risky component so with the prospect (300,0,8;200;0,2), the riskless 200 is sperated and the game is simply perceived as 0,8 probability of 100.

Cancellation:
Any similar outcomes between two choices are cancelled out from the choice.

Detection of dominance: Outcomes are scanned and rejected if strictly dominated.

Question 6

Prospect theory is modeled through two different steps, the editing phase and the evaluation phase.
What does the evaluation phase consist of? also explain subadditivity, subcertainty and subproportionality (because I cant)

Answer 6

The evaluation phase consist of a choice by the decision maker which chooses the outcome with the highest value V.

V is expressed as a function of v(x) and pi(p). v(x) reflects the decision makers valuation of the outcome x and pi(p) is an assigned weight to the probability p.

The values of pi(p) and v(x) reflect experimental evidence.
Possible valuefunction v(x) captures riskaversion in gains, riskseeking in losses and that losses are given more weigth than gains even if the amplitude is the same.

pi(p) is of course increasing, but contains subadditivity, subcertainty and subproportionality.

Question 7

What does the value function suggested by KT in 1979 look like? what about the wighting function?

Answer 7

v(x)=(x^a) if x>0
v(x)=(-lambda(-x)^b) if x<0

“a” is the factor of risk aversion
“b” is the factor of risk loving

the weighting function:

(p^y)/((p^y+(1-p)^y)^(1/y)) with y being different depending on whether or not p>0

Question 8

In which areas of finance could prospect theory be relevant? (areas mentioned in the course)

Answer 8

There are three different areas of connection.

Cross section of average returns:
consistent with PT, a security’s skewness can explain over or underpricing of assets, and therefore changes the expected return.
a positive skew would mean a small change of a big return, and with small propabilities being overweighted
investors will push the price higher than in an economy with EU investors. takeoff from empirical results:
positive skewed returns are positively negatively correlated with average returns. (IPO is positively skewed)

Aggregate stock market :
equity premium puzzle

Trading of financial assets over time:
PT is used to explain the disposition effect, which is the tendency to keep losers and sell winners.

Question 9

what is the disposition effect and how can prospect theory explain it?

Answer 9

The disposition effect is the observed phenomena of traders selling their winning assets and keeping their losers. This is, of course, defined given a certain reference point. This is particular puzzling due to the observed momentum effect in asset prices, which indicates that winners will win more in the future.

The disposition effect is particularly salient when selling apartment or houses as presented by Genesove and Mayer (2001)

Prospect theory says that investors are risk-averse in the gain domain and risk seeking in the loss domain, hence explaining the disposition effect.

Question 10

Which underlying psychological mechanism can explain the observed ambiguity aversion?

Answer 10

Trying to avoid criticism, since decisions are backed up by fewer facts.

Question 11

Under which tradition framework is the equity premium indeed a puzzle?
How can behavioral finance explain this?

Answer 11

using simple risk aversion to explain the willingness to hold the riskfree assets.

Myopic Loss Aversion is a combination of loss aversion, the relatively larger fear of losses and a relative frequent update of price information. The short-term view of investments puts a higher weight on losses and therefore risk-free assets becomes more attractive.

Question 12

Which type of assets is prone to a high level of ambiguity aversion?
How can ambiguity aversion explain the equity home bias puzzle?

Answer 12

IPO’s, shares of smaller firms, small privately held companies.

The equity home bias puzzle is the observation of investors having a large share of national equity, even though historical data suggests benefits from international diversification. This could be explained by less knowledge about foreign assets and therefore higher ambiguity for the individual investor.
french and Poterba (1991) shows an average sacrifice of 3%

Question 13

What is the most important facets of overconfidence?

Answer 13

Miscalibration:
Overestimate the precision of their knowledge

Positive illusion:
Tendency of people to see themselves as better than average

Illusion of control:
Illusion of control over acutally random processes or processes with no posiblity to influence.

Unrealistic optimism:
almost the same as positive illusion but its an overly relative positive forecast about the individuals future.

Question 14

Which psychological biases contribute to overconfidence?

