BEHAVIORAL FINANCE MIDTERM MOD E 2013 INSTRUCTOR: GREGORY LA BLANC

Name; ______________________________________

Instructions: Do not turn this page until instructed!

You have 65 minutes to complete this exam. Try not to spend more than 8 minutes on each question You may use a single letter sized sheet of paper for reference You do not need to write complete sentences. Bullet points are fine. Write legibly. You will be graded only on what is legible.

1. Your roommate is planning on selling his commemorative Schwarzenegger gubernatorial porcelain plate on Ebay. He is interested in maximizing the price that he gets for the plate but is worried that the winning bid might be too low, so he is thinking of putting in a reserve which is close to his willingness to accept threshold. Why might this not be a good idea?

A high reserve price might discourage potential bidders from entering an initial bid. Experiments have shown that bubbles are more likely to form and the winners curse is likely to be more severe if there is some initial momentum, which is more likely with a lower initial price. Furthermore, once a bidder has entered an initial bid, he will have a tendency to make upward adjustments to his bid because of escalation of commitment. One potential benefit of having a reserve might be if it creates an high anchor in the minds of potential bidders, i.e. taking advantage of the framing effect.

2. You are having discussions with your old college friend who is getting her finance PhD. She says that the observed serial correlation of returns on stocks over relatively short time frames (momentum) is not evidence of market inefficiency because it is predicted in a four factor Fama-French-Carhardt model where the fourth factor is a momentum factor. You can not realize cumulative abnormal returns over and above what is predicted by this model simply by trading on momentum. How would you reply? You can not determine if markets are efficient and pricing assets correctly without an asset pricing model. The problem is we can not test these two hypothesis separately. Factor models predict what prices will be as a function of various factors, they do not say what prices should be. Just because a factor model predicts what prices will be doesnt mean that markets are pricing assets correctly. After all we could include irrationality as one of our factors and be done with the whole problem.

3. Your other college friend (currently in Leavenworth, KS) claims that the market is inefficient because he was able to make massive abnormal returns through information that he acquired on acquisition targets in his capacity as an associate at Bear Stearns. Do you agree? Why or why not?

For those of you who dont know: there is a federal prison in Leavenworth. Hypotheses about the efficiency of the market are hypotheses about the degree to which information is incorporated into prices. The weak form and the semi-strong hypotheses do not claim that non public information is contained in the prices. Only the strongest of the strong form. So to know whether the availability of profitable insider trading strategies is evidence of inefficiency, you need to define efficiency and under the most widely used definitions of efficiency, insider trading is excluded.

4. It is well known that mutual fund managers tend to invest in similar stocks. Some would say that the correlation of buying and selling behavior is a form of herding motivated by ignorance about fundamentals and the belief that the investment behavior of a managers peers provides some insight into future returns of the stocks. What is another explanation of this herding? Behavior is considered herding if the actors are engaging in correlated behavior but not because of shared beliefs which are warranted by independent evaluation of the asset, but rather because of observations about the behavior of other evaluators. This could be because they believe that that behavior says something about the value of the asset, or it could be just to blend in with the crowd. This latter behavior is optimal if straying from the crowd will result in asymmetric payoffs: in other words, if standing out results in more severe negative payoff when it goes wrong relative to the positive payoff when it goes right. One theory of this herding presumes that risk averse fund managers want to avoid losing assets in a down market. If all managers are down by a similar amount, no one will lose funds.

5. One of the best known books written about the internet was called The Long Tail. In it, the author argued that unconstrained by the inventory limitations of bricks and mortar stores, individuals with esoteric wants could obtain their desired goods and specialist producers would arise to satisfy their wants. Has this been borne out? Why or why not? The long tail story assumes that preferences will remain constant and not be affected by the internet. In fact, in some domains, the internet has changed preferences by inducing imitative behavior, i.e. herding in purchasing decisions. Think of this as the Harry Potter effect. People can much more easily observe the behavior of others, not just through facebook ,etc, but they will tend to click on the most clicked articles and email the most emailed articles and buy the most bought books and download the most downloaded music, etc

6. In the article Famous First Bubbles the author goes to great lengths to argue that we must exhaust all rational explanations of fluctuations in asset prices before resorting to irrationality. In another well known article, it was claimed that the valuations of internet and fiber optic stocks in 99-00 could be justified with sufficiently high asset sigmas. What do you think of this argument? Equity is a call option on the assets of the firm. So if the underlying assets are very volatile, this should increase the value of the equity. This is especially true when the firm itself has numerous embedded real options. Using this logic, we should expect the value of stocks in very volatile, uncertain industries to trade at much higher levels than other businesses. The problem with this story is that while it might be true for individual stocks it has to be modified in the aggregate by the covariances between the individual stocks. After all: If Pets.com has a high value because it might take over the on line pet supply space and Petsrus.com has a high value because it might taek over the on line pet supply space, its can not be the case that both take over the on line pet supply space simultaneously. So this story which might work in isolation suffers from the composition fallacy and can not explain the high price level for the entire sector.

7. In the first TARP proposal, the US Treasury planned on using part of the budgeted $750B to purchase devalued mortgage backed assets from trouble banks. Suppose that the Treasury knew the distribution of values of these assets and thus the average or expected value of these assets. Suppose also that the banks were so desperate for cash that they were willing to sell these assets at a discount to what they knew them to be worth. What problem could you have foreseen for the Treasury had it implemented such a plan? If the banks have superior information about the value of the individual assets then they will be sure to sell the treasury only those assets which are worth less than treasury has offered. Note that this lemons problem or adverse selection problem does not require that the banks have perfect knowledge of the assets value, only that they have better knowledge than treasury which is highly likely. The only way around this, given the facts above (i.e. the treasury knows the average value) is for the treasury to mandate the sale of all of the assets at that price.

8. In March of 2000, famed hedge fund manager Julian Robertson liquidated his Tiger fund and returned what little assets that remained to his investors. His strategy had been to buy undervalued securities and short overvalued securities. What went wrong? Timing: He was right in the end but by then it was too late. The divergence from fundamental values persisted too long and even worsened between the time that he took out his value based strategy and when he reached his liquidity limits. If he were able to ride out his strategy for another month even, he would have turned the corner and ultimately made a fortune. George Soros knew that the internet stocks were overvalued but bought them anyway believing that he could attract more investors by buying what they wanted.

Please detach this page and turn in at the break. NO NAME REQUIRED

Compared to the rest of the class, how well do you think you did on this exam. Express your answer in terms of what percent of the class did you do better than.

_______________________________