UNIVERSITY OF DUBLIN TRINITY COLLEGE. Faculty of Arts Humanities and Social Sciences. School of Business

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1 UNIVERSITY OF DUBLIN TRINITY COLLEGE Faculty of Arts Humanities and Social Sciences School of Business M.Sc. (Finance) Degree Examination Michaelmas 2011 Behavioural Finance Monday 12 th of December Luce Upper Time 14:00-16:00 Closed Book Examination Prof. Khurshid Ahmad Prof. Brian Lucey Prof. Angela J. Black Instructions to Candidates: Non programmable calculators are permitted for this examination please indicate the make and model of your calculator on each exam book used. The examination is two hours in duration You may answer three questions out of five. Attempt one question each of the Sections You may not start this exam until you are instructed to do so by the invigilator UNIVERSITY OF DUBLIN 1

2 Section I: Information and Uncertainty: Professor Ahmad Question 1. This question is about Kahneman and Tversky s prospect theory 1 (a). It has been argued by Barberis, Ming and Tano (2001), that there are three main puzzles associated with aggregate stock market behavior: First, the equity premium puzzle; second, the volatility puzzle; and third, the predictability puzzle. Describe one of the three puzzles in your own words. Give at least two arguments as to why the puzzle you have described in some sense contradicts the conventional expected utility theory in economics. 1 (b) (i) What do you understand by the terms isolation effect and certainty effect as used in Kahneman and Tversky s critique of the expected utility theory? (ii) Kahneman and Tversky have argued that decision making under uncertainty involves a fast process and that this process is complemented by a slower process that is used when the decision maker is reasonably confident and certain about information at hand. Describe diagrammatically how perception and intuition are used in some circumstances and reasoning in others. 1 ( c). Kahneman and Tversky have performed a series of experiments on college students to argue that the framing of propositions plays a role in decision making. Consider their oft-cited experiment where volunteers (college/university students) are asked to imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. The volunteers were asked to consider two scenarios. In each scenario two alternative programs to combat the disease were proposed. Assume that the exact scientific estimates of the consequences are as follows: Program adopted Consequence Percentage supporting the program Scenario I: Program A 200 people will be saved. 72 Program B 1/3 probability that people will be saved and 2/3 probability that no people will be saved. Scenario II Program C 400 people will die 22 Program D 1/3 chance that nobody will die; 2/3 chance all 600 will die 78 UNIVERSITY OF DUBLIN 2

3 Explain the differences between the results in two scenarios and between the programs comprising the scenario? 1 (d) Kahneman and Tversky have argued that framing effects resemble perceptual illusions more than computational errors. The so-called dominance requirement of rational choice is obeyed in certain cases. Consider three scenarios, each with two gambling decision together with the results of volunteers that voted for each of the six decisions Gambling Decisions Poll Results Scenario I: Choose between A: A sure gain of $240 84% B: 25% chance of gaining $1000; 75% 16% chance to gain nothing Scenario II: Choose between C: A surety of a $750 loss 13% D: 75% chance of losing $1000; 25% 87% chance of losing nothing Scenario III: Choose between E: 25% chance to win $240; 75% 0% chance to lose $760 F: 25% chance to win $250; 75% 100% chance to lose $750 (i) Describe the key difference between the type of person who has dominated Scenario I results and those who have dominated Scenario II results. [20 Marks] (ii) What is the relationship between decisions A, B, C, D, E and F? And what does the relationship tell us about human decision making. [20 Marks] UNIVERSITY OF DUBLIN 3

4 Q2. This question is about herding and noise traders. 2 (a). Describe the behaviour of an informed trader and noise trader in a contingency table demarcated by optimism and pessimism. [30 Marks] 2 (b). Let: µ be the number of noise traders (n), and the rest, 1-µ, are informed traders (i). λ be the demand for an asset by the two types of traders, the normalized demand for a risky asset u is + = Consider two assets: First, a safe asset, s, paying dividend r and has a fixed price of 1 forever; second, an unsafe asset, u, paying dividend r forever but its price and supply depends on the misperception of the noise traders. Assume that the n noise traders misprice the asset u at time t by with mean and variance. The mean is construed as the average amount of bullishness/bearishness of the noise trader. Bradford Delong and colleagues have given a solution for the price of the unsafe asset (u) as: = where γ is the risk aversion factor associated with the informed trader. Describe in your own words (a) how the price will vary according to the noise traders mispricing; (b) how will the price vary if the noise traders perpetually misprices by ρ* constantly; (c) how will the informed trader deal with optimism or pessimism of the noise trader. 2c. The exponential growth in the volume traded on major stock exchanges around the world has been attributed in part to noise traders. Give at least three other sources of noise in a trading environment. [25 Marks] UNIVERSITY OF DUBLIN 4

5 Question 3.This question is about mental accounting. The Oxford English Dictionary (OED) defines accounting as the action or process of reckoning, counting, or computing; numeration, computation. Now especially the management of financial affairs, e.g. those of a business enterprise. Accounting is governed by the laws of the Land, conventions, and precedence. Richard Thaler has defined mental accounting as the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities. 3 (a) Describe in your own words at least two differences between the conventional notion of accounting (as given in the OED) and Thaler s definition of mental accounting? You may refer to the different ways in which the perceptive/intuitive system in the human brain differs from the reasoning system in the brain. [20 Marks] 3 (b) Imagine a shop called Loc-Money that sells calculators and DVD players, and is next door to where you live. Loc-Money is selling a calculator for 15 and an equally well known DVD player for 125. You have just found out that there are two other stores, Zippity specializing in calculators (and computers) and Seeall specialising in DVDs, are selling the calculator for 10 and the DVD for 120. Both are 20 minutes walk from where you live. Richard Thaler asked a group of volunteers which of the three shops they would buy the products from, he received the following overall response: Consumer Good Buy from Loc-Money (%) Buy from Zipity/Seeall (%) Calculator DVD Explain in your own words the difference in the two responses, between the calculator and DVD purchases, and refer to the utility maximization hypothesis. [40 Marks] 3 (c). Barrack Hussain bought a baseball bat autographed by a famous player for $1000 in He has found that in the year 2000 that another bat with the same autograph has been auctioned for $5000. However, Shakila, his daughter, wanted Barrack s bat as a birthday present. Barrack gave the bat to his beloved daughter. A group of people were surveyed about this transaction and it was found that: (i) Barrack made no loss/gain (30% of the respondents); (ii) Barrack gained made a profit of $4000 (25%); (iii) Barrack made a loss of $4000 (20%); and (iv) Barrack lost $1000, with or without interest (25%). Describe the differences in the response of groups (i-iv). You may refer to the notion of fungibility. [40 Marks] UNIVERSITY OF DUBLIN 5

6 Question 4 : Biases Section 2: Biases and Heuristics: Professor Lucey Outline five major biases and for each one discusses the implications it has for investors and corporate financial decision makers. In your answer refer to any relevant research findings. [ 20 marks for each bias, 100 in total] Question 5: Challenges Behavioural Finance has been held up by some as an alternative to traditional finance, while others contend that it is a logical interdisciplinary extension of same. In your view, does Behavioural Finance challenge or strengthen traditional finance? In your answer please refer to the relevant literature. [100 marks] Question 6: Social and Emotional Outline the risk as feelings model, and discuss how this may reconcile and incorporate the role of social/emotional states into the pricing and trading of financial assets, referring to the relevant literature on this and on neurofinance throughout. [100 marks] UNIVERSITY OF DUBLIN 6