Amity Campus

Uttar Pradesh
India 201303

ASSIGNMENTS
PROGRAM: MFC
SEMESTER-IV
Subject Name
Study COUNTRY
Roll Number (Reg.No.)
Student Name

: Behavioral Finance
: Somalia
: MFC001512014-20160164
: Kenadid Ahmed Osman

INSTRUCTIONS
a) Students are required to submit all three assignment sets.
ASSIGNMENT
Assignment A
Assignment B
Assignment C

DETAILS
Five Subjective Questions
Three Subjective Questions + Case Study
Objective or one line Questions

MARKS
10
10
10

b)
c)
d)
e)

Total weightage given to these assignments is 30%. OR 30 Marks

All assignments are to be completed as typed in word/pdf.
All questions are required to be attempted.
All the three assignments are to be completed by due dates and need to be
submitted for evaluation by Amity University.
f) The students have to attached a scan signature in the form.

Signature :
Date
:

_____
_______
________28-04-2016_______________

( ) Tick mark in front of the assignments submitted

Assignment A

Assignment B

Assignment C

Behavioral Finance
ASSIGNMENT- A

Q.1 Explain the methodology behind predictability of bonds.

Answer:
Methodology behind Predictability
It is well documented that the rates of return to holding common stocks and
bonds are to some extent predictable over time. There is controversy over the source of
the predictability. Some authors attribute predictability to market inefficiencies, and
others maintain that predictability is the result of changes in the required return. The
evidence suggests that a rational asset pricing model which focuses on risk can explain
most of the predictability.
The asset pricing models imply that the expected returns of securities are related
to their sensitivity to changes in the state of the economy. Sensitivity is measured by
the securities beta coefficients. For each of the relevant state variable, there is a
market-wide price of beta, measured in the form of an increment to the expected
return (a risk premium) per unit of beta. In such a model, the predictable variation of
returns can be driven by changes in the betas and changes in the price of beta.
This is a type of market risk that is closely related to the investment methods and
decisions of noise traders. There is a much greater noise trader risk if there is more
volatility in the market price for a specific security. Although this risk is found in all
types of securities, it appears to be more prevalent in small cap stocks.
A well-known stylized fact about financial markets is that average returns on
stocks, long government bonds, and corporate bonds are higher than the return on
short bonds. Why do investors demand high compensation for such investments? In a
frictionless model with optimizing investors, there are two possible answers: either
households are highly risk averse, or they perceive these investments to be very risky.
Another well-documented stylized fact is that the returns on certain long-short
strategies are predictable: low current stock valuations relative to fundamentals (for
example, dividends or earnings) tend to be followed by high subsequent returns. The
returns on currency carry trades are predictable based on interest rate differentials. The
carry trade involving only domestic bonds is predictable based on the slope of the term
structure.
Why don't investors simply borrow and buy some more stocks when expected
returns on stocks are high? An economic explanation of return predictability needs a
mechanism that discourages investors from doing just that. If investors were to buy

