BF Exam questions

Question 1

What is the difference between rationality and irrationality concerning beliefs in decision-making?

Answer 1

Rationality concerning beliefs means that if people receive new information, they update their beliefs instantly and correctly. Irrationality concerning beliefs means that beliefs are not updated instantly or correctly.

Question 2

What is prospect theory?

Answer 2

The prospect theory, developed by Daniel Kahneman and Amos Tversky, suggests that people make decisions based on the potential value of losses and gains rather than the final outcome. The theory includes four elements: reference dependence, loss aversion, diminishing sensitivity, and probability weighting.

Question 3

What is Expected Utility Theory (EUT)?

Answer 3

Expected Utility Theory (EUT) is a theorythat suggests that when individuals are faced with a choice, they try to make the decision that will likely give them the most happiness or satisfaction, given their beliefs and preferences.

Question 4

What is short-term momentum and long-run reversals in stock returns?

Answer 4

Short-term momentum refers to the positive correlation in stock returns over short horizons, especially after earnings announcements. Long-run reversals refer to the negative correlation in stock returns over long horizons (3-5 years).

Question 5

What is the role of overconfidence and loss aversion in financial decision-making?

Answer 5

Overconfidence can lead to underestimation of risk and too much certainty about forecasts, while loss aversion can lead to risk-averse behavior, especially after experiencing losses. These biases can interact and potentially lead to irrational financial decisions.

Question 6

Can you provide examples of anomalies in the cross-section of returns?

Answer 6

Examples of anomalies in the cross-section of returns include the size premium, long-term reversal, and value premium. The size premium refers to the observation that smaller firms tend to outperform larger ones. Long-term reversal refers to the tendency of stocks with poor past performance to outperform stocks with good past performance over the long term. Value premium refers to the tendency of value stocks (those with high book-to-market ratios) to outperform growth stocks (those with low book-to-market ratios).

Question 7

What are belief-based models when it comes to explaining anomalies?

Answer 7

Belief-based models are used to explain anomalies by considering the role of investors’ beliefs and perceptions. These models suggest that anomalies may arise due to investors’ overconfidence, biased expectations, or limited attention, etc.

Question 8

What is the difference between systematic risk and idiosyncratic risk?

Answer 8

Systematic risk refers to the risk that affects all securities in the market and cannot be diversified away. On the other hand, idiosyncratic risk is specific to a particular security and can be reduced through diversification.

Question 9

How does gender play a role in finance?

Answer 9

Research suggests that gender can influence financial decision-making. For example, women are often found to be more risk-averse than men and may be less overconfident in their financial decisions. Additionally, there is a gender gap in financial literacy, with men often scoring higher than women.

Question 10

How does the concept of anomalies in asset pricing relate to the Efficient Market Hypothesis (EMH)?

Answer 10

Anomalies in asset pricing challenge the Efficient Market Hypothesis. According to EMH, asset prices should fully reflect all available information. However, anomalies such as the size premium, value premium, and long-term reversal suggest that there are predictable patterns in returns that cannot be explained by the available information, indicating that markets may not be fully efficient.

Question 11

How does overconfidence contribute to the anomalies observed in asset pricing?

Answer 11

Overconfidence can lead investors to trade more frequently than is optimal, based on the belief that they have superior information or abilities. This excessive trading can create price pressures that deviate from fundamental values, contributing to anomalies such as momentum and reversal effects.

Question 12

How does limited attention impact the disposition effect in investment decisions?

Answer 12

Limited attention can exacerbate the disposition effect. Investors may pay more attention to their winning stocks and sell them too quickly, while neglecting their losing stocks and holding on to them for too long. This behavior can lead to suboptimal investment decisions and lower returns.

Question 13

How does financial literacy influence the ability of investors to diversify their portfolios and manage risk?

Answer 13

Financial literacy equips investors with the knowledge and skills to understand the importance of diversification in risk management. Investors with higher financial literacy are more likely to hold diversified portfolios, which can help reduce idiosyncratic risk and improve risk-adjusted returns.

Question 14

How does the concept of libertarian paternalism apply to financial decision-making and the design of financial products and services?

Answer 14

Libertarian paternalism suggests that it’s possible to design choices in a way that “nudges” individuals towards better outcomes without restricting their freedom of choice. In the context of financial decision-making, this could involve designing financial products and services in a way that encourages behaviors like saving for retirement, investing in diversified portfolios, or avoiding high-cost debt.

