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1
Q

Framing in Finance

A

Asian disease Problem,+ Price group forecasts show lower average return than return group

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2
Q

Metntal Accounting

A

Theatre Ticket

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3
Q

Traditional Finance conclusions

A

Agents are rational (Bayes), Agents Make normatively Acceptable Choices (Utility Function), irrational investors don’t matter – rational eliminate mispricing

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4
Q

Certainty Equivalent

A

u(CE)=EU(x)

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5
Q

Risk Premium

A

RP=E(a)-CE(a)

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6
Q

Expected utility 3 axioms

A
  1. Complete ordering (Completeness – lotteries can be compared; transitivity– a>b and b>c then a>c);
  2. Continiuty (there is some p, prob which in combination with a and c is as good as b (a>b>c)
  3. Independance (preference should not change if both connected to same lottery)
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7
Q

Arrow absolute risk aversion

A

r(x) = -(u’‘/u’) then r’ and r’<0– agent increases amount of risky asset

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8
Q

Arrow relative risk aversion

A

r(x)=-(u’‘/u’)*x, r’ <0, agent increases fraction of risky asset

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9
Q

Sensitivity

A

Positive is defined as positive

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10
Q

Specificity

A

Negative is defined as negative, much more important in very low base rate

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11
Q

Gambler’s Fallacy examples

A

BGGB GGGBBB, Weber 98 “The disposition effect in securities trading, lab experiment where they had virtual money and invested in 6 assets– subjects knew that the asset is not winning but still bought it.

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12
Q

Overconfidence

A
  • excessive optimism (marriage)
  • illusion of control (game with Dapper- confident or Schnook- shy)
  • miscalibration (70% sure that Jakarta is Capital of Indonesia)
  • Above average (driving safety skills)

Example from paper : Barber, 2001 “Boys will be boys” where there appeared to be a strong link between overconfidence and excessive trading, especially in men, + “Odean,99 “Do investors trade too much?” rational vs overconfident investors, where overconfident overestimate their trading profits and precision of information signal

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13
Q

Disposition effect

A

Selling winners too soon and holding losers too long

2 experimental papers (Shefrin and Weber)+ Odean who describes the OPPORTUNITY TO SELL

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14
Q

Potential Survivorship bias

A

Successful investors are overreplaced at the end of the sample hence investors sell winners (-don’t have losers)
Paper of Odean 98 “Are investors reluctant to realize their losses?” - he also uses excess return in paper (excess return= raw return- value weighted CRSP like S&P500)

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15
Q

Why do we compute excess return? (Odean 98, “Are investors reluctant to realize their losses?”)

A

Idea: Investors select the stocks to sell based on their future performance, i.e. they keep (sell) the stocks that will perform best (worst)?

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16
Q

Excessive trading, do investors trade rationally? Do trading profits cover trading costs?

A

“Do investors trade too much?” Odean 99, no they don’t they misinterpret info and overestimate the presicion of this info

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17
Q

Where do investors misinterpret info and overestimate the presicion of info?

A

While trading too much, Odean 99, they don;t even cover their trading costs

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18
Q

Odean’s 99 “Do investors trade too much?” motivation?

A

Odean’s motivation is based on the traditional framework.
The traditional finance framework assumes that investors will only trade if they have different beliefs about an asset’s fundamental value.
In this traditional setting, taxes, liquidity needs, and other factors that would cause trading activity are ignored

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19
Q

Describe where authors used calendar time PORTFOLIOS and why

A
  1. Odean 99 “Do inv trade too much?”
    use CALENDAR time portfolios to check systematic risk (sell stocks with high beta and buy with low beta)
  2. Engelberg “Market Madness” calendar-time portfolois - = months (or whatever time unit the study uses) are weighted equally
  3. Ang, et al - calendar time appr using total vol and idiosyncratic vol to show that vol is negatively priced
  4. Bali et al. use calendar time approach for Max return calculation (to show thta stocks with max 1 day returns underperform)
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20
Q

Describe Event-time approach

A

Odean 99, “Do investors trade too much”

The return calculations are in event time. The individual returns (𝑅𝑗,𝑡+𝜏)of the stocks (=1 to N) are calculated from one to 40/252/504 days (=T) after the event (=transaction).
•Time periods with many transactions get higher weight than periods with few trades.
Event-time = each event is weighted equally

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21
Q

Which attention proxies do u know

A
  • News (stock featured in media)
  • Abormal trade volumes
  • Abnormal returns (either high or low)

Investor attention proxies positively related to trading activity

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22
Q

Conjunction fallacy

A

Specific conditions are more probable than general ones, Linda’s problem

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23
Q

Statisticical or casual base rate is usually underweighted?

