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78 Cards in this Set
- Front
- Back
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Define Market Efficiency. |
Market efficiency: the degree to which stock prices reflect all available and relevant information. it is not possible for an investor to outperform the market because all available information is already built into all stock prices. |
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Active Management Passive Management |
Active: the belief that the market is making a mistake and trading on that belief. Requires markets are irrational, correlated, and predictable in some way.
Passive: the belief that the market incorporates all information already (efficient) |
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Why does traditional finance suggest that rational models predict better than behavioral models? |
1. Arbitrageurs are rational agents 2. People on average behave rationally 3. Irrationalities "cancel out" 4. People will act rationally with big $$$ at stake 5. Important players in markets are likely to be rational 6. Smart money wins in the end |
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What is the argument of people who believe in behavioral finance against traditional finance? |
1. There are limits to arbitrage 2. There is not enough rational money in the market |
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What is an "Investment Philosophy"? |
A set of guiding principles that inform and shape an individual's investment decision-making process
Examples: 1. Value Investing 2. Growth Investing 3. Technical Investing (using past prices only to predict future prices, based on weak-form information) |
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Is passive management identical with "buy and hold"? |
No. In a "buy and hold" strategy, investors buy stocks and hold them for a long period of time, regardless of market fluctuations. Investor is not concerned with ST price movements and technical indicators.
Passive investors write an investment policy statement with an asset allocation plan based on assumptions about their unique ability, willingness, and need to take risk. The plan defines the target amount they will invest in each asset class. When it gets out of whack, he/she rebalances. |
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How does the value philosophy differ from growth philosophy? |
1. Value investing: markets systematically undervalue firms with some identifiable characteristics. Value investors comb the market for stocks that are trading below FMV. Other characteristics: Low P/E, high dividend, low PBV, high ROE, undervalued stock relative to model using DCF of FCF 2. Growth investing: Markets systematically undervalue growth in some companies. Growth investing is choosing stocks that are expected to grow (appreciate in value) over the LT. Other characteristics: P/E>Growth, Small cap, industry focus, emerging markets |
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Suppose you sell short 100 shares of IBM now selling at $120/share.
1. What is your maximum possible loss? 2. What happens to maximum loss if you place a stop-buy order at $128? |
1. In principle, potential losses are unlimited, growing directly with increases in IBM price 2. If stop-buy order can be filled at $128, max loss per share is $8. If the price of IBM share goes above $128, the stop-buy order would be executed, limiting the losses from the short sale. Maximum possible loss under this scenario is $800 (100 shares x $8 loss per share) |
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What benefits do short-sellers provide for securities markets? |
Short sellers helps investors with "price discovery," a process that helps them understand the full range of opinions and views about a particular stock. Short sellers run counter to the market's natural bias towards going long, expressing their opinion that the market is overpriced. As a result, they help keep the market in balance with their contrarian opinions. If investors just want to buy, prices will skyrocket. Somebody has to step in and sell, and if none of the longs want to, a short seller is able to supply the shares. This provides additional liquidity to the market. |
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The Siegel Data in the book "Stocks fo rhte Long Run" shows that a well-diversified portfolio of stocks outperformed bonds over every 30-year period in the past 200 years. Further, it shows that the Std. dev. of stock returns is lower than bonds for 20- and 30-year periods. The data has not been seriously questioned and show that stocks are less risky than bonds.
So, why is there an equity risk premium?? |
Stocks outperformed bonds every 30 year period we have data for. There is no need for an equity risk premium because there is no risk over the very long term.
Maybe the risk premium exists because: 1. Investors have severe loss aversion 2. They don't believe the data 3. They have a more short-term outlook than 30 years. |
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Assume that the stock market consists of 3 stocks. Write the formula for: 1. An equally-weighted index and 2. A value-weighted index
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1. Equal-weighted index: (20 + 10 + 40)/3 2. Value-weighted: [(20*1,000) + (10*20,000) + (40*5,000)]/26,000 = $16.15 |
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1. How is the Russell 3000 index constructed? 2. How does it differ from the S&P 500? |
1. Weighted by Market Capitalization (outstanding shares x share price). Generated by determining the total market cap of all stocks in index and dividing by total #shares of all stocks 2a. Russell 3000 measures performance of 3,000 public US companies (98% of investable US equity market). It is more frequently and carefully adjusted. 2b. S&P 500 is comprised of 500 of most widely traded stocks in the US (70% of total value of US stock markets) |
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Suppose you are an active money manager and your clients ask you to choose a broad based index to be your benchmark.