Answer 14

Self-attribution bias
to attribute succes to one self and failure to others

Hindsight bias
“i knew it all along”

Confirmation bias
searching for evidence consistent with prior beliefs.

Question 15

Overconfidence in finance is among other things seen as excessive trading volume. How does Glaser and Weber (2007) test the relation between overconfidence and trading volume?

Answer 15

First, with more overconfidence among traders there will be more different believes about the value of an asset which opens up trades.
Glaser and Weber (2007) tests this hypothesis through internet questionaire testing the participants for overconfidence ( testing miscalibration, positive illusion, illusion of control and unrealistic optimism), one finds that the overconfident tend to trade more.
People who trade more tend to think they are better than average
They also find that the predicted variance of the asset tend på to be lower than what historical data shows. They give themselves a too narrow confidence interval.

Question 16

In the context of Behavioral corporate finance, what are the goals of managers

Answer 16

Managers have three goals: maximizing fundamental value, catering to the wishes of the short-term investors and market timing.

Question 17

What was Barber and Odean’s findings in relation to genders and overconfidence? Can something else than overconfidence explain their result?

Answer 17

Barber and Odean (2001)

Their study assumes that men are more overconfident than women, given research suggesting this.

They test if men trade more than women
And if trading more hurts the performance of their portfolio

they find highly significant results supporting this.

A difference in risk aversion among could explain their results and not overconfidence. However, with lower risk aversion comes more trades, which should improve the portefolio, but the results show bad performance. Therefore, risk aversion could not explain it alone.
Gasmbling is also a plausible alternative. Trading for intertainment could explain higher trading volume among men, and worse performance.

Question 18

What underlying psychological phenomena could explain the heuristic judgment called anchoring?

Answer 18

selective accessibility:
Selectively retrieve knowledge that is consistent with an anchor, hence a valuation relatively closer to the anchor.

Tversky and Kahneman’s “Anchoring and adjusting” is the idea that people set an anchor as a starting point and adjust away to a supposedly final answer. However,m pople adjust insuffeciently making the final answer biased towards starting point.

Question 19

Mention how the three judgments heuristics Representativeness, availability and anchoring can affect financial decision making.

Answer 19

The representativeness heuristic can affect the belief of what is a good or a bad investment. If a company has a high-quality management and a strong image and growth, one might think it is a good investment, but all this should already be embedded in the price.
Shefrin and Statman (1995) use a survey from fortune magazine asking executives about their belief about companies quality of long term investment. They find that the quality of management, size and the book to market ratio is positively correlated with the idea of a good long-term investment.

Momentum-chasing can also affect financial decision making. Given a stock has risen a lot, investors are prone to invest more in that stock. This can be seen as representativeness, as the past performance represents the future. It can also be seen as availability since the near past performance is easier to imagine.

Availability can also be seen considering a specific market. If a company in a particular market encounters bad news, then bad news in the whole market is seen as more “available”.

The level of the price of a stock or index is arbitrary, but the changes in the price is consistent with the news. It can, therefore, be said that stock prices are anchored to yesterdays price.

anchoring can also be seen on the real estate market. Northcraft and neale finds that only 25 % of real estate agents mentions list price as a factor they use to price a house, but th data shows otherwise using two different groups of real estate agents who are given a different listing price for the same house. They also find that higher list price gives a higher influence which in behavioral finance can be explained by salience.

With attention being a scarce resource, it would be natural to think that the availability heuristic has an influence on the trading volume of stocks that is usually mentioned in the news.

Question 20

How is time preferences tested and what is the usual main result?

Answer 20

Time preferences are often tested via simple choice experiments where the participants can choose between “sooner and smaller” or “later and larger”

Thaler finds that short-run discount rates are higher in the short run compared to the long run. Said differently, we tend to become more patient the further away the consequences lie.

Question 21

Define Conservatism Bias. Which underlying psychological mechanism could explain the conservatism bias?

Answer 21

conservatism bias is a tendency among people to not sufficiently change their beliefs when given new information. (compared to Bayes’ rule). This phenomenon can be explained by anchoring and costly information processing.