Question 15

How does the peer effect influence financial anomalies like momentum and reversal effects?

Answer 15

The peer effect can contribute to financial anomalies as investors may be influenced by the actions of their peers. For example, if a group of investors starts buying a particular stock, it may drive up the price and create a momentum effect. Conversely, if investors start selling a stock, it could lead to a reversal effect.

Question 16

How does neuroeconomics help us understand the behavioral biases that contribute to financial anomalies?

Answer 16

Neuroeconomics combines economics, neuroscience, and psychology to study how individuals make economic decisions. By understanding the neural mechanisms behind decision-making, neuroeconomics can provide insights into behavioral biases like overconfidence, loss aversion, and limited attention that contribute to financial anomalies.

Question 17

How does gender influence financial literacy and the propensity to exhibit behavioral biases in financial decision-making?

Answer 17

Research suggests that there are gender differences in financial literacy, with men often scoring higher than women. Additionally, women are often found to be more risk-averse and less overconfident in their financial decisions, which can influence their investment choices and financial outcomes.

Question 18

What are the four key features of experience effects as discussed in Article 1?

Answer 18

The four key features of experience effects are: (1) Long-lasting effects of past experiences, (2) recency bias, (3) different processing of stimuli, and (4) personal experiences affecting even experts.

Question 19

How does personal shopping experiences influence individuals’ perceptions and expectations of inflation according to the empirical evidence presented in Article 1?

Answer 19

Personal shopping experiences significantly influence individuals’ perceptions and expectations of inflation. Past high inflation exposure predicts higher fixed-rate mortgage balances and overestimation of future nominal interest rates.

Question 20

What is the significance of neural plasticity in the context of experience effects as discussed in Article 1?

Answer 20

Neural plasticity allows for structural brain changes, which enables the long-lasting effects of past experiences, recency bias, different processing of stimuli, and the influence of personal experiences on experts.

Question 21

How does the author suggest remedying persistent imbalances caused by experience-based learning in Article 1?

Answer 21

To remedy persistent imbalances, it’s essential to actively expose underrepresented groups to similar environments where others thrive.

Question 22

How can the concept of neuroeconomics, mentioned in the notes, help in understanding the experience effects discussed in Article 1?

Answer 22

Neuroeconomics, which combines economics, neuroscience, and psychology, can provide insights into the neural mechanisms behind decision-making. This can help in understanding how past experiences, including personal and professional experiences, can rewire the brain and influence economic decisions, as discussed in Article 1.

Question 23

How does the concept of experience effects discussed in Article 1 relate to the behavioral biases mentioned in the class?

Answer 23

Experience effects, as discussed in Article 1, refer to the impact of past experiences on current beliefs and behaviors. This concept is closely related to behavioral biases mentioned in class. For instance, overconfidence, loss aversion, and limited attention can all be influenced by past experiences. For example, an investor who has experienced significant losses in the past may become more loss averse, while those with successful investments may become overconfident.

Question 24

What is the prospect theory and how does it influence investor behavior as discussed in Article 2?

Answer 24

Prospect theory is a behavioral economic theory that suggests people don’t make decisions based solely on expected outcomes, but also evaluate them based on a reference point and are more sensitive to losses than gains. This theory predicts biases such as loss aversion, the endowment effect, and the framing effect.

Question 25

How does the model presented in Article 2 incorporate prospect theory and narrow framing?

Answer 25

The model incorporates traditional mean-variance preferences and a term-capturing prospect theory and narrow framing. It adopts the generalized hyperbolic skewed t distribution for asset returns to accurately capture skewness and fat tails.

Question 26

How does the prospect theory discussed in Article 2 explain the anomalies in asset pricing mentioned in the class?

Answer 26

Prospect theory, as discussed in Article 2, suggests that people evaluate decisions based on a reference point and are more sensitive to losses than gains. This can explain anomalies in asset pricing, as investors may overreact to negative news (loss aversion) and underreact to positive news (disposition effect), leading to predictable patterns in returns that deviate from the predictions of the Efficient Market Hypothesis.

Question 27

What are some of the anomalies that the model successfully explains and where does it struggle according to Article 2?

Answer 27

The model successfully explains 14 anomalies, including momentum, failure probability, idiosyncratic volatility, and gross profitability. However, it struggles to explain nine anomalies, including size and value, due to a discrepancy between the predicted and empirical alphas.

Question 28

What are the three dimensions in which the new model offers significant advances in research on prospect theory applications in finance in Article 2?