A

Cab accident, statistical, as it is treated as info about individual case and is combined with other case-specific info

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24
Q

4 explanations of disposition effect in Shefrin, “The disposition of sell winners too early and hold losers too long”

A
  1. Prospect theory (gains- risk averse, losses- risk prone)
  2. Mental accounting
  3. Regret aversion (pride to sell winner, regret to sell loserr)
  4. Self- control (System 1 feels pride and regret, System 2 knows optimal strategy but not successful sometimes to persuade S1)
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25
Q

3 explanations of Disposition effect in Weber, “The disposition effct in securities trading”

A
  1. Self-control
  2. Pride and regret
  3. Gambler’s Fallacy!
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26
Q

Where do investors forego tax benefits?

A

In disposition effect
1. Shefrin 85, “The disposition to sell winners” , lost tax benefits while selling winners and holding losers

  1. Odean 98, “Are investors relctant to realize losses?” - when they may not have opport to sell loser,
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27
Q

How to solve disposition effect?

A

a. Strickt rules (loss of 10% means sell)
b. Stop-loss orders
c. Unexpected circumstances that cause liquidity needs as add motivator
d. Reminder/ deadline of tax loss selling

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28
Q

Where do we find impact-reversal pattern?

A

IR pattern: firstly prices go up but with the time they go down

Attention matters

Where?

  1. Barber and Odean “All that glitters” -stock will be affected if the retail investors’ oders have price impact (=create demand)
  2. Engelberg “ Market Madness” -long term reccomendation returns for stocks with high o/n return
  3. Da et Al. :In search of attention”-GSV- post ipo performance: investors negatively predict med-long-term returns, prices return to fundamentals
29
Q

Why distinguish between stocks with and without news?

A

(1) Cramer could select stocks that had some important event (positive earnings etc)
(2) Positive returns are caused by these unobserved events (and not Crammers’ recomm)

30
Q

Self-attribution bias

A

Good outcomes- own ability

Bad outcomes - bad luck

31
Q

What is mitigating representativeness?

A

Heart attack example (from conjunction fallacy topic) when from what % to how many the answes differ.

32
Q

What is subproportionality?

A

This is the violation of independance axiom , if one lowers the positive outcoe for both lotteries by same factor the preferences change

33
Q

What is subadditivity?

A

Small prob are overweighted (holds for small p)
6000;0.01>3000;0.02

people find it more attractive to have two 5% chances to win an amount than to have a 10% chance to win, i.e. pi(5) + pi (5) > pi (10) pi(0.05) > 0.5 * pi(0.1) pi (0.5 * 0.1) > 0.5 * pi (0.1)

34
Q

Weightning Function Shape

A

Subproportionality
Subadditivity
Subcertainty
Overweight of small prob

35
Q

Does experimental evidence contradicts EUT?

A 
Yes, because of:
•certainty effect
•reflection effect
•isolation effect
•assessment of probabilities does not seem to be objective
36
Q

What is isolation effect?

A

Isolation effect: the bonus is not taken into account because common to both options., individuals cancel out similar information when making a decision

37
Q

How to define lottery-type stock?

A
  1. Above-median idiosyncratic vol
  2. Above median idiosyncr SKew
  3. Below-median Price
38
Q

Charactristics of lottery-type stocks

A
  1. Owned by retail investors
  2. Have higher systematic risk
  3. Are young
  4. Rarely pay dividends
    5 .Are hard to value

They underperform!

39
Q

Showing past prices mean

A

People have higher expectations

40
Q

Showing past returns results

A

In lower expectations

41
Q

T stat formula

A

((Mean sample- mean hypothet)/ stnd dev) *sqrt(n)

42
Q

Fundamental risk reduction

A

Hedge position in market
Hedge position in same industry
Hedge position in close substitutes

43
Q

Noise trade risk

A

Risk that mispricing exploited by arb. worsens in short run

44
Q

If there’s no free lunch then prices are right?

A

No! due to arb being costly

45
Q

How can long-run IPO underpricing can be explained?

A

The returns there are highly positively skewed and investors prefer assets with positive skewness even if assets earn negative excess return.
In addition, a situation of overweighning of small prob- the investors believe each IPO to be next Google

46
Q

Why distressed stocks have low average return?

A

Overweight of small p of success

47
Q

Retail vs institutional investors and lottery stocks

A

Retail overweight, institutional underweight

48
Q

Is volatility priced correctly ? Shall one buy high vol stock to get high return?

A

No, risk is nit priced correctly, High vol stocks get lower return (Ang et al.), low beta stocks yiled higher returns than high beta stocks (Baker), stocks with largest 1 day return subsequently underperform (Bali et al.)