Question 22

Mention one or more experiments capturing the judgment heuristics called anchoring

Answer 22

Ariely, Loewenstein and Prelec (2003), conducted an experiment on 55 students who were asked if they wanted to buy goods for the prices equal to the last digits of their social security number. Afterward, they should state their Maximum willingness to pay for the good. They find a clear positive correlation between the social security number and the Maximum willingness to pay.

Question 23

Mention one experiment capturing the judgment heuristics called availability

Answer 23

K and T askes the question if it is more likely that a random word starts with a K og that K is its third letter

People tend to believe the K at the beginning is more likely since it easier comes to mind -> more available

Question 24

TRUE OR FALSE

Investors usually react with the self-attribution bias after a market bubble bursts.

Answer 24

FALSE

They react with hindsight bias, they think they knew it all along.

Question 25

One way to measure the irrationality behind a strong rise in a price is through the price earnings ratio. What are the shortcomings of this measure?
How can salience theory or prospect theory explain a strong bull market?
Can the judgment heuristics explain an insane bull market?

Answer 25

The price earnings ratio gives an idea about whether or not earnings justify the stock prices. However, with expected high future earnings, the ratio becomes insufficient.
Many experiments has shown that if participants are given a choice between two assets with the same expected value and one of them is a lottery asset (small probability to win alot), then they choose the lottery asset. A high demand for risky assets drives up the stock price indices.
prospect theory can explain this through the high weights on the small probabilities, and salience theory can explain this since the high payof is more salient.

Question 26

TRUE OR FALSE

“Bubbles can grow big and mighty, but by simply restricting short selling everything will be alright”

Answer 26

FALSE
By restricting short selling, it is only the pessimistic market participators who affects the stock price by selling the stock and leaving the market. Therefore, short selling opens up for pessimistic investors entering the market driving the price down which gives a price that reflects the view of the whole market.

Question 27

According to Mamendier and Tate (2005), why is there a positive relationship between the sensitivity of investment to cash flow and executive overconfidence?
(no idea)

Answer 27

CEO thinks the market understates R(i)

Unwilling to issue shares to finance desired investment level

Question 28

How is the goals “maximizing fundamental value” and “maximize the current share price of the firms securities” distinct when there is irrationa investors?

What is third goal for the manager?

Answer 28

In a perfect capital market, the market price of shares should be equal to the fundamental value. However, with irrational investors, the second goal for the managers are instead to “cater” for short term investors

The third goal is to exploit the misipricing from the irrational investors by supplying securities when they are overvalued and buying them back at a lower price. (market timing). Maximizing the stockprice becomes an objective in its own right

Question 29

TRUE OR FALSE

“If a firm’s stock is undervalued, managers would be more willing to invest in projects”

Answer 29

FALSE
Manager would be more willing to spend cash on repurchasing shares and create value through rising stock prices. This decision also depends on

Question 30

How does the Hurdle rates depend on the net present value of a repurchase of shares if the manager is constraint by capital structure?
what is the hurdle rate based on If managers can take on debt?

Answer 30

Given a contraint by capital structure the hurdle rate depends on the net present value of a repurchase of stocks and the available equity to finance the project.
If manager can take on debt i.e uncotraint by apital strcture, then the hurdle rate of the project only depends on the fundamental value and cost of debt. He chould therefore choose to repurchase share and invest in the project.

Question 31

Conservatism is closely related to anchoring. Name the three initial values from which people can adjust when being conservative mentioned in the lecture slides?

Answer 31

1. Prior information people have, Urn example
2. The result of partial computation, sequence example 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8 vs. 8 x 7 x 6 5 x 4 x 3 x 2 x 1
3. A value given from by the formulation of the problem, however unrelated to the answer, example: First number between 1 and 100 is determined by spinning wheel of furtune. Second people are asked to estimate the number of African countries in the United Nations.

Question 32

How is autocorrelation related to underreaction?

Answer 32

Stock prices incorporate information slowly, leading to trend in returns over short horizons. Cutler et al. (1991) found that there is positive autocorrelation in index returns over horizons between one month and one year.
Autocorrelation: Each observation is statistically dependent on the previous one.

Question 33

What is the main difference between the two models in the model of Investor sentiment that can accommodate both over- and underreaction?

