Michaelmas Term - Lecture 6

Question 1

Explain underreaction.

Answer 1

Conservatism - Investors take time to react to new information

Limited attention - Investors do not have the time/resources to take every piece of information into account

Question 2

Explain overreaction.

Answer 2

Representativeness - Investors over-extrapolate from a sequence of growing earnings and overreact

Bounded rationality - Momentum traders disregard fundamental values and extrapolate from past prices, pushing the price of winners above their intrinsic value

Question 3

What are the limits to arbitrage?

Answer 3

1) Implementation costs

2) Noise trader risk

Question 4

What are the implementation costs of short selling?

Answer 4

1) The foregone investment on the collateral
2) The haircut - the difference between the risk-free rate and the interest received on capital. The haircut is usually < the risk-free rate.

Question 5

Give 2 examples of noise trader risk/

Answer 5

1) When people sell stocks to finance mortgages

2) Inexperienced investors making mistakes

Question 6

What explains the dot com bubble of the 90s?

Answer 6

Overconfidence