Week 8 Tut Answers. PDF

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Tut answers for Week 8 Equities and Investment Analysis....

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Topic 7 Week 8 Tutorial – Behavioral Finance Q1. Describe the differences and similarities between the Prospect Theory and the conventional Expected Utility Theory. Answer: Both theories try to explain how the expected utility (satisfaction) of an individual changes with wealth. Both theories assume that higher wealth brings higher utility. However, the Expected Utility Theory relates utility to the wealth level (i.e., overall $wealth), while the Prospect Theory relates utility to the changes in wealth relative to the current wealth level (i.e., $gains and $losses). The two theories predict different attitudes of individuals toward risk. In the Expected Utility Theory, individuals are always risk-averse, i.e., they would refuse a fair gamble with an expected outcome of zero. In the Prospect Theory, individuals are risk-averse when they receive gains and risk-seeking (they can accept a gamble with a negative expected outcome) when they receive losses.

Q2. Imagine a situation where an individual needs to choose between a sure outcome and a gamble (e.g., tossing a coin, rolling a dice, etc.). Create a situation in which an individual would make different decisions under the Prospect Theory and under the Expected Utility Theory. Answer: Here is one example. A sure loss of -$1,000 or rolling a 6-sided dice:  Any number above 3, you pay -$2,000  Any number below 4, you pay $0 The expected loss of a gamble is -$1,000 (-$2,000*0.5+$0*0.5). It is the same as the sure loss. Under the Prospect Theory, an individual is risk-seeking when they receive losses; therefore, they would choose a gamble. Under the Expected Utility Theory, an individual is always risk-averse; therefore, and they would choose a sure loss of -$1,000.

Q3. Jill Davis tells her broker that she does not want to sell her stocks that are now below the price she originally paid for them. She believes that if she just holds on to them a little longer, they will recover, at which time she will sell them. What behavioral characteristic does Jill demonstrate? a. Loss aversion b. Regret avoidance c. Risk aversion d. Conservatism Answer: a Jill uses loss aversion as the basis for her decision making. She holds on to stocks that are down from the purchase price in the hopes that they will recover. She is reluctant to accept a loss.

Q4. After John Dow sells his stock, he avoids following it in the media. He is afraid that it may subsequently increase in price. What behavioral characteristic does he exhibit? a. Loss aversion b. Regret avoidance c. Risk aversion d. Conservatism Answer: b John refuses to follow a stock after he sells it because he does not want to experience the regret of seeing it rise. The behavioral bias that characterizes his decision making is called regret avoidance, i.e., the fear of regret.

Q5. Match each example to one of the following behavioral characteristics: Example

Characteristic

a. Investors are slow to update their beliefs when given new evidence b. Investors are reluctant to bear losses caused by their unconventional decisions

i. Disposition effect

c. Investors are reluctant to sell stocks with “paper” losses

iii. Representativeness bias

d. Investors disregard sample size when forming views about the future from the past

iv. Regret avoidance

ii. Conservatism bias

Answer: a – ii b – iv c–i d – iii

Q6. Let’s remember one of the cases we discussed at the beginning of the course, namely, the one with GameStop (GME). Read an extract from the Forbes article that discusses the details of what has happened to GME: how the stock price surged, whether this price surge was driven by fundamentals, and how short sellers, who are generally considered to be rational, well-informed investors, were squeezed out of the market. Discuss decision-making biases that might have contributed to the GME price surge. Assuming that the GME stock was overpriced, what could have prevented short sellers from correcting the price to its fair value?

Answer: What biases could have contributed to the price surge?  Herding. Since many people heard about GME, many could have bought GME just following what others have done. Reasoning: GME is a great stock because Elon Musk recommended it, and you can see that many people are buying it (look at the Reddit forum).

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Representativeness bias. Reasoning: GME is a great stock because it is a tech stock. It might be a future Google or Amazon in its area. Overconfidence. Reasoning: The stock has already increased in price, it will likely continue to increase in the future, short sellers seem to surrender, there is a lot of trading volume in GME now. Forecasting error. Reasoning: The stock has gone up recently; thus, the trend should continue.

What could have prevented short sellers from correcting the price to its fair value? Generally speaking, limits to arbitrage. For example, short sellers have to pay stock-borrowing fees while their short positions are opened. Short sellers also usually use leverage, i.e., they are trading on margin. Since the GME stock price increased dramatically, short sellers probably received margin calls and had to put more money to their broker account to keep their short positions open. Of course, short sellers’ capital is limited, so they might have chosen to cover their short positions because of the above reasons instead of responding to margin calls. The fact that the GME stock continues to be at the high price level could also be an indication of a fundamental risk (the GME stock is still overpriced, and we don’t know when it will go down). At the same time, it could also be an idication of a problem with the short sellers’ asset pricing model (maybe GME is actually fairly priced, but the short sellers’ pricing model incorrectly identified that it was not)....