Answer 33

The main difference between the two models lie in the transition probabilities given by π_L<0.5 and 〖0.5

Question 34

What does it mean that the model 1 and model 2 are Markovs?

Answer 34

The state of the world today only depends on the state of the world in the previous period. Formally y_t only depends on y_(t-1).

Question 35

State the condition which allows for both over- and underreaction in the models?

Answer 35

Deviation from fundamental value: y_t (p_1-p_2q_t)
Underreaction:
Deviation from fundamental value must be negative on average, because people are underestimating the fundamental value:
p_1 p_2 〖q〗_low

Combining these two conditions yields the combined condition:
p_2 〖*q〗_low

Question 36

1. What is the difference between the “irrational investors approach” and “irrational managers approach”? What is assumed about the market in the different approaches?

Answer 36

a. Irrational managers: Managers have behavioral biases (e.g. overconfidence). This approach retains the rationality of investors, but limits the governance mechanisms they can employ to constrain managers. Irrational investors: Securities market arbitrage is imperfect, prices can be too high or too low. Rational managers are assumed to perceive mispricing, and to make decisions that encourage or respond to mispricing

Question 37

2. What are the implications on financing and investment levels, when CEOs are overconfident?

Answer 37

a. Given perfect markets, financing method does not matter (lending, issuing shares, cash financing). Therefore, if the CEO is rational, the optimal level of investment is equal to the fist best level, independent of the cash and debt capacity. However, if the CEO is overconfident, he thinks the market undervalues the company, and therefore he is less willing to issue shares. Therefore, the level of investment is increasing in cash holdings and dept capacity, as these are seen as “cheaper” financing methods. Furthermore, if the CEO is overconfident, then the choice of investment level is higher than the first best. (What about low levels of D and C?)

Question 38

3. Given irrational investors, how many different goals can the managers have, and are they conflicting? Why/why not?

Answer 38

a. Three conflicting goals: Maximize fundamental value, Maximize the current share price of the firms securities & exploit the current mispricing for the benefit of existing, long-run investors. If funds are limited, all goals cannot be achieved, as e.g. investment funds available should be used on projects given goal 1, but buyback of shares given goal 3 (not always, but scenario could arise)

Question 39

5. What are hurdle rates, and how does the managers goal affect them?

Answer 39

Hurdle rate: The rate of return a project must deliver for the manager to invest in it. Given a fundamental value approach, the hurdle rate will be equal to the cost of financing (perhaps a risk premium). However, if funds are limited and managers have a “market timing” goal, the hurdle rate could be higher, because the project has to give a higher ROI than a share buyback. Therefore NPV > 0 Projects will not always be invested in. If funding is unlimited, NPV > 0 will always be invested in, no matter the managers goal.

Question 40

What has recent literature acknowledged about our attention ability, which is what led to salience theory?

Answer 40

That it is limited and predictively drawn to specific features of our environment.

Question 41

What empirical phenomena does salience theory try to explain?

Answer 41

It is a novel, unified explanation of many empirical phenomena, e.g. frequent risk seeking behavior, Allais paradox (bonus question: explain this), preferences for assets characterized by high, salient payoffs.
 

Question 42

What is the Sebald et al. experiment designed to test for?

Answer 42

Salience effects in choices under risk. The last part is the new thing.

Question 43

Explain the experiment setup, and how they identify salience effects.

Answer 43

Internet based experiment with rounds where participants got an endowment of which they had to spend a certain amount on either Gamble A (the risky one) or Gamble B (where you always get the same output). The good output of A is larger than the safe output from B which is again larger than the bad output from A. So if individuals bet more on A, they gain more if they are lucky, but they also lose more if they are unlucky. Salience effects are identified by varying the return numbers while keeping the prospects fixed.

Question 44

How does a salient thinker choose the amount to bet?

Answer 44

He/she maximizes wgpv(cg) + wb(1-p)v(cb). w are the decision weights placed on state s. There is greater weight on more salient states. If xs/xf is farther from 1, state s is more salient.

Question 45

What are the experiment findings?

Answer 45

They find evidence of a salience effect on risk taking independent of risk preference and probability weighting.