2021

QUESTION ONE

a) Loss aversion refers to the tendency for people to weigh losses more heavily than gains of
the same absolute value. The value function V(x) in the given prospect theory formulation
captures loss aversion through two features:

1. The function is steeper for losses (x<0) than for gains (x≥0), indicating losses loom
larger than gains. Specifically, V(x) = -2(-x)^(1/2) for x<0 versus V(x) = x^(1/2) for
x≥0.
2. There is a kink in the value function at the reference point x=0, where the slope
changes discontinuously from 1 to -2. This captures the idea that losses are weighted
more heavily than equivalent gains.

b) To evaluate the prospects: P1(0.5, 0, £100) = 0.44 * (100)^(1/2) = 8.84 P2(1, £25) =
(25)^(1/2) = 5

The higher value is for P1, so the investor would choose prospect P1 over P2 according to
prospect theory with this value function.

This demonstrates risk seeking for gains - the prospect P1 with a 50% chance of £100 is
preferred over the certain gain of £25 in P2, violating the standard expected utility
framework.

c) i) P3(0.001, 9000) = 0.011 * (9000)^(1/2) = 8.49 P4(1, 9) = (9)^(1/2) = 3

The higher value is for P3, so she would choose the low probability high payoff prospect P3
over the certain small gain in P4.

This again shows risk seeking for gains, preferring the longshot low probability high payoff
gamble.

ii) P5(0.001, -9000) = -0.011 * 2 * (-9000)^(1/2) = -21.21 P6(1, -9) = -2 * (-9)^(1/2) = -6

The higher (less negative) value is for P6, so she would choose the certain small loss P6 over
the low probability large loss P5.

This demonstrates risk aversion for losses, preferring to avoid the small chance of a very
large loss.

QUESTION TWO

a) Overconfidence in behavioral finance refers to the tendency for people to overestimate

their own abilities, knowledge or precision of their information. Some key cognitive biases
that contribute to overconfidence include:

 Self-attribution bias: Taking too much credit for successes while blaming external
factors for failures
  Confirmation bias: Seeking out/interpreting evidence in a way that confirms one's
existing beliefs
 Hindsight bias: Believing past events were more predictable than they actually were
 Illusion of control: Overestimating one's ability to control or influence outcomes
 Desirability bias: Overestimating the probability of favorable events occurring

b) Empirical evidence suggests overconfidence can have significant impacts in financial

markets:

 Overconfident investors tend to trade more actively, increasing transaction costs

which hurts returns
 Overconfident CEOs are more likely to overpay for acquisitions destroying
shareholder value
 Overconfident investors are more likely to underdiversify their portfolios
 Overconfident investors tend to underreact to new information and hold onto losing
positions too long
 However, some studies find overconfidence can improve negotiation outcomes in
some contexts

Overall, overconfidence appears to be a costly bias for investors on average, though a

moderate level may have some benefits in specific situations. The impacts likely depend on
the domain and level of overconfidence involved.

QUESTION THREE

a) The equity premium refers to the excess return that investing in the stock market has
historically provided over safer investments like government bonds. It is calculated as the
difference between the average return on stocks and the average return on risk-free assets like
Treasury bills.

The equity premium puzzle refers to the observation that the historical equity premium has
been much larger than what would be predicted by standard economic models. Investors
appear to demand a very high premium for taking on the risk of holding stocks, which seems
puzzlingly large given the relatively low risk aversion implied by other economic behaviors.

b) Researchers have proposed several behavioral explanations to try to resolve the equity
premium puzzle:

1. Loss aversion: Prospect theory suggests that people are more sensitive to losses than
gains of the same magnitude. If investors are particularly averse to potential losses in
the stock market, they would demand a high premium to compensate for this.
2. Myopic loss aversion: Investors may evaluate their portfolios too frequently,
amplifying the pain of losses and causing them to be more risk-averse over the long
run.
3. Pessimism/ambiguity aversion: Investors may be pessimistic about the distribution of
future stock returns or averse to ambiguity in estimating probabilities, leading them to
require a high premium.
4. Narrow framing: If investors think about their stock holdings in isolation, rather than
as part of a broader portfolio, they may overweight the perceived riskiness of stocks.
 5. Preferences beyond consumption: Investors may derive utility from factors beyond
just consumption, like status or regret avoidance, which could affect their risk
attitudes.

QUESTION FOUR

a) Value stocks are stocks that trade at low prices relative to measures of their fundamental
value, like earnings, dividends, or book value. Growth stocks, on the other hand, are stocks
with higher valuations, reflecting expectations of strong future growth.