(You will probably respond broad based indices don’t measure what I am doing, and your client responds “I don’t care, I just want you to beat the market”).
1. If the Russell 3000, SP500 and Wilshire 5000 have a correlation of .99, which index would you use and why? 2. Will your answer be the same if you are a well-informed (about investments) client? |
1. As a manager, you may select the one with the lowest average return as a benchmark 2. As an investment client you may select the one with the highest average returns
**Because none of them are significantly higher than the others, it may not matter which one you select |
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Give 5 reasons why indices are constructed |
1. Market indices can give knowledge that it takes decades to gain from actual investing experience 2. Index data is used to confront conjectures with facts 3. Index data shows relationship between international markets 4. Indices are used to allocate assets: stocks vs. bonds, US vs. Non-US, value vs. Growth 5. Indices provide cover stories for poor performance |
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1. What is the definition of the word "statistic?" 2. What problem does a statistic attempt to solve? |
1. Statistic: A function of the sample data. A number that represents a piece of information. 2. Statistics attempt to find relationships and help to better understand unknown variables. |
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What do the mean, median, and mode attempt to measure? |
1. Mean: Average 2. Median: Middle number 3. Mode: Number that appears the most |
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1. What do variance and standard deviation measure? 2. What investment (really behavioral) assumption do they make? |
1. Variance: measure of dispersion of the distribution (a measure of risk) Standard deviation: the square root of variance. the ONLY relevant measure of risk 2. Variance and SD assume that the return distributions are normal. |
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1. What is the basic difference in how Kurtosis and Skewness are computed? 2. What do they attempt to measure? |
1. Kurtosis: (X-Xbar)^4 Skewness: (X-Xbar)^3
2. Negatively skewed distributions have a long left tail, which for investors means a greater chance of extremely negative outcomes. Positive skew means frequent small negative outcomes, and extremely bad scenarios are not as likely. Nonsymmetrical distributions are generally described as being either positively skewed (frequent small losses and few extreme gains) or negatively skewed (frequent small gains and a few extreme losses).
Kurtosis refers to the degree of peak in distribution. More peak than normal means that a distribution also has fatter tails and that there are lesser chances of extreme outcomes compared to a normal distribution |
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What is the difference between the sample mean (or sample median, sample mode) and the population mean (median or mode)? |
Sample: A portion of the population that is representative of the population from which it was selected Population: All possible measurements or outcomes that are of interest to us in a particular study
In finance we take a time series and assume it's from a distribution and predict the series will continue in the future - analyze data based on this series as if it were representative of the entire population. |
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What is the St. Petersburg Paradox and why is it relevant for expected utility? |
St. Petersburg Paradox: A theoretical game used in economics, to represent an example where if the decision maker based their decision only on the expected value, they will make an irrational decision. A person's valuation of a risky venture is not the expected return of that venture, rather the expected utility from the venture.
The game was a coin flip, where the payoff was 2^(# of flips). Expected return was infinite, but people are not willing to pay an infinite amount, which is why it's a paradox. People are willing to pay their expected utility, but not the expected return of the game. |
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Define the concept of a certainty equivalent. |
Someone would accept a guaranteed return that was lower, rather than taking a chance on a higher, but uncertain return. |
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(Not Sure)
Why does risk aversion require concave utility function |
1. Utility depends on consumption 2. More consumption always raises utility 3. The increase in utility brought about by a given increase in consumption is smaller the more consumption you already have (decreasing marginal utility) |
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When you use the historical mean and variance as measures of expected return and risk what assumptions are you making? |
1. Underlying distribution doe snot change 2/ Mean and variance don't change over time
For example, if you want to guess the average height of a player in the Big10, you grab 20 and take the average. If you apply this to the ACC, you are making the assumption it has the same distribution. |
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Suppose an investor’s utility function in wealth is U(w)=.1W-.00025W2 which the investor uses to maximize utility over the following choices: (Utility function-->use end of year wealth, not value.)
