frågor :)

Question 1

Define Classic finance and assumptions made in the Efficent market hypothesis.

Answer 1

Classic finance assumes that prices are 100% rational and the market is 100% efficent.
The assumption made is that the market fully reflects all available information and thus the price of equity is equal to fundamental value.

Question 2

Why is fair price important for markets?

Answer 2

• No speculative bubbles.
• Maximizes social welfare.
• Efficient risk allocations (highly speculative stock will attract risky investors).
• Diversification and long-term perspective will guard participants from losing money.
• Corporate governance (price would reflect the quality of managers).

Question 3

What is Tobin´s Q?

Answer 3

Q = MV / BV (market value / book value)
If Q > 1: invest, if Q < 1, don´t. Assumption to invest in companies that are expected to grow.
Assumes rationality.

Question 4

What is direct approach?

Answer 4

Test whether P = E [P*].
Testing if price is equal to expected price in regard to cash flows.
This is usually impossible.

Question 5

What is indirect approach?

Answer 5

Forecast returns with respect to a particular model: CAPM, C-CAPM, APT.

Question 6

What arguments does traditional approach use to disregard the effects of noise traders?

Answer 6

Traditional approach assumes that the effect of irrational agents is negligible and will be immediately counter acted to rational agents.
Friedman (1953) argues: If price is not equal to fundamental value, rational traders will jump in and fix the mispricing. He also argues that if the first step doesn´t work, noise traders will make less money and die out.

Question 7

What are the 5 risks that limit arbitrage?

Answer 7

Fundamental Risk
Nosie trader Risk
Horizon Risk
Model Risk
Transaction costs / Implementation costs

Question 8

What is Expected Utility?
What are the values on each axis?

Answer 8

Y: Utility (value)
X: Wealth

Expected utility explain the value earned from change in total wealth.
Utility is increased most when wealth is low and the least when wealth is high.

Question 9

Which preferences are satisfied with EU?

Answer 9

Invariance
Completeness
Transitivity
Independence

Question 10

What are the core assumptions in Prospect theory?

Answer 10

• Shows utilities over gains/losses, total wealth does not matter.
• Value (v) is concave over gains and convex over losses.
• People overweight low probabilities and underweight high probabilities.
• People are risk averse over gains and risk-seeking over losses.

Question 11

What is Ambiguity Aversion?

Answer 11

People dislike situation when they are uncertain about probability distribution.

(Therefore, if your opinions are also held by people of high reputation, such as stock analysts, you become more certain of your conviction. People prefer known probabilities to unknown).

Question 12

What is Narrow framing?

Answer 12

Situations are looked upon as individual risks instead of being seen as part of a diversification along with other situations.

Question 13

What is Conservatism?

Answer 13

People underrate the “representativeness-term” and are too slow to jump to conclusions when presented with new information.

Question 14

What is Confirmation bias?

Answer 14

People percieve the same information differently because of prior beliefs. When new information is presented, the weigh of that information is determined by prior conviction.

Question 15

What is Anchoring?

Answer 15

Starting at an initial guess and adjusting away from it.
Adjustment is too slow.

Question 16

What is Overconfidence?

Answer 16

People are too confident in their beliefs and estimates.

Question 17

What can explain non-participation in the stock market?

Answer 17

Narrow framing + Loss aversion
Ambiguity Aversion
Prospect theory

Question 18

What can explain under-diversification?

Answer 18

• Home-bias
• Home-bias at home
• Excessive allocation to own company stock in 401k plan
• Significant position in few stocks.

Question 19

What is Naive Diversification?

Answer 19

Even when diversification occurs, investors tend to allocate irrationally between different choices.
(1/n wealth to each n investment regardless of what they are)

Question 20

What is Disposition Effect? What can explain it?

Answer 20

People are reluctant to sell at a loss relative to purchase price. Investors sell stocks that have performed well and keep stocks that have performed bad.
Can be explained by:
Conservatism (not taking positive news into full account = overvalued = sell)
Prospect theory / Narrow framing (Risk averse with gains and risk-seeking with losses)

Question 21

How will the exam questions be formulated? :D

Answer 21

7 questions, open ended.
Most are formulated around a bias or a puzzle.
Which behavioral aspects are responsible for xyz?

Question 22

Who are the authors of Prospect theory?

Answer 22

Kahneman and Tversky

Question 23

What are two factors discussed in the course regarding Mergers and Acquisitions?

Answer 23

1. Overconfidence in Managers of overtaking firm.
2. Incorrect valuation, where overtaking firm is more overvalued than the acquired firm.

Question 24

What tools can be implemented to undo the effect of management irrationality?

Answer 24

• Executive stock options (incentives)
• High leverege (forces them to perform)
• Takeover markets (management can be replaced)
• Board of directors (managers can be replaced)

Question 25

How is investment policy within a firm affected by valuation?

Answer 25

In an ideal world, investments should only depend on the existence of profitable investment prospects.
However,
Underpriced firms will choose to cut back on actual investments instead of raising capital.
Likewise, if the firm is overpriced, managers choose to invest in more projects with lower ROI / NPV.

Question 26

What is Catering? Name two examples.

Answer 26

Managements actions to boost current share price by appealing to irrational investor sentiment. Short horizon from managers.

1. Name changes (for example .com)
2. Paying dividends.

Question 27

Name two explanations for Divident payment

Answer 27

1. Assymetric information (management have more information than investors, investors dont like dividend cuts)
2. Agency costs (the manager has other incentives than maximizing fundamental value)

Question 28

How is equity share defined?

Answer 28

Equity share = equities / (debt + equities)

Equity share can predict future returns, since change in equity share over time shows overvaluation.

Question 29

How can momentum be explained by disposition effect?

Answer 29

People tend to realize winnings when a stock has increased in price, which creates a downward pressure on the price. The same goes for negative news about a stock, where people are reluctant to sell at a loss which means that enough sell-pressure is not reached. This means that price takes longer to reach the fundamental price, creating momentum.

Question 30

What is skewness?

Answer 30

There is a positively or negatively pushed normal-distribution chart.
According to prospect theory, people overestimate low probabilities and therefore they chose to play lotteries (with positive skewness), or choose not to take part in the stock market (with negative skewness).