stocks in anticipation of high returns, then these purchases would drive up stock prices
today, destroying return predictability.
There are two ways to discourage investors from buying in a frictionless setting
with rational expectations. First, investors may be more risk averse in times when
expected returns are high. In bad times, when stocks are trading at low prices,
investors could be well aware that prices are likely to go up, but they may worry about
taking on the extra risk associated with holding more stocks. Second, investors may be
facing more risk in times when expected returns are high. During the financial crisis, for
example, the Dow dropped below 7000, and still households did not want to buy more
stocks. A plausible explanation is that they were worried about losing their jobs and
preferred holding cash.
The early work on quantitative asset pricing asked whether models could explain
one or maybe even a few of the above stylized facts in isolation. Over the last couple of
years, the focus has been on whether the models can explain a wide variety of
phenomena in financial markets simultaneously. This recent research has made
important progress: we now have a much more consistent explanation of the size and
time variation of risk premiums across different asset classes. By carefully documenting
dimensions along which existing models don't perform as well, we also have made
significant progress in understanding where the theory needs improvement.
Time Varying Risk Aversion
John Y. Campbell and John H. Cochrane develop a model in which investors have
time-varying risk aversion. The key assumption in their model is that investors' utility
functions depend on the past history of aggregate consumption, so they capture a
"Catching up with the Joneses" motive. Investors are more risk averse in recessions,
when their consumption is low relative to past aggregate consumption. They are less
risk averse in booms, when their consumption is high, and so gambling feels less
threatening. These countercyclical movements in risk aversion make investors want to
be compensated more for holding risky assets (such as stocks) in recessions. Thus, the
model generates expected returns that are high in recessions.
More recent papers have studied the performance of the Campbell-Cochrane
model in other asset markets. Jessica Wachter shows that a quantitative
implementation of a model with time-varying risk aversion can simultaneously explain
the predictability of stock returns (as in Campbell-Cochrane) and long-term government
bonds. Her paper provides a unified explanation of pricing for stocks and bonds.
Further, the real rate is countercyclical, so long-term real bonds are assets with low
payoffs in recessions. As a consequence, investors demand positive average
compensation for holding these bonds, generating an upward sloping real yield curve
(which helps the model generate an upward nominal yield curve as well.)

Long Chen, Pierre Collin-Dufresne, and Robert Goldstein apply the CampbellCochrane model to corporate bond markets. A challenge in these markets is that yields
on Baa-rated corporate bonds are much higher than those on Aaa-rated bonds, despite
the fact that the default probabilities of Baa bonds are only slightly higher than those of
Aaa bonds. A model with time-varying risk aversion can account for high Baa-Aaa
spreads, because investors are sensitive to the timing of defaults: defaults of Baa bonds
are more likely to happen in recessions, when risk aversion is high. Therefore, investors
want to be compensated with high yields for a small average amount of exposure to
default.
Adrien Verdelhan explores a model with two countries that are populated by
investors with risk aversion that depends on past aggregate domestic consumption. The
model also has a pro-cyclical real interest rate. When domestic consumption is low,
domestic investors are more risk averse and demand higher compensation for investing
in risky strategies. At the same time, the domestic real interest rate is low. This
mechanism explains why expected returns on the currency carry trade are high when
domestic rates are low.
Long Run Risk
Ravi Bansal and Amir Yaron pursue the idea that investors worry about long- run
risks, defined as small but persistent changes in expected consumption growth. They
consider investors who demand compensation for assets that have low payoffs when
bad news about future consumption growth arrives - such investors are said to have
"Epstein-Zin" utility functions. Bansal and Yaron apply this model to stocks and provide
a new story for the equity premium.
Recently, a large number of papers have applied this model to a variety of
markets. Several of the studies investigate the model's implications for the cross-section
of stock returns. Bansal, Robert Dittmar, and Christian Lundblad document that the
cash flows of "value stocks," stocks of companies with high book values relative to their
market values, vary more with news about future consumption growth than the cash
flows of "growth stocks," stocks of companies with low book-to-market values. In the
long-run-risk model, this larger covariance makes investors perceive value stocks as
more risky. They therefore demand a higher compensation for holding them, explaining
the value premium. Lars-Peter Hansen, John Heaton, and Nan Li document that the
covariance between cash flows and news shocks will depend on how the estimation
deals with time trends.
Long-run risk provides interesting new interpretations of average premiums, but
by itself implies constant premiums. Therefore, long-run risk does not explain the
predictability of asset returns, or the high volatility of returns. I will discuss later some
recent attempts at combining long-run risk with time variation in risk.

Q.2 Explain the significance of Pro-EMH evidence.