Why is the Sharpe ratio irrelevant in this circumstance? |
Sharpe ratio is irrelevant because this is not an equilibrium environment that we could apply CAPM to. Share ratio also does not measure utility which is what we are trying to do here. |
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**PROBABLY ON EXAM:
Given the following probabilities and wealth levels, show that choosing A and B* (or A* and B) violates expected utility:
Question 1: consider a choice between: A: $1 million with certainty. A*: $5 million with prob(0.1), $1m with prob(0.89) and $0 with prob(0.01)
Question 2: consider a choice between: B: $1m with prob(0.11), $0 with prob(0.89). B*: $5m with prob(0.10), and $0 with prob(0.90) |
Prefer A over A*:
Prefer B* over B: 0.11u(i) < 0.1u(5) |
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Differentiate the following terms/concepts: 1. Prospect and probability distribution 2. Risk and uncertainty 3. Utility function and expected utility 4. Risk aversion, risk seeking, risk neutral |
1. A prospect is a lottery or series of wealth outcomes, each of which is associated with a probability, whereas a probability distribution defines the likelihood of possible outcomes 2. Risk is measurable using probability, but uncertainty is not. uncertainty is when probabilities can't be assigned or the possible outcomes are unclear 3. A utility function, denoted as u(*), assigns numbers to possible outcomes so that preferred choices receive higher numbers. Utility can be thought of as the satisfaction received from a particular outcome 5. Risk aversion describes someone who prefers the expected value of a lottery to the lottery itself. Risk seeking describes someone who prefers a lottery to the expected value of a lottery. Risk neutral describes someone whose utility of the expected value of a lottery is equal to the expected utility of the lottery. |
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When eating out, Rory prefers spaghetti over a hamburger. Last night, she had a choice of spaghetti or macaroni and cheese and decided on the spaghetti again, The night before, Rory had a choice of spaghetti, pizza, or a hamburger, and this time she had pizza. Then, today, she chose macaroni and cheese over a hamburger. Does her selection today indicate that Rory's choices are consistent with economic rationality? Why or why not? |
Rory's preferences are consistent with rationality. They are complete and transitive. We see that her preference ordering is: Pizza, spaghetti, macaroni and cheese, hamburger |
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Consider a person with the following utility function over wealth: u(w) = e^w e = the exponential function (approximately equal to 2.7183) w = wealth in hundreds of thousands of dollars.
Suppose that this person has a 40% chance of wealth of $50,000 and a 60% chance of wealth of $1,000,000 as summarized by P(.40, $50,000, $1,000,000).
1. What is the expected value of wealth? 2. Construct a graph of this utility function 3. Is this person risk averse, risk neutral, or a risk seeker? 4. What is this person's certainty equivalent for the prospect? |
1. (w) = 0.4 * 0.5 * 0.6 * 10 = 6.2 U(P) = 0.4e^0.5 + 0.6e^10 = 13,216.54 2. Image 3. Risk seeker - graph is convex 4. e^w=13,216.54 gives w=9.4892244 or $948,922.44 |
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An individual has the following utility function: u(w) = w^5 where w = wealth 1. Using expected utility, order the following prospects in terms of preference from the most to least preferred: a. P1(.8, 1,000, 600) b. P2(.7, 1,200, 600) c. P3(.5, 2,000, 300) 2. What is the certainty equivalent for prospect P2? 3. Without doing any calculations, would the certainty equivalent for prospect P1 be larger or smaller? Why?