Answer 28

The three dimensions are theory, empirics, and scope. The model marks the first time a behavioral model has been used to make quantitative predictions about such a wide range of anomalies.

Question 29

How does the concept of narrow framing in Article 2 relate to the behavioral biases mentioned in the notes?

Answer 29

Narrow framing refers to the tendency of individuals to evaluate decisions in isolation, without considering the broader context. This concept is closely related to behavioral biases like overconfidence and limited attention, as these biases can lead investors to focus narrowly on specific information or experiences, neglecting other relevant factors.

Question 30

How does investor inattention affect stock returns according to the findings in Article 3?

Answer 30

Investor inattention leads to a lower immediate stock response and a larger delayed response for earnings announcements made on Fridays. This suggests that investors underreact to Friday announcements but eventually correct their trading strategies.

Question 31

What is the significance of the day of the week in the context of earnings announcements as discussed in Article 3?

Answer 31

The day of the week is significant as the immediate stock response is about 15% lower for earnings announcements on Fridays than for non-Friday announcements. The delayed response is about 70% larger for Friday announcements, suggesting that investor attention varies by the day of the week.

Question 32

How does the volume response to earnings announcements made on Fridays differ from that of other weekdays according to Article 3?

Answer 32

The volume response to earnings announcements made on Fridays is significantly lower compared to non-Friday announcements. This suggests a significant disparity in investor attention and subsequent trading volume on Fridays.

Question 33

What are some of the alternative explanations investigated for the distinctive volume patterns observed in the context of Friday announcements in Article 3?

Answer 33

The article investigates alternative explanations that might account for the disparity in volume response, including information processing time, pre-announcement release, announcement delay, and firm heterogeneity. However, these factors do not provide a comprehensive explanation for the distinctive volume patterns observed in the context of Friday announcements.

Question 34

How does the concept of limited attention discussed in Article 3 relate to the behavioral biases mentioned in the notes?

Answer 34

Limited attention, as discussed in Article 3, refers to the tendency of investors to overlook or neglect certain information. This concept is closely related to behavioral biases like overconfidence and loss aversion, as these biases can lead investors to focus excessively on certain information (such as gains or losses) while neglecting other relevant information.

Question 35

How can the findings of Article 3 be explained by the concepts of neuroeconomics and behavioral finance?

Answer 35

The findings of Article 3, which suggest that investor inattention influences stock returns, can be explained by concepts from neuroeconomics and behavioral finance. Neuroeconomics can provide insights into the neural mechanisms that lead to inattention, while behavioral finance can explain how this inattention influences financial decisions and market outcomes.

Question 36

According to Daniel Kahneman, society often reward leaders that are overconfident. Why do we choose leaders that are overconfident?

Answer 36

Overconfident leaders are often chosen because they project certainty and decisiveness, which can be reassuring and inspiring. However, their overconfidence can lead to risky decisions and a lack of flexibility.

Question 37

Can you name one good thing and one bad thing about overconfident leaders?

Answer 37

One good thing about overconfident leaders is their ability to inspire and motivate others. A downside is that they may underestimate risks and overestimate their own abilities, leading to poor decisions.

Question 38

Do you think you would invest better if you were to follow the advice of a financial advisor? Why (not)?

Answer 38

Whether investing with a financial advisor would be better depends on individual circumstances. Advisors can provide expert knowledge and help avoid emotional decision-making, but they also come with fees and potential conflicts of interest.

Question 39

What biases could you possibly encounter when having to choose a financial advisor? Specify whether these affect you or the advisor.

Answer 39

Biases when choosing a financial advisor could include confirmation bias (favoring information that confirms your pre-existing beliefs) and halo effect (assuming someone is good in all areas because they excel in one).

Question 40

According to Kahneman, being an optimist can be useful under some conditions. Can you think of some conditions or situations in which it can be useful?

Answer 40

Optimism can be useful in situations that require perseverance and resilience, such as entrepreneurship or challenging projects.

Question 41

Daniel Kahneman offers a couple of solutions to acting irrationally. One of them is to avoid overly strong emotions to events. This is often easier said than done. What does Dan Ariely suggest is a way to make decisions that are less affected by emotions?

Answer 41

Dan Ariely suggests using pre-commitment strategies to make decisions less affected by emotions. This involves making decisions in advance, before emotions are heightened.

Question 42

Another way to make people act more rational is to financially educate people (make them more numerate / financially literate). Why does this help?