Answer:
When the term efficient market was introduced into the economics literature
thirty years ago, it was defined as a market which adjusts rapidly to new information
(Fama et al 1969). It soon became clear, however, that while rapid adjustment to new
information is an important element of an efficient market, it is not the only one. A
more modern definition is that asset prices in an efficient market fully reflect all
available information (Fama 1991). This implies that the market processes information
rationally, in the sense that relevant information is not ignored, and systematic errors
are not made. As a consequence, prices are always at levels consistent with
fundamentals. The words in this definition have been chosen carefully, but they
nonetheless mask some of the subtleties inherent in defining an efficient asset market.
For one thing, this is a strong version of the hypothesis that could only be literally true
if all available information was costless to obtain. If information was instead costly,
there must be a financial incentive to obtain it. But there would not be a financial
incentive if the information was already fully reflected in asset prices (Grossman and
Stiglitz 1980). A weaker, but economically more realistic, version of the hypothesis is
therefore that prices reflect information up to the point where the marginal benefits of
acting on the information (the expected profits to be made) do not exceed the marginal
costs of collecting it (Jensen 1978). Secondly, what does it mean to say that prices are
consistent with fundamentals? We must have a model to provide a link from economic
fundamentals to asset prices. While there are candidate models in all asset markets that
provide this link, no-one is confident that these models fully capture the link in an
empirically convincing way. This is important since empirical tests of market efficiency
especially those that examine asset price returns over extended periods of time are
necessarily joint tests of market efficiency and a particular asset-price model. When the
joint hypothesis is rejected, as it often is, it is logically possible that this is a
consequence of deficiencies in the particular asset-price model rather than in
the efficient market hypothesis. This is the bad model problem (Fama 1991). Finally, a
comment about the word efficient. It appears that the term was originally chosen
partly because it provides a link with the broader economic concept of efficiency in
resource allocation. Thus, Fama began his 1970 review of the efficient market
hypothesis (specifically applied to the stock market): The primary role of the capital
[stock] market is allocation of ownership of the economys capital stock. In general
terms, the ideal is a market in which prices provide accurate signals for resource
allocation: that is, a market in which firms can make production-investment decisions,
and investors can choose among the securities that represent ownership of firms
activities under the assumption that securities prices at any time fully reflect all

available information. The link between an asset market that efficiently reflects
available information (at least up to the point consistent with the cost of collecting the
information) and its role in efficient resource allocation may seem natural enough.
Further analysis has made it clear, however, that informationally efficient asset markets
need not generate allocative or production efficiency in the economy more generally.
The two concepts are distinct for reasons to do with the incompleteness of markets and
the information-revealing role of prices when information is costly, and therefore
valuable (Stiglitz 1981).
Q.3 What do you mean by Noise trader risk.
Answer:
Noise Trader Risk
The risk of a loss on an investment that comes from a noise trader. A noise
trader is an investor who makes decisions based on feelings such as fear or greed,
rather than fundamental or technical changes to a security. If enough noise traders
panic, they can drive down the price of the security unnecessarily. Suppose an investor
owns 1,000 shares of a stock and they are currently at $50 per share. If noise traders
overreact to bad news, the price could drop to $40 per share without any fundamental
justification. This costs the investor $10,000. The possibility that this could happen is
noise trader risk.

Q.4 What do you mean by bubbles.

Answer:
Bubbles refer to asset prices that exceed an assets fundamental value because
current owners believe that they can resell the asset at an even higher price in
the future. There are four main strands of models that identify conditions under
which bubbles can exist. The rst class of models assumes that all investors have
rational expectations and identical information. These models generate the testable
implication that bubbles have to follow an explosive path. In the second category
of models investors are asymmetrically informed and bubbles can emerge under
more general conditions because their existence need not be commonly known. A
third strand of models focuses on the interaction between rational and behavioral
traders. Bubbles can persist in these models since limits to arbitrage prevent rational
investors from eradicating the price impact of behavioral traders. In the nal
class of models, bubbles can emerge if investors hold heterogeneous beliefs, potentially