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1. P2, P3, P1 with expected utilities 31.5972, 31.0209, and 30.1972 for prospects 2, 3, and 1 respectively 2. 998.3830 3. The certainty equivalent for P1 would be smaller because P2 is ranked higher than P1 |
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Consider two problems: Problem 1: choose between Prospect A and Prospect B. Prospect A: $2,500 with prob. .33, $2,400 with prob. .66, Zero with prob. .01 Prospect B: $2,400 with certainty
Problem 2: Choose between Prospect C and Prospect D. Prospect C: $2,500 with prob. .33, Zero with prob. .67 Prospect D: $2,400 with prob. .34, Zero with prob. .66
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This is an example of the Allais paradox. The first choice suggests that u(2,400) > .33u(2,500) + .66u(2,400) or .34u(2,400) . .33u(2,500) while the second choice suggests just the opposite inequality |
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Differentiate the following terms/concepts: 1. Systematic and nonsystematic risk 2. Beta and Standard Deviation 3. Direct and indirect agency costs 4. Weak, semi-strong, and strong form market efficiency |
1. Systematic risk: undiversifiable risk or market risk - the degree to which the stock moves with the overall market is called the systematic risk and denoted as beta Unsystematic risk: diversifiable risk or residual risk - the risk that is unique to a company such as a strike, the outcome of unfavorable litigation, or a natural catastrophe that can be eliminated through diversification 2. Beta - a measure of the volatility (systematic risk) of a security or a portfolio in comparison to the market as a whole Standard deviation - historical volatility - used by investors as a gauge for the amount of expected volatility 3. Direct agency costs (2 types): a corporate expenditure that benefits management but costs stockholders (luxurious/unneeded corporate jet) OR an expense that arises from the need to monitor management actions (paying auditors) Indirect Agency cost: lost opportunity 4. Weak form - Prices reflect all past information Semi-strong form - prices reflect all past and public information Strong form - prices reflect all past, public, and private information |
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A stock has a beta of 1.2 and the standard deviation of its returns is 25%. The market risk premium is 5% and the risk-free rate is 4%. 1. What is the expected return for the stock? 2. What is the expected return and standard deviation for a portfolio that is equally invested in the stock and the risk-free asset? 3. A functional analyst forecasts a return of 12% for the stock. Would you buy it? Why or why not? |
1. .04 + 1.2(.05) = .1 2. E(Rp) = .5(.1) + (.5)*(.04) = .07 STD = .5(.25) = .125 3. If the analyst is credible, buy as it is expected to generate an abnormal positive return |
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1. What is the joint hypothesis problem? 2. Why is it important? |
1. The joint hypothesis problem states that when a model yields a return significantly different from the actual return, one can never be certain if there exists an imperfection in the model or if the market is inefficient. 2. It implies that market efficiency per se is not testable |
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Warren Buffett has been a very successful investor. In 2008, Luisa Kroll reported that Buffett topped Forbes Magazine's list of the world's richest people wiht a fortune estimated to be worth $62 billion. Does this invalidate the EMH? |
Buffett's experience does not necessarily invalidate EMH. There is possibility that this is just lucky, given that there are numerous money managers, some are bound to perform well just by luck> Still, many would question this because Buffett's track record is consistently strong. |
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You are considering whether to invest in two stocks, Stock A and Stock B. Stock A has a beta of 1.15 and the STD of its returns has been estimated to be 0.28. For Stock B, the beta is 0.84 and the STD is 048.
1. Which stock is riskier? 2. If the risk-free rate is 4% and the market risk premium is 8%, what is the expected return for a portfolio that is composed of 60% A and 40% B? If the correlation between the returns of A and B is 0.50, what is the standard deviation for the portfolio that includes 60% A and 40% B? |
1. Stock A is riskier, though stock B has greater total risk 2. .6 (.04 + 1.15*.08)) + .4 (.04 + .84(.08)) = .12208 3. σp2 = (.6)2 (.28)2 + (.4)2(.48)2 + 2*.5(.6)(.4)(.28)(.48) = 9.7% σp = 31.2% |
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(Unsure)
Describe the arbitrage if, Rf = .04, Rm = .1 and a stock with a beta = 1.50 has an expected return of 12%. What exactly do you go long in and what do you go short in if all the assumptions of CAPM are true? |
.04 + (1.5*.19) = 19% Investment E(x) Risk Long Stock 1 .19 1.5 Short 1.5 Rm -1.5 -.15 -1.5 Long .5 Rf .5 .2 0 0 .6 0 |
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Describe the Arbitrage if Rf = .04, Rm = .1 and a stock with a beta = .5 has an expected return of 6%. What exactly do you go long in and what do you go short in if all the assumptions of CAPM are true? |
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How is the market model different from the CAPM? |
The market model says that the return on a security depends on the return on the market portfolio and the extent of the security's responsiveness as measured by beta. The return also depends on conditions that are unique to the firm.
