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CAS Exam 9 > BKM Chapter 12 > Flashcards

BKM Chapter 12 Flashcards

1
Q

Primary difference between traditional financial theory and behavioral finance theory

(BKM - 12)

A

traditional financial theory assumes investors are rational, behavioral finance theory does not

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2
Q

Complaint from behavioral financial theorists about traditional financial theory

(BKM - 12)

A

traditional financial theory ignores how people actually make decisions and that people make a difference (b/c investors do not always behave rationally)

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3
Q

Types of irrationalities under behavioral financial theory (2)

(BKM - 12)

A
  1. information processing errors

2. behavioral biases

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4
Q

Information processing errors

BKM - 12

A

mis-estimations of probabilities of events or the associated ROR

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5
Q

Behavioral biases

BKM - 12

A

investors often make inconsistent, sub-optimal, or otherwise irrational decisions

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6
Q

Types of information processing errors (4)

BKM - 12

A
  1. forecasting errors
  2. overconfidence
  3. conservatism
  4. sample size neglect & representativeness bias
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7
Q

Forecasting errors (aka memory bias) information processing error & related phenomenon explained

(BKM - 12)

A

tendency to give too much weight to recent experience compared to prior beliefs when making forecasts

> > may explain why high P/E ratio firms perform worse than low P/E ratio firms

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8
Q

Overconfidence information processing error & related phenomenon explained

(BKM - 12)

A

investors overestimate their ability to accurately predict stock returns

> > may explain popularity of active portfolio management despite underperformance

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9
Q

Conservatism information processing error & related phenomenon explained

(BKM - 12)

A

investors may be too slow to update beliefs in response to new information

> > may explain the momentum effect if investors are slow to recognize news

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10
Q

Sample size neglect & representativeness bias information processing error & related phenomenon explained

(BKM - 12)

A

investors may not account for sample size & treat small samples as though they are equally representative compared to large samples (e.g. infer patterns too quickly and extrapolate them too far into the future)

> > consistent with overreaction & correction anomalies

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11
Q

Types of behavioral biases (5)

BKM - 12

A
  1. framing
  2. mental accounting
  3. regret avoidance
  4. affect
  5. prospect theory
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12
Q

Framing behavioral bias

BKM - 12

A

decisions are impacted by how choices are framed

> > risky gains are more likely to be rejected compared to risky losses

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13
Q

Mental accounting behavioral bias

BKM - 12

A

investors differentiate decision making based on different goals that may elicit different levels of risk aversion

ex: standard brokerage account vs. child’s education fund

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14
Q

Anomalies that may be explained by the mental accounting behavioral bias (2)

(BKM - 12)

A
  1. disposition effect
  2. momentum in stock prices - more willing to invest more when they are ahead because the funds are viewed as coming from capital gains vs. out of pocket
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15
Q

Regret avoidance behavioral bias and anomalies explained (2)

(BKM - 12)

A

investors feel more regret when less convential investments go bad (b/c it reflects bad decision making vs. bad luck)

> > may explain:

  1. small firm effect
  2. high book-to-market ratio effect
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16
Q

Affect behavioral bias

BKM - 12

A

feeling of “good” or “bad” that investors may attach to a stock

17
Q

Examples of affect behavioral bias (3) and trend in prices and ROR

(BKM - 12)

A
  1. public perception of socially responsible policies
  2. attractive working conditions
  3. popular products

generally see increased prices and lower ROR

18
Q

Prospect theory behavioral bias and findings (2)

BKM - 12

A

alternative view of relationship b/w wealth and risk aversion that plots utility against changes in wealth and finds:

  1. risk aversion does not decrease as wealth increases
  2. investors are risk-seeking regarding losses
19
Q

Traditional relationship between utility, wealth, and risk aversion

(BKM - 12)

A

utility increases at a decreasing rate as wealth increases&raquo_space; leads to higher risk aversion

20
Q

Reason that mis-pricing from behavioral biases does not lead to arbitrage opportunities under behavioral finance theory

(BKM - 12)

A

b/c of the limits to arbitrage

21
Q

Limits to arbitrage under behavioral finance theory (3)