due to psychological biases, and they agree to disagree about the fundamental
value. Experiments are useful to isolate, distinguish and test the validity of dierent
mechanisms that can lead to or rule out bubbles.
Q.5 Explain the term systematic investor sentiment.
Answer:
Systematic investor sentiment ultimately derives from common cognitive
limitations and systematic biases in investors perceptions. Investor sentiment can be
defined very broadly the situation where security prices deviate from present values of
future cash flows.
There are two potential reasons for such deviations. First, investors may
incorporate considerations that are due to irrational reactions or emotions while
evaluating securities for an excellent overview of psychological biases). Second,
investors may have biased estimates of the distributions of firms future cash flows.
While the first type of investor sentiment has received substantial attention the effects
of ex-ante biased beliefs on firm value has received relatively little attention, which may
be due to the inherent difficulty of measuring investors subjective expectations.
To examine whether investors inability to correctly estimate probability
distributions of event outcomes affects market prices, we focus on the stock price
behavior of publicly traded sports clubs. This experimental design is desirable for at
least two reasons. First, frequent, easily quantifiable, and value-relevant information
signals have observable ex-ante (objective) expectations. Second, if investors
occasionally react irrationally to resolution of uncertainty, sporting events would be an
ideal setting for detecting such emotional reactions. These tests rely on a novel proxy
for investors subjective beliefs and, different from earlier studies, show that sentiment
is at least partially an ex-ante phenomenon, in the sense that investors are overly
optimistic ex-ante and, thus, typically end up disappointed ex-post.
The distinction between the two manifestations of investor sentiment is
important. Consider, for instance, firms earnings announcements. Skinner and Sloan
(2002) and
Trueman, Wong and Zhang (2003) find that stock prices of growth firms, and of
internet firms in particular, respond asymmetrically to earnings surprises. Specifically,
average realized negative returns following negative surprises are significantly larger in
magnitude than typical positive returns following positive surprises, a result that is not
due to a more frequent occurrence of positive surprises. This evidence could be
consistent with both types of investor sentiment. On the one hand, investors may be
overly optimistic ex-ante, resulting in average negative returns following earnings
announcements. On the other hand, even if investors have unbiased ex-ante beliefs

about earnings realizations, their irrational ex-post reaction to earnings surprises may
not be efficiently priced in before the announcements.
Notably, however, an asymmetric market response to earnings announcements
could also occur in a world in which prices are efficient, both ex-ante and ex-post.
Indeed, there is evidence that firms manage earnings to meet target thresholds (e.g.
Degeorge, Patel, and Zeckhauser, 1999) and that market prices react sharply to even
small negative earnings surprises. The possibility of firms purposely manipulating
reported event outcomes may contaminate analyses of the sources of investor
sentiment that are based on self-reported corporate events. Therefore, another major
benefit of this experiment is that match outcomes are verifiable and irreversible, all but
eliminating concerns that the market reaction to the resolution of uncertainty may be
partially driven by investors perception of potential manipulation.
Assignment B
Attempt any two analytical questions
Q.6 Explain the significance of understanding Efficient Markets Hypothesis.
Answer:
EFFICIENT MARKET HYPOTHESIS (EMH)
Efficient market is closely related to (the absence of) arbitrage. It might be
defined as simply an ideal market without arbitrage, but there is much more to it than
that. Let us first ask what actually causes price to change. The share price of a
company may change due to its new earnings report, due to new prognosis of the
company performance, or due to a new outlook for the industry trend. Macroeconomic
and political events, or simply gossip about a companys management, can also affect
the stock price. All these events imply that new inform ation becomes available to
markets. The Efficient Market Theory states that financial markets are efficient because
they instantly reflect all new relevant information in asset prices. Efficient Market
Hypothe sis (EMH) proposes the way to evaluate market efficiency. For example, an
investor in an efficient market should not expect earnings above the market return
while using technical analysis or fundamental analysis.
Three forms of EMH are discerned in modern economic literature. In the weak
form of EMH, current prices reflect all information on past prices. Then the technical
analysis seems to be helpless. In the strong form, prices instantly reflect not only
public but also private (insider) information. This implies that the fundamental analysis
(which is what the investment analysts do) is not useful either. The compromise
between the strong and weak forms yields the semis trong form of EMH according to