Answer 42

Financial education helps people act more rationally by improving their understanding of financial concepts and risks, enabling them to make more informed decisions.

Question 43

We discussed in class that self-attribution bias can make us more overconfident over time. Can you think of a way to minimize self-attribution bias?

Answer 43

To minimize self-attribution bias, one could practice humility, seek feedback from others, and regularly review and learn from past decisions.

Question 44

Malleability of preferences: can (and should) we change our or other people’s preferences?

Answer 44

Preferences can be influenced by factors like social norms, advertising, and personal experiences. Whether we should attempt to change them depends on the context and ethical considerations. FORGOOD

Question 45

Disposition effect: how can you explain this with prospect theory?

Answer 45

The disposition effect can be explained by prospect theory as people are more sensitive to losses than gains, leading them to sell winning investments too soon and hold onto losing investments too long.

Question 46

Momentum (positive autocorrelation of returns): (how) can conservatism and representativeness bias explain this phenomenon?

Answer 46

Conservatism bias can lead to underreaction to new information, contributing to momentum, while representativeness bias can lead to overreaction to patterns, contributing to reversals.

Question 47

Interaction of beliefs and preferences: can you think of some examples where heuristics in beliefs and preferences interact?

Answer 47

Interaction of beliefs and preferences can occur when our preferences influence our beliefs (confirmation bias) or when our beliefs influence our preferences (cognitive dissonance).

Question 48

What could be a rational explanation for earning the size premium?

Answer 48

A rational explanation for the size premium could be that smaller companies are riskier and therefore require a higher expected return as compensation for this risk.

Question 49

According to CAPM, how risky a stock is depends on its covariance with the marginal utility of consumption. When is marginal utility of consumption high?

Answer 49

Marginal utility of consumption is high when consumption is low, such as during economic downturns.

Question 50

According to CAPM, how risky a stock is depends on its covariance with the marginal utility of consumption. A stock is risky when it does not generate returns when you need them most. Which of these statements is true?

Answer 50

Both statements are true. A stock is risky if its returns are negatively correlated with the marginal utility of consumption, i.e., it does not provide returns when they are most needed.

Question 51

Belief-based models with institutional frictions often assume that there are limits to arbitrage such as short-sale constraints, in combination with heterogeneous beliefs. What is a common explanation for the absence of belief convergence in these models? How can this explain the lack of convergence?

Answer 51

A common explanation for the absence of belief convergence in belief-based models with institutional frictions is that investors interpret information differently due to biases or constraints, leading to persistent disagreement.

Question 52

When there is an overrepresentation of optimistic investors, the stock price is likely too high to be explained by its fundamentals. Subsequently, this leads to lower returns than can be explained by the CAPM. Imagine asking 100 analysts for their beliefs about the returns of 10 different stocks. What do you expect to find?

Answer 52

If there is an overrepresentation of optimistic investors, you would expect to find a wider range of return expectations, with a skew towards higher returns.

Question 53

In the model of Barberis, Jin, and Wang (2021) that we discussed in class, investors require a higher average return on more volatile assets. How can you explain this with loss aversion?

Answer 53

Loss aversion can explain why investors require a higher average return on more volatile assets, as they weigh potential losses more heavily than potential gains.

Question 54

Why does diversification not protect you from a weak economy?

Answer 54

Diversification does not protect you from a weak economy because many assets are correlated and tend to decline together during economic downturns.

Question 55

Why do companies want their employees to hold its stocks?

Answer 55

Companies may want their employees to hold its stocks to align their interests with those of the company, incentivizing them to work towards the company’s success.

Question 56

Why is it a bad idea from a diversification point of view to hold your own company’s stocks?

Answer 56

Holding your own company’s stocks is a bad idea from a diversification point of view because it concentrates your financial risk in one company.

Question 57

Do you think you have more information about companies that are geographically close to you, than companies that are further away?

Answer 57

You may have more information about companies that are geographically close to you due to familiarity and access to local news and networks.

Question 58

In the video on Overconfidence and trading, Terrance Odean talks about a study in which they showed that overconfidence is likely the reason that people trade too much, because they find that the men (who are, according to the psychology literature, on average more overconfident than women) in their sample trade more frequently than the women in their sample. Could you think of other reasons why men trade more frequently than women, conditional on being an active investor?

Answer 58

Other reasons why men might trade more frequently than women, conditional on being an active investor, could include differences in risk tolerance, financial goals, and social norms.