49
Q

Proxy for positive skewness and idiosyncr volatility

A

Max return

50
Q

3 properties of utility function

A
  1. Money’s marginal utility is positive (u’>0, having more money is desirable)
  2. Marginal utility decreases with increased amount of money (u’‘<0 - icrease from 1000 to 2000 counts more than from 1 mio)
  3. Absolute risk-aversion is not increasing if people become richer, i.e. they don’t decrease absolute amount in the risky asset than before.
51
Q

Risk attitude in PT

A

In positive domain- risk-averse, in negative- risk-seeking

52
Q

How do you consider changes in PT

A

From a REFERENCE POINT, don’t evaluate prospects in absolute lvls

53
Q

Is # of transaction a good measure in paper?

A

The number of transactions is not a good measure as it does not take into account the number of winners and losers in an investor’s portfolio. For example, if the overall stock market significantly increases (decreases) in value investors hold, on average, more (fewer) winners in their portfolios. So, selling more winners than losers does not necessarily indicate evidence for the disposition effect

54
Q

What for do we calculate abnormal return or turnover?

A

To show that this is an attention- grabbing stock

55
Q

Does selling more winners than losers necessarily indicates evidence for the disposition effect?

A

No, as if the overall stock market significantly increases (decreases) in value investors hold, on average, more (fewer) winners in their portfolios. Paper of Odean 98 “Are investors reluctant to realize their losses?” shows that. (Calculate PGR and PLR)

56
Q

Describe arbitrage risks

A
  1. Fundamental : revaluation if new info arrives
  2. Noice trader: if the price drops lower than you bought
  3. Implementation costs: lending fees, comissions.
57
Q

Hot hand phenomenon. Generally and in finance

A

If a basketball player scores several times in a row she is assigned a temporary higher probability to score –> she has a hot hand, – Cognitive illusion

In finance: Skill of fund managers, e.g., outperform the fund’s benchmark in three consecutive years.

58
Q

Is Buying behavior of retail investors is more heavily influenced by attention than is the buying behavior of institutional investors

A

Yes, proof: Barber et Odean “All that glitters”

59
Q

Is retail investor’s buying beh is more influenced by attention than their selling behavior?

A

Yes, proof: Barber et Odean “All that glitters”

60
Q

What attracts retail investor?

A
  1. Lottery type stocks (Kumar)– above mormal vol, abover meidan idiosyncr. skewness and below median price
  2. Attention- grabbing stocks (news stocks, unusual trading vol, extreme returns)
  3. Alphabetic bias?
61
Q

What types of stocks did Cramer recommend?

A
  1. Growth stocks (low B/M ratio)

2. Past winners (highest past-year returns)- momentum strategy

62
Q

Expected utility BASIC PROCEDURE

A
  1. assign a utility level to each possible outcome.
  2. weight utility by associated probability.
  3. choose the option with the highest expected utility.
63
Q

three forms of market efficiency

A
  1. Weak :Historical trading info
  2. Semi-strong: Market info
  3. Strong: All info
64
Q

Editing phase 2 tasks

A

1) Decision-makers do not evaluate prospects in absolute levels but consider changes from a reference point. Thus, they will transform absolute outcomes to changes, i.e. gains and losses.
2) Simplification: rounding of probabilities and outcomes as well as deletion of extremely unlikely outcomes.

65
Q

Evaluation phase

A

Case 1: Regular prospects, i.e. 𝑥≥0≥𝑦or 𝑥≤0≤𝑦.
•Value function: 𝑉𝑥,𝑝;𝑦,𝑞=𝜋𝑝𝑣𝑥+𝜋𝑞𝑣𝑦, where 𝜋0=0,𝜋1=1, and 𝑣0=0
probabilities 𝑝 are transformed to decision weights 𝜋𝑝
Typically: 𝜋𝑝+𝜋1−𝑝<1

Case 2: Strictly positive (negative) prospects, i.e. 𝑥>𝑦>0(𝑥

66
Q

In efficient markets, prices equal fundamental value

A

Yes, as Stock price is the discounted sum of expected future cash flows / dividends

67
Q

The positive abnormal returns prove that markets are inefficient

A

False, due to Joint Hypothesis Problem- we don’t know the true asset pricing model investors use;

68
Q

Finding that there an investment strategy yields positive abnormal returns implies:

A
  1. markets are not efficient (and the asset pricing model is right) or
  2. the asset pricing model is wrong (and markets are efficient) or
  3. markets are not efficient and the asset pricing model is wrong
69
Q

Two biases related to the perception of randomness

A

Gambler’s Fallacy and Hot hand Phenomenon

Beh Finance (1 decks)

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