which prices reflect all publicly available information and the investment analysts play
important role in defining fair prices.
Two notions are important for EMH. The first notion is the random walk, which
will be formally defined in Section 5.1. In short, market prices follow the random walk if
their variations are random and independent. Another notion is rational investors who
immediately incorporate new information into fair prices. The evolution of the EMH
paradigm, starting with Bachelors pioneering work on random price behavior back in
1900 to the formal definition of EMH by Fama in 1965 to the rigorous statistical analysis
by Lo and McKinley in the late 1980s, is well publicized [913]. If prices follow the
random walk, this is the sufficient condition for EMH. However, as we shall discuss
further, the pragmatic notion of market efficiency does not necessary require prices to
follow the random walk.
Q.7 Explain the term Behavioral Finance.
Answer:
What is Behavioral Finance?
Behavioral finance attempts to explain and increase understanding of the
reasoning patterns of investors, including the emotional processes involved and the
degree to which they influence the decision-making process. Essentially, behavioral
finance attempts to explain the what, why, and how of finance and investing, from a
human perspective. For instance, behavioral finance studies financial markets as well as
providing explanations to many stock market anomalies (such as the January effect),
speculative market bubbles (the recent retail Internet stock craze of 1999),
and crashes (crash of 1929 and 1987). There has been considerable debate over the
real definition and validity of behavioral finance since the field itself is still developing
and refining itself. This evolutionary process continues to occur because many scholars
have such a diverse and wide range of academic and professional specialties. Lastly,
behavioral finance studies the psychological and sociological factors that influence the
financial decision making process of individuals, groups, and entities as illustrated below

Figure 1: the behavioral finance decision makers

In reviewing the literature written on behavioral finance, our search revealed

many different interpretations and meanings of the term. The selection process for
discussing the specific viewpoints and definitions of behavioral finance is based on the
professional background of the scholar. The discussion within this paper was taken from
academic scholars from the behavioral finance school as well as from investment
professionals.
Behavioral Finance and Academic Scholars
Two leading professors from Santa Clara University, Meir Statman and Hersh
Shefrin, have conducted research in the area of behavioral finance. Statman (1995)
wrote an extensive comparison between the emerging discipline behavioral finance vs.
the old school thoughts of standard finance. According to Statman, behavior and
psychology influence individual investors and portfolio managers regarding the financial
decision making process in terms of risk assessment (i.e. the process of establishing
information regarding suitable levels of a risk) and the issues of framing (i.e. the way
investors process information and make decisions depending how its presented).
Shefrin (2000) describes behavioral finance as the interaction of psychology with the
financial actions and performance of practitioners (all types/categories of investors).
He recommends that these investors should be aware of their own investment
mistakes as well the errors of judgment of their counterparts. Shefrin states, One
investors mistakes can become another investors profits (2000, p. 4). Furthermore,
Barber and Odean (1999, p. 41) stated that people systemically depart from optimal
judgment and decision making. Behavioral finance enriches economic understanding by
incorporating these aspects of human nature into financial models. Robert Olsen
(1998) describes the new paradigm or school of thought known as an attempt to
comprehend and forecast systematic behavior in order for investors to make more
accurate and correct investment decisions. He further makes the point that no cohesive
theory of behavioral finance yet exists, but he notes that researchers have developed
many sub-theories and themes of behavioral finance.
Viewpoints from the Investment Managers
An interesting phenomenon has begun to occur with greater frequency in which
professional portfolio managers are applying the lessons of behavioral finance by
developing behaviorally-centered trading strategies and mutual funds. For example, the
portfolio manager for Undiscovered Managers, Inc., Russell Fuller, actually manages
three behavioral finance mutual funds: Behavioral Growth Fund, Behavioral Value Fund,
and Behavioral Long/Short Fund). Fuller (1998) describes his viewpoint of behavioral
finance by noting his belief that people systematically make mental errors and
misjudgments when they invest their money. As a portfolio manager or as an individual

