254662216 Sample Exam Questions Behavioral Finance doc PDF

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The Exam BF will consist of open-ended questions consisting of several sub-questions giving a total maximum score of 100 points. A minimum of 55 points has to be obtained for passing the exam.

Sample open-ended questions (summary of correct answer in bold): Suppose that you have initial wealth equal to $25. You receive a letter that states that you have won $16 in a lottery. However, the next day you receive a call from the lottery organizers. They tell you that it was a mistake so that in fact you did not win anything. Suppose further that you got the lottery ticket for free and that you consider the impact of wealth changes on your utility sequentially. How did your utility change as a result of these events according to

(A) Expected utility  Utility stays the same: first it increases but then it decreases by the same amount (B) Prospect utility  Utility decreases due to loss aversion: losses have a larger impact on utility than gains

Shefrin and Statman (1985) discuss four behavioural concepts to explain the disposition effect. Mention three of them and discuss how each of these concepts can explain the disposition effect. (2 points for each concept, max. ½ page) 1) Prospect Theory: risk averse in domain of gains, risk seeking for loss 2) Mental Accounting: reluctance to close mental account at a loss 3) Regret Aversion: quest for pride and avoidance of regret leads to a disposition to realize gains and defer losses 4) Self-Control: emotional doer stronger than rational planner

Shefrin and Statman (1984) explain the preference of investors for cash dividends. Empirical evidence shows a tendency of stock prices to fall when a company announces a decrease in dividend payments. Give 2 behavioral reasons and 1 rational reason for this effect. (2 points for each reason, max. ½ page)

Behavioral: 1) Reference point: decrease perceived as a loss 2) regret aversion, if people have to sell stock to finance consumption instead of using dividends 3) self-control 4) prospect theory (integration/ segregration) Rational: 1) Increase free-cash flow and therefore higher agency costs 2) Signals bad prospects for company

Benartzi and Thaler (1995) propose an explanation for the equity premium puzzle. Briefly explain their line of reasoning to explain the puzzle (2 points).

The two building blocks are: 1) Loss aversion 2) Mental accounting, which leads to myopic loss aversion (frequent evaluation)

Furthermore, using their framework, give an explanation for the time variation in the equity premium (2 points).

Time-varying loss aversion OR change in evaluation frequency

Finally, mention at least one important weakness in their analysis. (2 points) (max. ½ page in total)

Important weakness of the BT analysis is that it implies that currently investors have a very long evaluation period (8 years) to make the model consistent with the low expected future equity premium (2%). This is very unlikely (Internet would lead to more frequent evaluation!) In addition, pension funds do not have an infinite horizon as suggested by BT due to regulations imposed by the supervisory authorities. Hence, their short evaluation period is because of rational reasons instead of mental accounting...