Behavioral Finance Midterm 1

Front 1

Horizon risk

Back 1

increasing the length of the path reduces the arbitrageur's return

Front 2

Buy-in risk

Back 2

if arbitrageur is unable to maintain his short position he will be forced to terminate the trade.



When shares available for shorting are most scarce, brokers cannot maintain their clients’ short positions no matter what interest rate the investor is willing to pay. This situation, which arises when owners of the stock demand that their loaned-out shares be returned, is often referred to as being “bought-in.”



The possibility of being bought-in at an unattractive price provides a disincentive for arbitrageurs to take a large position and represents a substantial friction to executing the arbitrage trade.



Overall: returns to a specialized arbitrageur would be roughly 50% higher if the path to termination was smooth

Front 3

Fundamental risk

Back 3

The risk that mispricing may become more extreme before prices get corrected

Front 4

Noise trader risk

Back 4

Average bullishness of noise traders leads to an increase in the price of the risky asset
If the noise traders are more/less bullish than on average they bid up/down the price
Increased volatility in the market lowers the price of the risky asset today and increases the expected return tomorrow
Fundamentally unrelated securities subject to the same noise trader risk move together
Arbitrage risk: Arbitrageur is risk averse and uncertain if riskless profit can be realized
Arbitrageurs face the risk that noise traders beliefs become more extreme before prices revert to the mean
In effect it is a risk about fundamental value of an asset

Front 5

Prospect utility function

Back 5

Utility function is defined in terms of deviation from reference point
Risk-averse (concave) in gains; risk-seeking (convex) in losses
Sensitivity (steepness) is higher in domain losses
Decision weights are not true probabilities
Underweighting of middle range probabilities
Overweighting extreme probabilities

Front 6

narrow framing

Back 6

people tend to evaluate individual decisions separately from other portions of their wealth

Front 7

dynamic aggregation

Back 7

Simple repetitions of the same outcome are unattractive if evaluated one at a time
When investors are loss averse, they will more willing to take risks if they evaluate their performance (or have their performance evaluated) infrequently
Playing the same gamble multiple amount of times is perceived as less risky!

Front 8

Briefly describe the nature of joint hypothesis problem in the context of evaluating market efficiency.

Back 8

In order to claim that the price of security differs from its fundamental value one needs a proper asset pricing model
Fama (1970): any test of mispricing is therefore a joint test of mispricing and of an asset pricing model
Is it that security is mispriced?
Or that your model is wrong?

Front 9

One of the asset pricing puzzles is excess volatility puzzle. Briefly describe what this puzzle is about. How does behavioral finance explain this anomaly? Provide intuition.

Back 9

After run-up in stock prices investors are less risk-averse since those gains will cushion any subsequent loss. Since they are less risk-averse they are more inclined to keep more stocks in their portfolios which pushes stock prices up.
After a drop in stock prices investors are more risk-averse and wary of further losses. After the value of their financial portfolio decreased recently investors are unwilling to hold risky securities in their portfolios and have to be compensated extra for doing this. This puts a downward pressure on stock prices.
After a big loss in the stock market investor can experience a sense of regret over his decision to invest in stocks; he may interpret his loss as a sign that he is a second-rate investor; painful blow to ego; humiliation in front of friends and family etc
We achieve higher stock volatility of stock returns than supported by fundamentals of the stock market/companies as a result of time-changing preferences of investors towards holding stocks.

Front 10

Present stylized facts describing a closed-end fund puzzle. Provide brief explanation of the puzzle from the behavioral viewpoint (noise trading risk). (Make sure that your answer does not go beyond the space provided).

Back 10

stylized fact is a simplified presentation of an empirical finding.[1] A stylized fact is often a broad generalization that summarizes some complicated statistical calculations, which although essentially true may have inaccuracies in the detail.

A prominent example of a stylized fact is: "Education significantly raises lifetime income."

Front 11

Limits to arbitrage

Back 11

What do we mean by this:

1. Price of security does not reflect its fundamental value

2. This mispricing is not corrected within short period of time

Front 12

negative stub

Back 12

market value of the parent is less than market value of parent’s ownership stake in a publicly traded subsidiary

Front 13

Where do negative stubs come from?

Back 13

-Equity carve-outs (3Com/Palm)
-Acquisitions of stakes in publicly listed companies

Front 14

What happens when Short-selling not allowed?