investor, recognizing the mental mistakes of others (a mis priced security such as a
stock or bond) may present an opportunity to make a superior investment return
(chance to arbitrage). Arnold Wood of Martingale Asset Management described
behavioral finance this way: Evidence is prolific that money managers rarely live up to
expectations. In the search for reasons, academics and practitioners alike are turning to
behavioral finance for clues. It is the study of us. After all, we are human, and we are
not always rational in the way equilibrium models would like us to be. Rather we play
games that indulge self-interest. Financial markets are a real game. They are the
arena of fear and greed.
Our apprehensions and aspirations are acted out every day in the marketplace. So,
perhaps prices are not always rational and efficiency may be a textbook hoax. (Wood
1995, p. 1) Now that you have been introduced to the general definition and viewpoints
of behavioral finance, we will now discuss four themes of behavioral finance:
overconfidence, financial cognitive dissonance, regret theory, and prospect theory.

Q.8 What do you mean by Arbitrage. How Long-short trades help a arbitrager
to make money.
Answer:
Arbitrage Defined
Arbitrage refers to the purchase and sale of similar items in two different
markets in order to take advantage of a price discrepancy. In the strictest sense of the
definition, arbitrage implies the ability to use the commitment in one market to offset
the commitment in the other market, while still leaving a profit margin. In other words,
a pure arbitrage would imply a virtually riskiess trade. The profit margins in pure
arbitrage are so slim that normally only the most efficient trade participants can
effectively engage in this type of trading.
Arbitrage is also often used in a less restrictive context to mean a spread
between two closely related markets (i.e., without any further requisite ass umption
regarding the feasibility of physical offset). This is the implicit interp retation of the term
arbitrage as used in this chapter.
In an arbitrage trade, there are very strong links between the long and short
legs that prevent the spread from moving beyond certain reasonable bounds. The
arbitrage trader seeks to take advantage of markets being out of line in terms of
historical or theoretical boundaries. Thus, a long T bill/short CD spread, implemented at
a time when CD rates are at only a 0.75 percent premium to T bill rates, would be an
arbitrage, since CD rates will always command some premium to T bill rates. However,
a long T bill/short T bond position would not truly be an arbitrage (although some

traders may prefer to call it such for cosmetic reasons), since there is no theoretical
limit to the premium to which short rates can move relative to long rates.
Some typical examples of arbitrage trades in the interest rate markets would
include cashlfutures spreads between similar instruments, spreads bet ween futures on
the same type of security traded at different exchanges (e.g., CBOT T bonds vs. NYFE T
bonds), and spreads between different interest rate futures with the same maturity
(e.g., T bills vs. CDs). In this section, we will be concerned with the latter type of
arbitrage.
How Long-short trades help a arbitrager to make money.
Answer:
Making moneys easy when a market is rocketing skyward with consistent and
appreciable gains. Or at least, it always seems like it was easy when you look back on
it. And if your trading program is prepared to short sell financial instruments, making
money can be just as easy when a market is collapsing. Its the volatile times when a
markets tantrums arent predictable in one given direction, or the doldrums when a
market seems to roll along in a flat line that seem to challenge a lot of traders. The
ones whove developed programs to make money by being neither net long nor net
short in a market can thrive in all these environments.
Ok, the easiest way to be neither long nor short in a market is just not to trade
that market. But you wont make any money that way. So the other way to accomplish
a net neutral position is to be both long and short in the same market. You can be
assured that one of the two positions will end up being a winner. And believe it or not,
thats why there are people who actually use this apparently befuddled strategy to
become quite profitable: arbitrageurs.
An arbitrageur is a trader who uses arbitrage to profit on the differences
between two similar assets within the same market. An arbitrage trade has two legs:
one long in the market and one short in the same market, so by being both long and
short in the same market, an arbitrageur doesnt have to have a strong bullish or
bearish inclination toward the market as a whole; he just has to believe his long
position will gain relatively more value (or lose relatively less value) than his short
position.
Developing the decision of which side to go long and which side to go short is
the major trick to this strategy. Basically, a trader just has to identify one overpriced
asset within a market and one underpriced asset, and then he simultaneously sells the