CAPM says that investors need to be compensated in 2 days: time value of money and risk. TVM is represented by the Rf rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. |
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Give two determinants of beta. |
1. Leverage 2 Fixed costs (higher fixed costs or higher leverage cause higher beta)
possible 3rd: is industry cyclical? |
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1. What is the "arbitrage pricing model?" 2. What are the 2 assumptions and how is the arbitrage portfolio constructed? |
1. APT recognizes that the return on the mkt portfolio is not the only systematic risk factor that affects the LT average returns on individual assets or portfolios. By decomposing market risk, the APT seeks to identify major component systematic risk factors of market risk that determine the variations of asset returns in an efficient capital market.
The APT model takes multiple sources of systematic risks into account and performs better than the CAPM. It implies the same return-beta relationship as CAPM but does not require all investors be mean-variance optimizers.
Appeal of APT: its implication that compensation for bearing risk may be comprised of several risk premiums (macroeconomic factors) rather than just one risk premium (CAPM)
Underlying philosophy of APT is law of one price. AKA 2 assets that bear the same level of risk cannot sell at different prices.
The recognition that the unanticipated part of the return that results from surprises is the only relevant risk of an investment. |
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Can a one factor model be an "Arbitrage Pricing Model?" If so, then what exactly is the difference between a one factor arbitrage pricing model and the CAPM? |
Yes, a one factor model can be included in an APM. In this case, it is possible that the APM and the CAPM would be the same - that is to say that the one factor in the APM could be beta.
The difference, however, is that the APM could be based on any variable whereas the CAPM relies solely on beta. |
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What assumptions does expected utility maximization make that are questionable? |
1. You know all the outcomes 2. You know their probabilities 3. You know their utility function 4. You can maximize it
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What is "bounded rationality?" |
The idea that when individuals make decisions, their rationality is limited by: 1. The information they have 2. The cognitive limitations of their minds 3. The time available to make the decision |
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Describe the two steps that investors use to evaluate investments if they are following prospect theory. |
1. Editing stage: the possible outcomes of the decision are ordered following some heuristic which he may or may not get the probabilities correct. In particular, people decide which outcomes they see as basically identical, and they set a reference point and consider lower outcomes as losers and larger as gains 2. Evaluation stage: People behave as if they would compute a value (utility), based on the potential outcomes and their respective probability, and then choose the alternative having a higher utility. |
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What is the role of the value function in prospect theory and what is its shape? |
The value function is defined on deviations from a reference point and is normally concave for gains (implying risk aversion), commonly convex for losses (risk seeking) and is generally steeper for losses than for gains (loss aversion) |
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What predictions does prospect theory make for losses and gains? |
People are risk loving in loss. They want to get out of losses so they can begin to take more risk to get back to their reference point (breakeven -> what you started with).
People are less willing to gamble with gains than with losses. |
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How does prospect theory help explain the "equity premium" puzzle? |
Prospect theory explains the equity premium puzzle because the market is volatile and people feel losses and try to get back to the reference point. They must be compensated for this. Investors are not averse to variability but dislike the fact that stocks show losses more frequently than bond returns. |
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What are rational, non-behavioral reasons for selling winners and holding losers? |
By holding onto our losers, we are hoping they will go up.
For our stocks that are winners, we aren't compelled to gamble and want to lock in our gains. As a result, we sell our winners and hold onto our losers (some investors believe in mean reversions.
Some portfolio strategies generate something that looks like the disposition effect (selling winners, holding losers) because they want equally weighted portfolios. |
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What effect does professional trading have on disposition effect? |
1. Disposition effect: unwillingness to sell losers 2.Professional traders are good at controlling their biases, which minimizes the disposition effect |
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Find answer:
An individual with wealth of $100,000 faces a 10% chance of losing $15,000. An insurance policy to avoid this risk costs $200. Will they buy the policy if: 1. They had a utility function of ln (wealth)? 2. They followed prospect theory with v(z)=.88(-z)^.88 and ?(.10)=.10 |
No answer yet |
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How does distortion of the probabilities matter in prospect theory?
