CFA Level III Flashcards
Cognitive Error Category
- Belief perseverance
2. Processing errors
Belief perseverance biases (5)
Conservatism, confirmation bias, representativeness, illusion of control, hindsight bias
Processing errors
- Anchoring and adjustment bias
- Mental accounting bias
- Framing bias
- Availability bias
Emotional Biases (unable or unwilling to change)
- Loss aversion
- Overconfidence bias
- Self-control bias
- Status quo bias
- Endowment bias
- Regret-aversion bias
Four axioms of utility
completeness, transitivity, independence, continuity
Four alternative behavioral finance models
(1) consumption and savings, (2) behavioral asset pricing, (3) behavioral portfolio theory, (4) adaptive market hypothesis
Behavioral finance is
descriptive - it tries to explain observed investor decision making
Four alternative behavioral finance models
(1) consumption and savings, (2) behavioral asset pricing, (3) behavioral portfolio theory, (4) adaptive market hypothesis
Risk-averse (shape of utility function)
Concave
Risk-neutral (shape of utility function)
Linear
Framing bias
person’s inclination to interpret the same information differently depending on how it is presented
Bounded rationality
investors attempt to make the most rational decision possible based on the amount of information they deem satisfactory. Satisficing.
Framing bias
person’s inclination to interpret the same information differently depending on how it is presented
Availability bias
refers to the was with which information is attained or recalled
Confirmation bias
(related to confirming evidence) relates to the tendency to view new information as confirmation of an original forecast or position
Momentum Effect
pattern of returns that is correlated with the recent past
Disposition effect
investors more willing to sell winners and hold onto losers, results in the excessive trading of winning stocks
Momentum Effect
pattern of returns that is correlated with the recent past
Disposition effect
investors more willing to sell winners and hold onto losers, results in the excessive trading of winning stocks
Four behavioral finance portfolio construction model
- Consumption and savings model
- Behavioral asset pricing model
- Behavioral portfolio theory
- Adaptive markets hypothesis
Adaptive Markets Hypothesis
Adapt of perish.
Behavioral Portfolio Theory
Pyramid - layers, ignores correlation between layers. Low priority goals can be funded with high risk assets. High priority goals can be funded with low risk assets.
Cognitive Error: Conservatism
an initially rational view is maintained even when new information contradicts. FLAW: slow to update views and may hold securities longer than rational
Cognitive Error: Confirmation
new evidence is sought or used to support an original view. FLAW: thought processes or screenings are signed to find supporting information and ignore contradictory information, which can lead to under-diversified portfolios or concentration in employer stock
Cognitive Error: Representativeness
New evidence is classified and interpreted based on past classification or experience FLAW: attach to much emphasis to data covering only a short time period or immediately reclassify based on the new information without doing a full analysis
Cognitive Error: Illusion of Control
Individual incorrectly thinks they can control results. FLAW: trade too frequently and under diversify
Cognitive Error: Hindsight
Selectively remember what was done or known in the past. FLAW: overestimate ability to take too much risk
Cognitive Error: Anchoring and adjustment
subsequent adjustment for new information are around the initial “anchor” point. FLAW: focus on initial anchor point results in insufficient adjustments
Cognitive Error: Mental Accounting
Money is treated differently based on how it is categorized
Cognitive Error: Framing
Data presentation order affects the decision
Cognitive Error: Availability
Probability estimates are based on ease of recall. FLAW: Making decisions base on what is familiar, failing to diversify, results in suboptimal asset allocation.
Emotional Bias: Loss-aversion
Hold onto losers, selling winners. Disposition effect.
Availability
Probability estimates are based on ease of recall. FLAW: Making decisions base on what is familiar, failing to diversify, results in suboptimal asset allocation.
Emotional Bias: Loss-aversion
Hold onto losers, selling winners. Disposition effect.
Emotional Bias: Overconfidence
An unrealistically high opinion of intuitive reasoning/cognitive ability
Emotional Bias: Self-control
Lack of self-discipline to delay gratification in pursuit of long-term goals
Emotional Bias: Regret-Aversion
Avoid errors of commission while ignoring errors of omission.
Barnewell Two-way Model
Classify investors as either Active of Passive based on work and personal history. Active investors create wealth by risking their own capital, higher risk tolerance, feel a need to control. PASSIVE: investors inherit, patiently save, or accumulate by working for others, lower risk tolerance, executives or professionals.
Emotional Bias: Regret-Aversion
Avoid errors of commission while ignoring errors of omission.
Behavioral portfolio theory suggests
that portfolios are constructed in layers to satisfy investor goals rather than to be mean-variance efficient. Think of pyramid.
Social proof bias
individuals are biased to follow the beliefs of a group.
Behavioral portfolio theory suggests
that portfolios are constructed in layers to satisfy investor goals rather than to be mean-variance efficient. Think of pyramid.
Social proof bias
individuals are biased to follow the beliefs of a group.
What is situational profiling?
Situational profiling is an analysis of behavior in determining preferences and biases, as well as philosophy. It does not determine investor behavior.
ALM
Asset/liability management - The management of financial risks created by the interaction of assets and liabilities.
Shortfall Risk
The risk that portfolio value will fall below some minimum acceptable level during a stated time horizon; the risk of not achieving a specified return target.
Economic growth can be partitioned into two components:
(1) cyclical and (2) trend-growth
Within Cyclical analysis, there are two components:
(1) the inventory cycle
(2) the business cycle
How long does the typical inventory cycle last?
