INSTITUTE OF MATHEMATICAL SCIENCES

BBS FINANCIAL ECONOMICS

CAT 2
BSE 4122: BEHAVIORAL FINANCE
MARKING GUIDE
th
DATE: Thursday, 7 July 2022 Time: 1 Hour

Instructions
Answer all questions in this paper in the answer booklet provided

Question 1 (Representativeness, overconfidence, hyperbolic discounting)

a) Which description of Angela has higher probability?

1) Angela loves to play tennis.
2) Angela loves to play tennis and, during the summer, averages at least a game a
week.
Explain your answer. Define the conjunction fallacy. How does it apply here?
(4 marks)

The second probability must be less because it has one more requirement (not only do you have
to love tennis, but you also must play regularly, but some tennis lovers might just be too busy to
do this). When people commit the conjunction fallacy (the belief that the joint probability is more
likely than one of its components), they will think the second (joint) event is more likely because
it sounds logical that someone who loves tennis will also play regularly.

b) Discuss what the empirical evidence from research (using brokerage data, survey data, and
experimental data) suggests about the relationship between overconfidence, trading activity,
and portfolio performance. (4 marks)

Excessive trading activity – Most of the evidence indicates that overconfidence leads to greater
trading activity.
Worse portfolio performance – It is appropriate to use the word “excessive” because this trading
leads to poorer portfolio performance.
Mixed evidence on manifestations of overconfidence – The evidence is mixed on what
manifestation of overconfidence (miscalibration vs. the better-than-average effect) contributes
the most.
Underdiversification – overconfidence is associated with underdiversification and excessive risk
taking.

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c) Amina is an exponential discounter. Her discount function, which illustrates her preference
for money at various points in time, is characterized as follows:

∂(t)=1/(1.05)t for t=0,1,2,…

Fred on the other hand is a hyperbolic discounter. His discount function is:

∂(t) =1 for t=0

= 0.6/ (1.01) t-1 for t=1, 2,….

i. What would Amina and Fred rather have: $1000 today or $1100 next year? Explain.
(5 marks)

PV amount PV amount received in Decision

received today 1 year
Amina $1000 1100 * 1/1.05 = $1047 $1000<$1047
Prefers $1100 in 1year to $1000 today
Fred $1000 1100 *0 .6 = $660 $1000>$660
Prefers $1000 today to $1100 in 2
years

ii. What would Amina and Fred rather have: $1000 next year or $1100 the year after that?
Explain. (5 marks)

PV of amount PV amount received Decision

received in 1 year in 2 years
Amina 1000 * 1/1.05 = 1100 * 1/1.052 = $998 $952<$998
$952 • Prefers $1100 in 2 years to $1000
in 1 year
• Since deferral always holds
Amina is consistent in her rate of
time preference.
Fred 1000 *0 .6 = 1100 *(0.6/1.01) = $653<$1667
$1667 $653 • Prefers $1100 in 2 years to $1000
in 1 year
• Since deferral sometimes holds
but also sometimes does not hold
Fred is inconsistent in his rate of
time preference

Question 2 (Limits to arbitrage, market anomalies, explanations for market anomalies)

a) Differentiate the following terms/concepts:

i) Momentum and reversal

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With momentum we observe positive correlation in returns, whereas with reversal we observe
negative correlation in returns.

ii) Value and growth stocks

Stock prices for value stocks are low relative to accounting measures such as earnings, cash
flow, or book value, whereas stock prices for growth (or glamour) stocks are low relative to
earnings, cash flow, and book value, at least in part because the market anticipates high future
growth.

iii) Fundamental risk and noise-trader risk

Fundamental risk arises because of the potential for rational revaluation as new information
arrives and noise-trader risk arises because mispricing can become more severe in the short
run.
(6 marks)

b) Historically, value stocks have outperformed growth stocks. Some researchers argue
irrational investor behavior might be responsible for the higher risk-adjusted returns of value
stocks. Describe how biases and heuristics might cause this value-growth-anomaly!
(4 marks)

• Excessive optimism – Investors might tend to extrapolate past growth rates too far into
the future.
• Representativeness (base rate neglect) – They might put excessive weight on recent past
history and neglect aggregate statistical evidence (in the form of a rational prior).
– Then, the future earnings growth of glamour stocks will be disappointing (leading
to future underperformance), while value stocks pleasantly surprise investors
(leading to future outperformance).
• Representativeness (good companies are good stocks) – Moreover, investors might just
equate recently well-run (growth) companies with good investments (irres- pective of
price).

c) Hong and Stein (1999) present a behavioral model which explains overreactions and
underreactions. Explain how the interaction of different types of market participants creates
both under- and overreactions. In which way does their model fundamentally differ from the
models of Barberis et al. (1998) and Daniel et al. (1998)? (5 marks)
(Hong, H., & Stein, J. C. (1999). A unified theory of underreaction, momentum trading, and
overreaction in asset markets. The Journal of finance, 54(6), 2143-2184.)

• Hong and Stein (1999) model the phenomena of underreaction and overreaction by
focusing on a market composed of two types of investors: “newswatchers” who trade on

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 private information, and “momentum traders” who trade on simple forecasts by
extrapolating past price changes.
• The authors also assume that private information diffuses gradually across the
newswatcher population. For example, when newswatchers are active, prices will adjust
slowly to new information causing an underreaction, but never an overreaction.
• Similarly, when momentum traders are active they will trade on the basis of past price
changes, thereby generating momentum and causing prices to overshoot in the longer
run, arbitraging away any underreaction left behind by the newswatchers.
• the use of heterogeneous groups of investors causes under-reaction in the short-run
because of gradual diffusion of private information (i.e., conservatism) and overreaction
in the long-run because of incorrect extrapolation of past price trends.
• The HS model differs fundamentally from the models of DHS and BSV in the sense that
DHS and BSV models rely on the idea of a single representative agent, while HS model
introduces the interaction of different trader types as a key to understand short-term
Momentum and long-run Mean Reversion.

(TOTAL: 36 MARKS)

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