Reading 7

Question 1

What is the difference between traditional finance and behavioral finance

Answer 1

Traditional finance models people as ‘rational’

Behavioral finance models people as ‘normal’

Question 2

What are the three approaches to study how individuals make economic decisions and how
markets behave?

Answer 2

1. Normative
2. Descriptive
3. Prescriptive

Question 3

______, which tells us what should happen in an ideal world.

Answer 3

Normative

Question 4

_____, which studies what actually does happen in the real world

Answer 4

Descriptive

Question 5

_______, which attempts to explain how we can move from what happens in the
real world to what we would like to see happen in an ideal world.

Answer 5

Prescriptive

Question 6

Traditional finance is a ___1____approach that tells us how we can expect individuals to
make economic decisions in an ideal world. Behavioral finances is a ____2___approach that examines how individuals actually do
make economic decisions in the real world.

Answer 6

1 = Normative
2 = Descriptive

Question 7

Traditional finance makes six assumptions about how individuals make investment
decisions. Specifically, individuals:

Answer 7

1. Maximize the present value of their expected utility subject to a budget constraint
2. Update probability calculations using Bayes’ formula
3. Are perfectly rational
4. Are self-interested
5. Have perfect information
6. Are risk averse

Question 8

What are the 4 axioms of utility theory?

Answer 8

Completeness assumes that an individual has well-defined preferences and can decide between any two alternatives.

Axiom (Completeness): Given choices A and B, the individual either prefers A to B, prefers B to A, or is indifferent between A and B.

Transitivity assumes that, as an individual decides according to the completeness axiom, an individual decides consistently.

Axiom (Transitivity): Transitivity is illustrated by the following examples. Given choices A, B, and C, if an individual prefers A to B and prefers B to C, then the individual prefers A to C; if an individual prefers A to B and is indifferent between B and C, then the individual prefers A to C; or, if an individual is indifferent between A and B and prefers A to C, then the individual prefers B to C.

Independence also pertains to well-defined preferences and assumes that the preference order of two choices combined in the same proportion with a third choice maintains the same preference order as the original preference order of the two choices.

Axiom (Independence): Let A and B be two mutually exclusive choices, and let C be a third choice that can be combined with A or B. If A is preferred to B and some amount, x, of C is added to A and B, then A plus xC is preferred to B plus xC. This assumption allows for additive utilities. If the utility of A is dependent on how much of C is available, the utilities are not additive.

Continuity assumes there are continuous (unbroken) indifference curves such that an individual is indifferent between all points, representing combinations of choices, on a single indifference curve.

Axiom (Continuity): When there are three lotteries (A, B, and C) and the individual prefers A to B and B to C, then there should be a possible combination of A and C such that the individual is indifferent between this combination and the lottery B. The end result is continuous indifference curves.

Question 9

Rational Economic Man

Answer 9

The model for individuals who make economic decisions according to utility theory and use Bayes’ formula to update probabilities is called Rational Economic Man (REM). REM has perfect information and is perfectly self-interested and perfectly rational in pursuit of its utility-maximizing objectives. In short, REM is the embodiment of the traditional finance
assumptions about how individuals make economic decisions.

Question 10

Decision theory

Answer 10

concerned with identifying values, probabilities, and other uncertainties relevant to a given decision and using that information to arrive at a theoretically optimal decision.

Question 11

Is decision theory:

a. ) Normative
b. ) Descriptive
c. ) Prescriptive

Answer 11

a.) Normative - decision theory is concerned with finding the most optimal decision.

Question 12

Bounded Rationality

Answer 12

recognizing that people are not fully rational when making decisions and do not necessarily optimize but rather satisfice (defined below) when arriving at their decisions. Simon introduced the terms bounded rationality and satisfice to describe the phenomenon where people gather some (but not all) available information, use heuristics to make the process of analyzing the information tractable, and stop when they have arrived at a satisfactory, not necessarily optimal, decision.

Question 13

Prospect Theory

Answer 13

prospect theory assumes that individuals establish a reference point and
evaluate economic decisions based on whether the choice is framed as the prospect of a
gain or a loss. The concept of reference dependence is incompatible with expected utility theory

Question 14

Does traditional finance or behavioral finance support efficient market hypothesis?

Answer 14

traditional

Question 15

Forms (3) of Efficient Market hypothesis:

Answer 15

Weak
• All past price and trading volume data

Semi-strong
• All past price and trading volume data
• All publicly-available information

Strong
• All past price and trading volume data
• All publicly-available information
• All non-public information

Question 16

Fundamental Anomalies

Answer 16

A fundamental anomaly exists if an asset’s market price fails to reflect what its value should be, based on its fundamentals. The most notable fundamental anomaly is the apparent underpricing of value stocks compared to growth stocks. While some studies show excess
returns generated from investing in value stocks, it may be that this “mispricing” is simply a reflection of the market demanding a higher return in exchange for the higher risk associated with value stocks.

Question 17

Technical Anomalies

Answer 17

A technical anomaly exists if future price movements can be predicted based on an analysis
of past price and trading volume data (for example, moving averages and support or resistance levels). If such opportunities exist, it is possible to generate excess returns from
technical analysis and the weak-form EMH does not hold.

Question 18

Adaptive Markets Hypothesis

Answer 18

fund managers are engaged in a kind
of Darwinian competition and must adapt their investment strategies or risk failing. AMH
allows that excess returns are possible in the short-term if a manager can exploit market
anomalies, but concedes that it is impossible for a manager to outperform the market in the long-run.