Back 14

Optimists are there, but pessimists can not make their opinion count
The price is biased upwards

Front 15

margin risk

Back 15

If the arbitrageur faces a margin call, he will be forced to post additional collateral or partially liquidate

Front 16

How does a combination of constraints on short-selling and limited horizon by arbitrageurs lead to persistent deviation from fundamentals?

Back 16

-1 type of risk: fundamental
-3 ingredients:
1. Something that pushes the prices away from their intrinsic values

2. Something that prevents arbitragers from correcting the price on the spot



3. Something that prevents arbitragers from taking large long-term positions

Front 17

What pushes prices away from their intrinsic values?

Back 17

Systematic noise (correlated mistakes by noise traders)

Front 18

What prevents arbitragers from correcting the price on the spot?

Back 18

Inelastic suppy of risky asset (limited ability to short = fixed/low supply)

Front 19

What prevents arbitragers from taking large long-term positions?

Back 19

Short horizon of arbitrageurs (fear of liquidation at a loss)

Front 20

What is Neoclassical Asset pricing (Cochrane)?

Back 20

Investor must decide how much to save and how much to consume and what portfolio of assets to hold
Investors care only about wealth, but consume out of wealth and derive utility from consumption (increasing in wealth at a progressively lower rate)
Financial assets help investors to optimize their consumption over time
If investor is wealthy today, but anticipates a low income tomorrow she can consume part of its wealth today, invest the rest in financial asset
In the future she can liquidate financial asset and spend the proceeds to increase its future consumption

Front 21

What are earlier rational explanations of the CEF puzzle?

Back 21

-Taxes
-Assets illiquidity
-Agency costs

Front 22

What is the CEF puzzle?

Back 22

Why do CEFs have the pricing pattern of premium, then discount, that correlates with small stocks?

Front 23

What is the behavioral explanation of the CEF puzzle?

Back 23

-2 types of investors: rational & noise trader
-both trade according to different beliefs
-assets are risky & all investors are risk averse
-equilibrium prices reflect both opinions

Front 24

What is the new rational response to the CEF puzzle?

Back 24

closed-end fund discount is not related to a systematic risk (investor sentiment as a market-wide phenomenon)

Front 25

What does rational finance say about managers?

Back 25

-at the start (IPO) there is uncertainty about managerial ability
-bad managers stay while good managers leave

Front 26

Horizon risk is best described as

Back 26

arbitrager is uncertain over the time it would take for the mispricing to correct itself

Front 27

Buy-in risk is best described as

Back 27

arbitrager is unable to maintain his short position due to recall of borrowed shares by a broker and is forced to terminate the trade

Front 28

Fundamental risk is best described as

Back 28

arbitrager is unable to maintain both sides of his position as the link between parent and subsidiary is broken (e.g. delisting of parent company, acquisition of the subsidiary)

Front 29

Noise Trader Risk of arbitrager is best described by

Back 29

b) future trading activity of some investors is unpredictable
e) some investors trade not on information, but on psychological biases
f) judgment errors of some investors are correlated

Front 30

3. Prospect utility function is best described by (3 points) (choose as many answers as you find necessary to provide the complete answer):

Back 30

a) people use decision weights, rather than true probabilities when estimating expected utility value of a risky outcome
c) people evaluate their well-being in terms of gains and losses to some reference point
g) people are risk-averse in the area of gains and risk-seeking in the area of losses

Front 31

4. Mental accounting is a combination of narrow framing and dynamic aggregation. Narrow framing is best described by (1 point)

Back 31

d) people evaluate risky gambles/decisions in isolation rather then estimating their effect on the overall well-being

Front 32

What are the 4 pieces to the CEF puzzle?

Back 32

1) Start at premium (10%)
2) Move to discount (10%)
3) Wide fluctuations of discounts over time
4) Discounts shrink at termination

Front 33

What are the assumptions to the behavioral explanation of the CEF puzzle?

Back 33

1) Short horizons for rational investors (care about resale value)
2) Noise traders are random & unpredictable (additional risk for rational investors who resell)

Front 34

Why can't a rational arbitrageur buy
the fund selling at a discount and sell short its portfolio?

Back 34

1) The CEF could change its portfolio, which may be difficult for the arbitrageur to copy
2) The hedge of the short sale is not costless
3) This is not pure arbitrage unless there is an infinite time horizon & no forced liquidation

Front 35

What is the problem with an arbitrageur who takes over a fund and sells its assets at NAV?

Back 35

Shareholders will not tender their shares to the bidder unless they receive NAV, which would leave no profit for the arbitrageur

Managers & regulation also present major hurdles for the bidder