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Final Exam

FIN 550E: Behavioral Finance

Q1 (10 points) 

A number of experts were asked to make a forecast and give their 95% confidence interval. When the true value was given, only half of the experts had the appropriate answer within their confidence interval. Describe the bias that the experts are exhibiting and explain why it is a bias that a rational agent would not make.

Q2 (10 points)

The following figures come from the paper “All that glitters: The effect of attention and news on the buying behavior of individual and institutional investors” by Barber and Odean (RFS, 2008). Explain why the net buying conditional on previous day’s return differ between individuals investors (Panel A) and institutional investors (Panel B)?

Panel A: individual investors Panel B: institutional investors

 

Q3 (15 points)

(1) Edmans (2011) shows that high levels of employee satisfaction generate superior stock returns.  Briefly explain potential mechanisms on how employee satisfaction could affect a company’s stock return.

(2) The following tables come from “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices” by Edmans (2011). The tables show the abnormal returns of longing stocks from the Best Company list regarding employee satisfaction relative to different benchmarks (risk-free rate, industry benchmark, characteristics-based benchmark).

Table A: Full Sample Period (1984-2009)                     Table B: Salient-info Period (1998-2009)

                 

a. What do the positive abnormal returns indicate?

b. There are two hypotheses we want to test: 1) Market is not aware of the BC list 2) Investors have difficulty in incorporating intangible information into traditional valuation models. Suppose the BC list is not salient to investors before 1998, then

b.1 What hypothesis (or hypotheses) does Table A support?

b.2 What hypothesis (or hypotheses) does Table B support?

Q4 (25 points) Earnings Announcement

(1) When examining return reactions to earnings announcements we focused on the earnings surprise. Describe one way to define the earnings surprise.

(2) Briefly describe an example of a returns pattern related to earnings announcements consistent with the market reacting too conservatively (underreacting) to information in the earnings surprise.

(3) Briefly describe an example of a returns pattern related to earnings announcements consistent with the market overreacting to information in the earnings surprise.

(4) Briefly describe an example of a returns pattern related to earnings that we discussed in class where the market ignores information released before the earnings announcement, but is subsequently predictably surprised when earnings are announced.

(5) In addition to reacting to earnings surprise, stock prices also rise on average around earnings announcement dates, which is documented as earnings announcement premium in the literature. What can be the possible reason(s) for this phenomenon?

Q5 (15 points)

Over the course of many years, the Gallup survey asks individual investors about their beliefs about the stock market over the next twelve months. We will indicate this future return over the next 12 months as . The survey was conducted at the beginning of each month, call it . We can take the average of the forecasts across surveyed subjects and call it the consensus expectation from these subjects of the return from time  to time , .

(1) The figure below compares the Gallup survey expectations with flows into equity mutual fund. According to the figure, do you think Gallup survey expectations could reasonably reflect the expectations of the participants? Briefly explain. Your explanation should be based on the patterns in the figure.

 

(2) To explore what determines the forecast of returns, we regress the expectations of future returns on a set of variables as follows:

 

where  denotes the cumulative returns that occurred over the year prior to the survey,

 denotes the log price-dividend ratio—a measure of the price-level—and  denotes other fundamental variables, such as earnings growth, unemployment and risk-free rate. We run 4 separate regressions, each using one or more of the independent variables specified in the equation. The estimated coefficients are reported in the table below, the numbers in brackets are corresponding t statistics.

 

According to the table, do you think investor’s expectations depend more on past returns or more on past fundamental information? Briefly explain. Your explanation should include information from the table.

Q6 (25 points)

Joe’s value function for monetary gains and losses “” is as follows:

 

(1) Graph . Comment on features of preferences that the value function  captures.

(2) Suppose Joe must decide whether to accept a gamble in which he wins $1000 with a probability of 0.5 and loses $125 with a probability of 0.5. Will he accept the gamble?

(3) Now Joe is offered a second gamble, which simply repeats the gamble above twice. That is, a coin is flipped with heads leading to a gain of $1000 and tails a loss of $125, and then the coin is immediately flipped again with heads leading to a gain of $1000 and tails a loss of $125. What is the probability distribution of total gains and losses from this gamble? (Report all possible total gains and losses and their corresponding probabilities.)

(4) Given the distribution of total gains and losses you have just computed, will Joe accept this second gamble?

(5) Now suppose Joe joined the gamble in Question (2) and he lost $125. He is offered another gamble in which he wins $125 with a probability of 0.5 and loses $125 with a probability of 0.5. Will he accept the gamble now?