overpriced one and buys the underpriced one. He profits when the over/underpriced
situation corrects itself.
To find two assets to pair together for arbitrage may require you to redefine
what you think of as a market. An easy example is grain futures, which trade the
same underlying commodity but with different expiration dates. So for instance, an
arbitrageur could buy September wheat futures and sell December wheat futures.
Equity futures or equity index futures could be used for similar calendar-based arbitrage
opportunities, but with equities themselves, you have to start thinking of entire sectors
moving together to make an arbitrage opportunity work. For instance, within the energy
sector, Exxon Mobil stock (XOM) may be overpriced in relation to BP (BP), so an
arbitrageur would sell the former and buy the latter.
The reason arbitrage is such an attractive trading strategy is because it limits
overall loss. Selling XOM and buying BP could result in losses to your portfolio on both
trades if the XOM share price increases while the BP share price simultaneously
decreases. However, because the two assets are in the same market, as defined by an
arbitrageur, they are both likely to move in the same general direction at the same
time. One may gain relatively more than the other (or lose relatively less) and that is
profitable to the correctly positioned arbitrageur but the overall energy market is
likely to move either up or down together, and it doesnt matter to the arbitrageur
which way they go.
So how does a trader who wants to place an arbitrage trade decide which asset
to buy and which asset to sell? Its like any market strategy: there are as many
techniques as there are types of traders. It could be a discretionary decision based on
nothing but instinct, it could be based on careful stock valuations, or in the case of
commodity futures, its often based on how the spread between two calendar months
relates to the actual carrying costs of the underlying commodity. At the end of the day,
it always comes down to identifying underpriced or overpriced assets, according to
some definition of what those prices should be.
There is an entire segment of the hedge fund industry which refers to itself as
Statistical Arbitrage trading (or StatArb). These traders define what assets relationships
should be based on massive statistical calculations, and as such, they typically require
sophisticated computer hardware to accomplish their goals on the scale and in the
timeframe they need to be profitable. If XOM shares suddenly grow overpriced
compared to the statistical expectation for their relationship with BP shares (i.e. the
spread between them grows too large), a StatArb fund would instantaneously short sell

XOM and buy BP. They would exit the trade when the relationship got back to within a
statistically expected range, and their profit would be the difference between the spread
when it was out of line and when it was in line with expectations. The fund would never
be net long or net short in energy market equities, and therefore it would never face
the risk or being incorrectly bullish or bearish overall.
To see the math of an arbitrage trade in more detail, lets consider an
arbitrageur who is long September wheat futures at $7.50 and short December wheat
futures at $7.70. He is a bear spread trader, one who is effectively short the spread
between September and December wheat futures (a 20-cent spread). Because he is
neither net long nor net short in the wheat market overall, the bear spread trader can
make money either way the wheat market moves:
1. If the whole wheat market goes up. Lets say September wheat moves to
$8.00 (a $2500 gain for the trader whos long a 5,000-bushel contract) and
December wheat moves to $8.15 (a $2250 loss, because hes short). The
arbitrageur netted a $250 gain from both legs of the trade, because the
September contract gained relatively more than the December contract. The
spread between them narrowed.
2. If the whole wheat market goes down. Lets say September wheat moves
to $7.00 and December wheat moves to $7.15. The spread between them once
again narrowed by five cents, and the arbitrageur netted a $250 gain. In this
case, the long September contract lost relatively less than the short December
contract.
It may stick out to you that this particular wheat trader could have made a larger
profit by simply going long or short in the wheat market. He could have kept the whole
$2500 gain if he had just one contract and no offsetting arbitrage trade but only if he
had analyzed the bullish or bearish potential of the market correctly. And thats risky,
because he could just as easily have taken the wrong side. Thats why arbitrage is
attractive in volatile markets. An arbitrageur doesnt have to hold risky, un-hedged
positions in an uncertain environment. He may be more confident in the direction a
spread will move than he is in the direction an entire market will move. For instance, a
20-cent spread in the wheat market is relatively large compared to the actual costs of
carrying wheat three months between September and December, so that may be why
the trader in our example correctly decided to short that spread.
Still, this arbitrageur is settling for a smaller profit per trade than someone who
takes the risk and goes straight long or short. Thats true of the StatArb fund, too.