Empirically, value stocks have tended to outperform growth stocks over long time periods, a
phenomenon known as the value premium. Studies have found that portfolios of value stocks
generate higher risk-adjusted returns than portfolios of growth stocks.

b) Several competing explanations have been proposed for the value premium:

1. Risk-based explanation: Value stocks may be riskier, perhaps due to higher financial
distress risk or heightened sensitivity to macroeconomic conditions, justifying their
higher expected returns as compensation for risk.
2. Behavioral explanations:
o Investors may overreact to negative news about value stocks, driving their
prices too low.
o Investors may have an irrational preference for glamorous, high-growth
companies, overpaying for growth stocks.
o Value strategies may exploit the cognitive biases of other investors.
3. Data mining/statistical issues: The value premium could be an artifact of specific time
periods, markets, or the way value is defined and measured.
4. Risk-related characteristics: The value premium could reflect compensation for
undiversifiable risks related to characteristics like firm size, liquidity, or leverage.

QUESTION FIVE

a) i. Under-diversification: Individual investors tend to hold undiversified portfolios, often

concentrating holdings in a few stocks, particularly those of their employer.

ii. Buying decision: Individual investors exhibit behaviors like the disposition effect (holding
losers too long and selling winners too soon), trend-chasing (buying assets after recent strong
performance), and familiarity bias (favoring local or well-known stocks).

iii. Selling decision: Investors are reluctant to realize losses (due to prospect theory's loss
aversion) and exhibit inertia in making portfolio adjustments.

b) Psychological effects potentially relevant:

 Loss aversion (aversion to realizing losses)

 Overconfidence (leading to underdiversification and trend-chasing)
 Representativeness heuristic (judging based on stereotypes like "good" vs "bad"
companies)
 Anchoring (e.g. anchoring on purchase price when considering selling)
 Mental accounting (separating components of wealth into different mental accounts)
  Regret aversion (fear of the regret of selling a winner too soon or missing further
gains)
 Status quo bias (preference for inaction over portfolio adjustments)
 Self-control problems (inability to follow an optimal investment plan)
 Attention effects (focusing on salient features like past returns)

The psychological effects help explain seemingly irrational investment behaviors that deviate
from the assumptions of standard economic models.
2019

QUESTION ONE

a) The main features of prospect theory that distinguish it from expected utility theory are:

1. Reference Dependence: Utility is defined over gains and losses relative to a reference
point, rather than over final wealth levels as in expected utility theory. This is evident
in the provided value function V(x) which is defined over changes in wealth (x) rather
than final wealth levels.
2. Loss Aversion: Losses loom larger than gains of the same magnitude. This is captured
by the steeper slope for losses (-2(-x)^(1/2)) compared to gains (x^(1/2)) in the value
function.
3. Diminishing Sensitivity: The value function exhibits diminishing sensitivity, with
marginal values decreasing as one moves away from the reference point in either
direction. This is reflected by the concave shape for gains (x^(1/2)) and convex shape
for losses (-2(-x)^(1/2)).
4. Probability Weighting: Prospect theory assigns decision weights π(p) to stated
probabilities p, which overweight low probabilities and underweight moderate and
high probabilities, unlike expected utility theory which uses stated probabilities
linearly.

b) To evaluate the prospects, we calculate the prospect theory values:

P1 value = 0.44 * (100)^(1/2) = 4.4 P2 value = 1 * (50)^(1/2) = 7.07

Since P2 has a higher prospect theory value, the investor would choose P2 over P1.

c) To evaluate the prospects, we calculate the prospect theory values:

P3 value = 0.64 * (-2*(-16000)^(1/2)) = -160 P4 value = 1 * (-2*(-9)^(1/2)) = -6

The investor would choose P4 over P3, as P4 has a higher (less negative) prospect theory
value, indicating a smaller loss.

This choice is consistent with loss aversion, where investors are more sensitive to losses than
gains of the same magnitude. The larger loss associated with P3 is weighted more heavily
than the smaller loss of P4, despite P3 having a higher probability of occurring.

QUESTION TWO

a) The two main approaches to behavioral corporate finance are:

1. Managerial Biases: This approach focuses on how cognitive biases and heuristics of
corporate managers influence their decision-making, leading to departures from
rational behavior assumed in traditional corporate finance theories.
2. Market Inefficiencies: This approach examines how investor sentiment, driven by
psychological biases, can create mispricing of securities, leading to inefficient capital
markets and affecting corporate financing and investment decisions.
While the managerial biases approach studies deviations from rationality within the firm, the
market inefficiencies approach looks at deviations from rationality outside the firm, in the
financial markets.

b) Prospect theory has been applied to explain the underpricing phenomenon in Chinese
IPOs. Key points:

 Chinese IPOs exhibit significant and persistent underpricing, with average initial
returns far exceeding those in other markets.
 Researchers like Loughran and Ritter (2002) suggest that prospect theory, particularly
the concepts of loss aversion and probability weighting, can explain this behavior.
 Issuers may be willing to underprice IPOs significantly to avoid the perceived losses
associated with failed offerings, even if the probability of failure is low (loss
aversion).
 Investors may overweight the small probability of large gains from underpriced IPOs
and underweight the higher probability of moderate gains from fairly priced IPOs
(probability weighting).