Compare problems 3 and 4 in Behavioral Finance chapter 3 (and understand notation) ^^Look these up for notation |
Problem 3 has given probabilities and problem 4 has distorted probabilities (which makes smaller probabilities larger and bigger probabilities closer to 1).
The equation takes into account the fact that people tend to overvalue very low risks (i.e. GMOs, asteroids, nuclear explosions, vaccinations, etc.) and undervalue higher risks that they are more familiar with (i.e. cancer) |
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How does stating a choice in the negative versus the positive affect which choice people make? |
People prefer gains and are more averse to losses |
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Give a general definition of framing. |
A frame in social theory consists of a collection of anecdotes and stereotypes that individuals rely on to understand and respond to events. In simpler terms, people have, through their lifetimes, built a series of mental emotional filters. They use these filters to make sense of the world. The choices they then make are influenced by their frame of emotional filters.
In psychology, framing is influenced by the background of a context choice and the way in which the question is worded. |
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Discuss the reasons for framing. |
1. Provide people with a quick and easy way to process information 2. One can frequently frame a decision using multiple scenarios that express benefits as a relative risks reduction or as absolute risk reduction 3. Control over cognitive distinctions between risk tolerance and reward anticipation adopted by decision makers can occur through altering the presentation of relative risk and absolute benefits 4. When decision options appear framed as a likely gain, risk averse choices predominate 5. Framing decision problems in a positive light generally result in less risky choices |
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Arbitrage is limited because the wealth of arbitrageurs is limited. Discuss this statement in the context of those who are managing their own money and those who are managing other people's money |
With other people's money you are more concerned with losing your job than just losing someone's money. There is an agency cost of the manager losing their job rather than just maximizing the value of the investment.
Manager might invest their own money in a value company because they are looking at the long-term returns.
Clients might prefer ST returns and the manager could then lose their job if they don't deliver in the ST. It is hard to communicate a value investing strategy to clients. |
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1. What are the two key assumptions of an inefficient market? 2. If the market is never efficient for a particular set of information can you still make money? |
1. Correlated Investor Irrationality - Investors must be irrational in some way that the manager can develop into investor rules, the irrationality can not be random. 2. Limits to arbitrage - there must be limits to what informed, rational investors can do, otherwise they will wipe out the irrational investors. a. Restrictions of demand - those going long or short must be limited by capital or transactions costs b. Restrictions on supply - companies themselves must have restrictions on issuing new (overpriced) shares or buying back (underpriced) shares |
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List four limits to arbitrage |
1. The need to invest and the risk free return - real arbitrage is not the same as CAPM arbitrage. Investors need to put up money so a risk-free arbitrage should earn more than the risk free rate 2. Transaction costs - stocks have direct transaction costs (bid-ask spread, commission) and indirect transaction costs (price impact, speed of transaction) 3. Investment limits - The amount of money invested can be limited as can the ability to short sell 4. Timing - the market may stay irrational longer than you can stay invested |
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What is the definition of SUE? How might we take advantage of this anomaly? |
1. SUE: Standardized Unexpected Earnings. Earnings surprise occurs when the firm's reported earnings per share deviates from the estimate.
SUE = (QE - FE)/P QE = Actual Quarterly Earnings FE = Forecasted earnings P = This quarter price
To take advantage, calculate SUE. Rank this quarter's SUE by last quarter's SUE and rank by deciles. Get SUE = 1 (losers) - SUE 10 (winners)
Invest long in SUE 9 and 10 and short in SUE 1 and 2
Hold for 9 months to a year
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(Partially answered)
What are the key variables that managers use to distinguish value stocks from groth stocks? What can we expect to earn by long value, short growht? What is the risk of this strategy? |
Value - Low P/E, slow growth, stability, low Price/Book Growth - They compete in fast-growing and "scalable" (capable of expansion) market niches. Leading market shares, generate above-average FCF, attractive ratio of price/FCF, positive earnings revisions, above-average ROE
Risks: value stocks can stay cheap longer than investors can remain solvent and realize the gains from the stock (you run the risk of having a negative beta portfolio) |
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How exactly do you construct momentum and reversal portfolios? |
Momentum: at the beginning of each month rank stocks in ascending order on the basis of their geometric return over the past N months. (ex. look at the past 6 months). Rank all stocks from top return to bottom return and determine the deciles. Average (equally weight) each stock in each decile. Top decile is called "winner" bottom is called "loser. Buy winners and short losers, holding this position for # months. Close out the position that is #+1 months old. Rebalance portfolio to keep weights equal.
