FINANCE 361

Workshop 4
Topics 9 and 10 – Market Efficiency & Behavioural Finance

Question 1 (2015 S2 Midterm Q1)

Consider a perfectly competitive market with no trading frictions, no taxes, no private
information, no trading constraints, no arbitrage, unlimited availability of capital and
fully rational market participants with an unlimited ability to process information. In
such a fictional setting, prices fully reflect available information – there is no
mispricing.

Which of the above assumptions would you need to remove in order to obtain a
market in which persistent mispricing can occur? Explain by way of example how
mispricing could occur in your revised market. [5 Marks]

Question 2 (2016 S1 Midterm Q1)

Compare and contrast asymmetric information and bounded rationality in the context
of market frictions. In particular, what are the similarities and differences between
these two concepts? [5 Marks]

Question 3 (2017 S2 Midterm Q5)

“The impact of behavioural biases on equilibrium returns depend critically on the
presence of limits to arbitrage.” Is this true? Discuss. [5 Marks]

Question 4 (2019 S2 Midterm Q5)

A substantial fraction of German government bonds are currently trading at negative
yields. This means that if you buy them now and hold them to maturity, you would
receive LESS in total than you initially paid for them.
a) Design a risk-free arbitrage strategy for investing 1 billion euros. Assume perfectly
frictionless markets (including unlimited short-selling without posting collateral).
Assume you have a physical safe that is really 100% safe and doesn’t cost you
anything to own and operate. [3 Marks]
b) Drawing on your understanding of market frictions and limits to arbitrage, what
possible reasons could there be for real-world investors to invest billions in these
bonds nonetheless? Note calling investors stupid is not a valid reason, no matter
how satisfying you may find it. (And the correct term is boundedly rational, not
stupid.) [4 Marks]