2-4 years (short term)
How long does the typical business cycle last?
9 to 11 years (long term)
The business cycle is characterized by five phases:
(1) initial recovery
(2) early upswing
(3) late upswing
(4) slowdown
(5) recession
disinflation
the declaration of the interest rate, slowing down but still positive
Why is deflation a threat to economic activity?
(1) it encourages default on debt obligation
(2) limits the ability of central banks to stimulate the economy through monetary policy
What are some of the challenges in setting capital market expectations?
- Limitations of economic data (lack of timeliness, changing definitions, changing calculations
- data measurement errors and biases (including transcription errors, survivorship bias, and appraisal [smoothed] data)
- limitations of historical estimates (nonstationarity)
- ex post risk as a biased risk measure
- biases in analysts’ methods
- failure to account for conditioning information
- misinterpretation of correlations
- psychological traps
What are some psychological traps?
anchoring, status quo, confirming evidence trap, overconfidence trap, prudence trap, recall ability trap
Grinhold-Kroner model
This model states that expected return on equity is the sum of the expected income return (D/P), the expected nominal earnings growth (g + i), and the expected repricing return (ΔP/E).
Five elements of pro-growth government structural policy
- Fiscal policy is sound
- public sector intrudes minimally on private sector
- competition within the private sector is encouraged
- Infrastructure and human capital development are supported
- tax policies are sound
Purchasing power parity pertains to ________.
purchasing power parity pertains to long-run equilibrium
The capital flows approach states that _____.
The capital flows approach states that long-term capital flows will flow to where the best opportunities are, thus increasing that country’s currency value
Employment levels can be further broken down into ____?
Employment levels can be further broken down into population growth and the rate of labor force participation.
The productivity component can be broken down into ___?
The productivity component can be broken down into spending on new capital inputs and total factor productivity growth.
An economy’s TFP can change over time due to the following:
- changing technology
- changing restrictions on capital flows and labor mobility
- changing trade restrictions
- changing laws
- changing division of labor
- depleting/discovering natural resources
What is TFP?
Total Factor Productivity = is the rate of managerial and technological innovation, measuring the ability of an economy to produce more real output for the same inputs of labor and capital.
Cobb-Douglas Function
Average Growth Rate = TFP + 𝛿(Capital) + (1-𝛿)(Labor)
Cobb-Douglas Function
Cobb-Douglas Function provides a macroeconomic forecast of the growth rate for the underlying economy and this is the base for estimating cash flow and dividend growth rates for DDM.
An assumption of the Cobb-Douglas production function is that economic growth and growth in corporate earnings are _____.
An assumption of the Cobb-Douglas production function is that economic growth and growth in corporate earnings are equal. In the short-term the two can be quite different, but over the long-term the assumption is reasonable. The Cobb-Douglas production function also assumes constant returns to scale.
Strategic asset allocation reflects what systematic risk exposure?
Investor’s desired systematic risk exposure.
The steps in the asset allocation process are:
- Determine the investor’s risk, return, and constraints.
- Formulate long-term capital market expectations.
- Determine the mix of assets (allocation) that best meets the objectives of the IPS.
- Monitor the portfolio.
- Adjust the portfolio as necessary for strategic or tactical asset allocation.
A high R-squared would indicate?
A high R-squared would indicate that the model explains a good proportion of portfolio returns.
What is a covered call?
buying underlying security and selling a call option
What is the purpose of a covered call?
Generate additional portfolio income when the investor believes that the underlying stock’s value will remain uncharged over the short term (IE nobody is going to exercise the call and I get to keep the premium)
What is a protective put?
holding long position in underlying security and buying a put option.
What is the purpose of a protective put?
Limit downside risk. Provides a lower limit to the position at a cost of lowing the possible profit (due to cost of premium/insurance). Ideal for investor who thinks that the stock may go down in the near future yet wants to preserve upside potential.
Bull Spread
Long call and short call. Short has higher X price and subsidizes premium of long call. Offers gains if asset price goes up with a limit.
Bear Spread
Opposite of bull spread.
Butterfly Spread
two long and tow short call positions.
Collar strategy
covered call combined with a protective put. Combined it limits the downside and upside of the position. Desire is for the position to stay in the range.
Long Straddle
Long call and long put with the same exercise price. the great the move in the stock price, the greater the payoff from a straddle.
Box Spread
combines a long put and short put with log call and short call to produce a guaranteed return (risk free rate).
Interest rate collar
combination of a cap and floor where the investor is long one and short the other. Can be used to guarantee a minimum received (lender) or maximum paid (borrower).
Delta hedging
generally refers to immunizing the value of an option position from changes in the value of the underlying asset.
Delta
Change in price of Option / Change in Price of Underlying (think of this as slope, speed).
Gamma
Change in Delta / Change in Price of Underlying (think of this as acceleration, or the 2nd order derivative).
Missed trade opportunity cost is ____?
Missed trade opportunity cost is weighted by the portion of the order that is not filled. It is calculated using the difference between the price at which the order is cancelled and the original price.
Realized profit and loss uses ____?
Realized profit and loss uses the difference between the execution price and the previous day’s closing price. This is divided by the original price and weighted by the portion of the order filled.
The term delay costs refers to ______?
The term delay costs refers to the inability to complete the desired trade immediately because of its size and the liquidity of markets. Delay costs are often measured on the portion of the order carried over from one day to the next.
The total sensitivity is given by _____.
The total sensitivity is given by the duration times the country beta