Reversal: For every stock with at least 85 months of return data (without missing months) starting in January 1930, determine the market-adjusted, excess returns, Rt-Mt, for a five year "formation" period and a "test" period, Mt is the equally weighted average of all NYSE stock returns. The procedure is repeated 16 times for each of the 10-year periods starting in January 1926, January 1927, etc. Each time adding more stocks as they appear. For each stock in each sample, the cumulative excess (CU) returns are formed. The 50 stocks with the highest CU are assigned to a winner portfolio and the 50 stocks with the lowest CU are assigned to a loser portfolio |
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Define System 1 and System 2.
Why is it useful to make sure the distinction between these two ways of thinking? |
System 1 is the system of thinking that relies on emotion, perception, and instinct. System 2 is a slower, more deliberate system of thought that relies on logic and careful calculation.
It is useful to understand the differences in order to detect certain cognitive biases that may influence our decisions. |
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Define: 1. Hindsight bias 2. Outcome bias 3. Belief bias 4. Confirmation bias
What are the sources of these biases? |
1. Hindsight bias: the "knew it all along" effect. Past events look less random than they actually were 2. Outcome bias: the distorting effect outcome info can have on our evaluations of decision quality 3. Belief bias: tendency to treat information differently based on if it already aligns with current beliefs. People are more uncritical of ideas consistent with their beliefs, and hypercritical of information that challenges our beliefs 4. Confirmation bias: inclination to seek out information that confirms our beliefs
Some sources of these biases include the selective, reconstructive nature of memory |
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Define the gambler's fallacy and distinguish it from the regressive fallacy |
Gambler's fallacy: We tend to believe that luck will somehow "even out," but if we're talking about truly random events that simply may not be so. This is different from the regressive fallacy, which is failing to take into account natural and inevitable fluctuations in things when ascribing causes or making predictions |
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What is the conjunctive fallacy and what are its implications for decision making? |
Conjunction fallacy: tendency to misunderstand compound probabilities. People tend to believe that events with more conditions are more likely to occur (or "work out as planned") than one single, more general condition
Implications: understanding this fallacy can help explain why projects often aren't completed on time, the relationship between complexity and reliability, the odds of success for highly complex strategies, and wisdom of committing repeated regulatory violations |
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What are the two processing systems that psychologist show humans have when confronted with decisions that involve risk? |
System 1: Operates automatically and quickly with little or no effort and no sense of voluntary control
System 2: Allocates attention to the effortful mental activities that demand it, including complex computations |
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How do our motivations place obstacles in the path of risk perception? |
When you feel you are at risk, excessive protective action kicks in. However, when you do not believe you are at risk, not enough attention is allocated to risk management. We want to maintain positive emotions, which causes us to fail to prepare for some risks that seem less urgent. |
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Give examples of how people over-estimate the probability of rare events and underestimate the probability of frequent events. What factors determine by how much they do so? |
Someone considering a move to San Francisco may overestimate the probability that the Bay Area will suffer from an earthquake in the next 5 years. However, small probability events can loom large in decisions, even when these events are not overestimated. For example, consumers find lottery tickets attractive, even though they may be very much aware of the low chances of winning.