BKM - 12

A
  1. fundamental risk
  2. implementation costs
  3. model risk
22
Q

Fundamental risk limit to arbitrage

BKM - 12

A

risk of under-pricing becoming worse in the short-term when buying an under-priced stock

(e.g. price does not converge to it’s intrinsic value within the investment horizon)

23
Q

Implementation cost limit to arbitrage & examples (3)

BKM - 12

A

possible to profit from short-selling when securities are over-priced, but high costs of short-selling can be a barrier

Ex:

  1. high cost to borrow shares
  2. short-selling may not be possible due to trading restrictions
  3. shares may not even be available to short
24
Q

Model risk limit to arbitrage

BKM - 12

A

risk that the model used to identify mis-priced securities is flawed

> > makes exploiting arbitrage opportunities risky

25
Q

Examples of limits to arbitrage and the Law of One Price (3)

BKM - 12

A
  1. Siamese twin companies - merged operations that should have similar prices
  2. equity carve-outs - spinoffs/separations that should have similar prices
  3. closed-end funds - pooled assets that often sell at premiums/discounts from net asset value
26
Q

Criticisms of behavioral finance theory (2)

BKM - 12

A
  1. anomalies are inconsistent between types of irrationality - suggest overfitting of behavioral biases to anomalies
  2. difficult to assess the statistical significance of results
27
Q

Relationship between technical analysis and behavioral finance (2)

(BKM - 12)

A

technical analysis relies on identifying momentum in stock prices and momentum can be explained by behavioral biases

  1. disposition effect - creates momentum because investors are not acting rationally
  2. overconfident investors trade more - increased trading volume is seen as an indicator of positive returns
28
Q

Disposition effect

BKM - 12

A

tendency to hold on to losing investments because investors do not want to realize losses

29
Q

Market indicators used in technical analysis to identify profit opportunities (3)

(BKM - 12)

A
  1. moving averages (MA)
  2. relative strength
  3. breadth
30
Q

Moving average (MA) market indicator in technical analysis and relationship between MA and current stock price

(BKM - 12)

A

measures the overall trend/momentum of a security
= avg prior n days of stock prices

MA > current price when prices are consistently falling
MA < current price when prices are consistently rising

31
Q

Bullish signal in moving averages

BKM - 12

A

shift from a falling trend to a rising trend (= buy signal)

graphically: current stock price pierces MA from below

32
Q

Bearish signal in moving averages

BKM - 12

A

shift from a rising trend to a falling trend (= sell signal)

graphically: current stock prices pierces MA from above

33
Q

Relative strength market indicator in technical analysis, formula, & buy signal

(BKM - 12)

A

measures how well an individual stock performs relative to the market

relative strength = individual stock price / market index for the same industry

buy signal = consistently increasing ratio (indicates market strength)

34
Q

Breadth market indicator in technical analysis, formula, & buy signal

(BKM - 12)

A

extent movement in a market index is reflected in the price movement of all socks

breadth = # market advancers (stock price increases) - # market decliners (stock price decreases)

buy signal = positive trends

35
Q

Market sentiment

BKM - 12

A

general level of optimism among investors

36
Q

Market sentiment indicators (3)

BKM - 12

A
  1. Trin statistic
  2. confidence index
  3. Put/Call ratio
37
Q

Trin statistic definition, formula, & buy signal

BKM - 12

A

measure of the extent trading volume is associated with market movement

Trin = (volume declining / # declining) / (volume advancing / # advancing)

buy signal: trin < 1 (indicates higher volume of advancing vs. declining stocks)
sell signal: trin > 1

38
Q

Confidence index definition, formula, & buy signal

BKM - 12

A

measures how well lower-rated corporate bonds perform relative to higher-rated corporate bonds

confidence index = avg. yield on top 10 rated corporate bonds / avg. yield on 10 intermediate-grade corporate bonds

buy signal: ratio trending towards 1 (suggests a lower risk premium is required for lower-rated bonds)

39
Q

Put/Call ratio definition, formula, & buy signal

BKM - 12

A

measures extent investors are betting on stock price decreases relative to stock price increases

put/call ratio = # outstanding puts / # outstanding calls

intuitively, buy signal = decreasing put/call ratio (more bets on price increases), but consensus is mixed

CAS Exam 9 (26 decks)

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