The change in the difference between two stock prices is almost always going to
be smaller than the change in the prices themselves. Arbitrageurs make up for their
smaller profits by more confidently making a greater volume of trades. It takes a lot of
expertise and a lot of trading but by being both long and short in a market, an
arbitrageur can limit his risk and make money in all kinds of market environments.

CASE STUDY
Q.9 Write down your observation of below mention research paper.
Answer:
The following main observations my observation of the research:
The research paper examines the relation between futures trading activity by
trader type and returns over short horizons in five foreign currency futures
markets British pound, Canadian dollar, Deutsche mark, Japanese yen, and
Swiss franc.
The research clearly states that the efficiency of foreign exchange (FX) markets
has long been a central issue in international finance research.
It can be observed that the research adopts a more recent research tools from
the market microstructure literature to study currency price dynamics in terms of
order flow between various types of FX dealers.
More recent research applies tools from the market microstructure literature to
study currency price dynamics in terms of order flow between various types of
FX dealers.
The paper also adds to the recent literature by examining whether a specific
trader type consistently beats the market in five actively traded foreign currency
futures markets that include the British pound (BP), Canadian dollar (CD),
Deutsche mark (DM), Japanese yen (JY), and Swiss franc (SF).
It can be found that the research adopt a two-stage procedure to investigate
whether the profits to speculators are attributable to market risk premiums,
hedging pressure, or rewards to superior forecasting ability.

ASSIGNMENT C(MCQs)
Q01
Q02
Q03
Q04
Q05
Q06
Q07
Q08
Q09
Q10

E
D
C
A
E
D
C
C
C
D

Q11
Q12
Q13
Q14
Q15
Q16
Q17
Q18
Q19
Q20

B
A
C
D
C
A
B
B
D
F

Q21
Q22
Q23
Q24
Q25
Q26
Q27
Q28
Q29
Q30

B
A
D
E
B
A
E
C
B
A

Q31
Q32
Q33
Q34
Q35
Q36
Q37
Q38
Q39
Q40

D
A
A
A
B
C
C
E
B
E

References:
1. http://www.investorwords.com/11718/noise_trader_risk.html#ixzz1w9Pk4thk
2. http://www.traderslog.com/arbitrageurs
3. http://financial-dictionary.thefreedictionary.com/Behavioral+Finance
4. http://www.investopedia.com/university/behavioral_finance/default.asp#ixzz1wA
r7YRYf
5. http://www.moolanomy.com/532/efficient-market-hypothesisemh/#ixzz1wAvTZXdH
6. http://www.simplestockinvesting.com/efficient-market-hypothesis.htm
7. http://www.investorglossary.com/behavioral-finance.htm
8. http://ssrn.com/abstract=1343685
9. http://www.sciencedirect.com/science/article/pii/S0378426603000475
10. http://financial-dictionary.thefreedictionary.com/Arbitrage+Strategy
11. http://www.docstoc.com/docs/58652745/Profits-and-Risks-in-Investing
12. http://www.investorwords.com/11718/noise_trader_risk.html
13. http://www-rcf.usc.edu/~ferson/papers/JAI93.PDF