The factors that determine by how much they do so include whether or not the event is dreaded and if the event is known or unknown to us. |
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Briefly describe how the following create obstacles to better risk perceptions: 1. Hyperbolic discounting 2. Finite cognitive capacity 3. Endowment effect 4. Memory 5. Cognitive dissonance |
1. Hyperbolic discounting: tendency to prefer smaller payoffs now over larger payoffs later 2. Finite cognitive capacity: inability to deal with too much choice. Limited working memory and attention cause bounded rationality. More choices do not lead to better decisions and the quality and satisfaction of choices are reduced. 3. Endowment effect: same as status quo bias 4. Memory: memory is selective and reconstructive in nature. Memory can be distorted by suggestion and information acquired after the fact. Memories can also be "recovered" 5. Cognitive dissonance: happens when we hold two conflicting views. We ignore facts that are painful to us (i.e. saving for retirement when we are young because we don't want to imagine being old) |
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What is the "home bias" and how is it created by the psychological problems with perceiving risk correctly? |
Americans will tend to invest in American companies, French in French companies, etc. PMs even tend to invest around the cities in which they live. We prefer to invest in familiar companies. |
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Describe the effect of cognitive dissonance on the propensity to save. |
Cognitive dissonance refers to a situation involving conflicting attitudes, beliefs, or behaviors. We want to ignore information that we don't want to hear. Young people do not want to save money for retirement because they do not want to think about getting old. |
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How might an investor's portfolio have changed from 1995 to 2000 if the investor became overconfident? |
Internet stocks kept going up during this time. People did not fully understand the application of the technology and investors over invested in internet stocks (overconfident) |
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How does overconfidence relate to trading and what effect does it have on a portfolio's return? |
Find answer* |
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How does online trading contribute to the relationship between a portfolio's return and stock trading? |
People trade too much with online trading without a broker asking you why you're doing the trade, and you have higher transaction costs. The portfolio returns go down |
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Why might agency traders be less subject to the biases of overconfidence than proprietary traders? |
They are not the primary decision makers, they are executing someone else's trades and they are less impacted by the trade. The agency traders try to get the best prices but they are less overconfident and they are trading in the market more (have less bias and get more feedback on their trades because of their frequency) |
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Differentiate between the following terms/concepts: 1. Miscalibration and excessive optimism 2. Better than average effect and illusion of control 3. Self-attribution and confirmation bias 4. Pros and cons of overconfidence |
1. Miscalibration: misestimation of the probability of something happening Excessive optimism: assigning higher probabilities to favorable events (winning the lottery, getting a good grade) 2. Better than average effect: people tend to rate themselves as better than average. This happens because there might not be an exact definition of what excellence is or people are looking for a self-esteem boost. Illusion of control: when one thinks they have more control over an event than the actually do (rolling dice, drawing cards) 3. Self-attribution: the tendency of people to attribute success or good outcomes to their own abilities but blame failures on factors outside of their control (leads to increased overconfidence) Confirmation bias: the tendency to look for evidence that is consistent with one's prior beliefs and ignore conflicting data |
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Is miscalibration greater for easy questions or hard questions?
Is it greater when we look at 50% confidence ranges or 98% confidence ranges? |
Miscalibration is greater for hard questions we underestimate our abilities
98% confidence intervals have more miscalibration |
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Provide an example where someone can be both excessively optimistic and miscalibrated at the same time? |
A doctor could be excessively optimistic that patients do not have a disease and also be miscalibrated |
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HIGH PROBABILITY ON TEST:
Despite their obvious success, their fans were still a bit overconfident going into the playoffs. The consensus among fans was that they would average 50 points per game in the playoffs. Plus, their fans were 95% sure that they would be within 5 points of this number (45-55). Illustrate the dimensions of their overconfidence. (for the purposes of this question, assume the patriots participated in 4 playoff games) |
Both miscalibration and excessive optimism are present. To illustrate, the Patriots scored on average 36.81 points. It is believed that they will score 50 points in the playoffs. This seems to be a case of excessive optimism. (Also it is likely that their opponents will be better in the playoffs.) As for miscalibration, the standard deviation of points scored during the season is easily calculated to be 10.19. The standard deviation of the mean based on four observations is 10.19 / 2 = 5.09. A 95% confidence interval should be about four standard deviations in width, or in this case over 20 points. This is twice as wide as the actual standard deviation of the fans of the Patriots. |