However, critics argue that institutional factors like regulatory constraints and rent-seeking
behavior by underwriters may also contribute to the observed underpricing in China.

QUESTION THREE

a) Momentum and reversals are two patterns observed in stock returns:

Momentum: This refers to the tendency for stocks that have performed well (poorly) over the
past 3-12 months to continue to perform well (poorly) over the subsequent 3-12 months. It
represents a continuation of past returns.

Reversals: This refers to the tendency for stocks that have performed poorly (well) over the
past 3-5 years to subsequently outperform (underperform) over the next 3-5 years. It
represents a reversal of long-term past returns.

b) Behavioral biases have been proposed to explain the momentum anomaly:

1. Conservatism Bias: Investors may be slow to update their beliefs in response to new
information, causing them to underreact to news and driving momentum.
2. Self-Attribution Bias: Investors may attribute success to their own skill and failure to
external factors, leading them to hold on to winning stocks too long and sell losing
stocks too quickly.
3. Overconfidence: Overconfident investors may overweight their private information,
leading to an initial underreaction to news and subsequent overreaction as more public
information arrives.
4. Disposition Effect: Investors' reluctance to realize losses and eagerness to realize
gains can cause them to hold onto losing stocks too long and sell winning stocks too
soon, generating momentum.
5. Representativeness Heuristic: Investors may erroneously expect patterns or streaks in
stock returns to continue, leading them to extrapolate past performance into the future
and driving momentum.
Combinations of these biases, such as the interplay between conservatism and
representativeness, have also been proposed as explanations for momentum.

QUESTION FOUR

a) The stylized facts about the stock market are:

i) Equity Premium Puzzle: The observed equity risk premium (the excess return of stocks
over risk-free assets) is much higher than can be justified by standard economic models based
on risk aversion.

ii) Volatility Puzzle: The observed volatility of stock returns is much higher than can be
explained by models based on underlying economic fundamentals.

iii) Bubbles: Stock prices occasionally exhibit large departures from fundamental values,
suggesting the presence of speculative bubbles driven by investor sentiment rather than
fundamentals.

b) Behavioral explanations proposed for these facts include:

Equity Premium Puzzle:

 Loss Aversion and Myopic Loss Aversion: Investors are more sensitive to losses than
gains, leading them to demand a higher premium for holding risky assets like stocks.
 Overconfidence: Overconfident investors may overestimate the risk of stocks,
requiring a higher premium.
 Ambiguity Aversion: Investors may demand a premium for holding stocks due to
uncertainty about their return distributions.

Volatility Puzzle:

 Overconfidence: Overconfident investors may trade too aggressively, increasing

volatility.
 Representativeness Heuristic: Investors may mistakenly expect patterns or trends in
stock returns, leading to excessive trading and volatility.
 Feedback Loops: Investor sentiment and trading can create feedback loops that
amplify volatility.

Bubbles:

 Overconfidence and Optimism Bias: Investors may overestimate the future prospects
of firms, driving prices above fundamentals.
 Representativeness Heuristic: Investors may extrapolate past returns into the future,
fueling bubbles.
 Social Contagion: Investors may be influenced by the beliefs and behaviors of others,
leading to herding and bubbles.
 Limited Arbitrage: Arbitrageurs may be unable or unwilling to correct mispricing due
to noise trader risk, fundamental risk, and other constraints.

QUESTION FIVE
a) Baker and Wurgler's (2007) composite sentiment index is a reduced-form measure of
investor sentiment constructed from several underlying proxies, including:

 Trading volume
 Dividend premium
 Closed-end fund discount
 IPO first-day returns
 Equity share in new issues

The index is constructed by taking the first principal component of these proxies, capturing
their common variation interpreted as investor sentiment.

While such an index may not be able to perfectly time the market, it could potentially be used
to devise profitable trading strategies:

 Go long (buy) when the index is low, indicating pessimistic sentiment and potential
undervaluation.
 Go short (sell) when the index is high, indicating optimistic sentiment and potential
overvaluation.
 Adjust portfolio exposures based on the level of the sentiment index.

However, successfully implementing such strategies requires careful consideration of

transaction costs, trading frictions, and other practical limitations.

b) It is possible for investors to enhance portfolio performance by applying lessons learned

from behavioral finance, such as:

 Avoiding or mitigating common psychological biases like overconfidence, anchoring,

and loss aversion that can lead to suboptimal investment decisions.
 Adopting a contrarian or value-based investment approach to exploit potential
mispricing caused by investor sentiment.
 Implementing disciplined rebalancing strategies to take advantage of mean reversion
in asset prices.
 Using strategies that exploit documented behavioral anomalies like momentum,
reversals, or post-earnings announcement drift.
 Diversifying across asset classes, strategies, and investment styles to mitigate