1behavioral Finance Fin 645midterm Exam Caution Please Note Th ✓ Solved

1 Behavioral Finance- FIN 645 Midterm Exam Caution: Please note this is an individual exam only- and not a team or group effort. All relevant UMUC policies- and especially those related to Academic Honesty- will be in full force. So please keep that in mind at all times. INSTRUCTIONS: 1. Please answer all the following four (4) questions.

2. There is a maximum of 100 points for this test. Scores for each question are shown in the parentheses at the end of each question. For qualitative questions, maximum allowed pages are also given at the end of each question. 3.

You will have until 11:59 PM EST on the due date, to submit your answers via the related file in your assignment folder. This gives ample time for the exam. 4. References are not counted against your page numbers. I wish all of you the very best.

Continued on next pages 2 QUESTION 1. Overconfidence (that is excessive optimism) is very commonly observed in human beings. Overconfidence leads to which types of irrational of behavior in financial markets? Please list 3 and explain in detail. Note: Write-ups that lack organization and order will lose points.

Maximum pages: 2 pages, double-space, size 12. Grade: 20 QUESTION 2. Details (from Behavioral Corporate Finance, Seohee Park) Between March and July 2000, Intel’s stock price rose rapidly, to the point where in July Intel’s market capitalization was above 0 billion, making it the largest firm in the world. Then on Thursday, September 21, 2000, Intel issued a press release indicating that its revenue for the third quarter would grow between 3 percent and 5 percent, not the 8 to 12 percent that analysts had been forecasting. In response to this news, Intel’s stock price dropped by 30 percent over the next five days.

Intel’s chairman, Craig Barrett, commented on the reaction, stating: “I don’t know what you call it but an overreaction and the market feeding on itself.†An academic study found that at the time, virtually none of the analysts following Intel used discounted cash flow analysis to estimate the fundamental value of Intel’s stock. Instead, the study points out that analysts react to bad news in the same way that a bond-rating agency reacts to bad news. Just as a bond-rating agency would downgrade the firm’s debt, analysts downgrade their stock recommendations. After Intel’s press release, approximately one- third of the analysts following the firm downgraded their recommendations. Some of the recommendation changes were extreme.

Notably, the cumulative return to Intel’s stock, relative to the S&P 500, displayed a negative trend for the period September 2000 through September 2002. In what some might see as a replay of history, consider an event that took place at the online firm eBay during January 2005. Between the end of 2002 and the end of 2004, eBay’s shares increased by over 200 percent. During December 2004, eBay’s stock price peaked at 8, and its forward P/E ratio was 73. At the time, the firm’s market value was .7 billion.

Fourth-quarter earnings for eBay grew by 44 percent to 5.4 million, or 30 cents a share. Just as Intel had announced that its earnings growth would be lower than forecast, eBay’s actual earnings for the fourth quarter of 2004 fell a penny below analysts’ consensus forecasts. Meg Whitman, eBay’s CEO, stated that future earnings would be lower because of higher advertising costs and reinvestment. In response, eBay’s stock price fell from 3 to per share. The firm’s market value fell to billion.

Many analysts immediately downgraded eBay’s stock. Rajiv Dutta, 3 eBay’s CFO, issued a public statement to say that his concern was managing eBay’s long-run prospects, not its stock price. On January 26, 2005, James Stewart wrote about eBay in his Wall Street Journal column “Common Sense.†Stewart indicated that he would consider purchasing eBay stock in the wake of its decline. While acknowledging that eBay could not grow at a stratospheric rate forever, Stewart noted that eBay is in the process of transforming world commerce and has a natural monopoly. Were he to own just one Internet stock, Stewart said, eBay would be that stock.

Questions: 1. What psychological phenomena may have influenced the analysts, both generally and in their reaction to Intel’s announcement in September 2000? 2. Does James Stewart’s assessment of eBay reflects any psychological phenomena, discuss. 3.

Discuss in what ways the events described at Intel and eBay are similar and in what ways are they different? Note: Points will be taken off for write-ups that lack organization and order. Maximum pages: 3 pages, double-space, size 12; Grade: 30 QUESTION 3. Bias Identification, please identify the biases and/or heuristics displayed by Professor French 1. Professor French tells you that South Africa’s stock market undervalued and suggests that it is a good investment.

You discover that South Africa is about to impose a new tax on security transactions, which will results in lower liquidity. The next class you bring this to Professor French’s attention. Simultaneously, another student mentions that as commodity prices recover South Africa’s stock market will rise sharply. Dr. French ignores the information you provide and congratulates the other student on excellent research.

Which type of bias is Professor French displaying? Explain briefly. 2. While reviewing the most recent four quarters of earnings estimates for MMM, Professor French notices that earnings growth rates were 15% per quarter. He announces to the class that MMM is a growth company.

Which type of bias or heuristic is Professor French falling victim too? Explain briefly. 3. Professor French’s father works for Boeing. Professor French holds 18% of his portfolio in Boeing.

Which type of bias or heuristic is Professor French displaying? Explain briefly. Maximum pages: 2 pages, double-space, size 12. Grade: QUESTION 4. 1.

Explain what is meant by an anomaly in finance? 2. Give 3 examples of anomalies uncovered by academic research in the past two decades (make sure and explain these anomalies in detail including references). 3. If markets are efficient what would you expect to happen to these anomalies after they were discovered?

4. If the anomalies persist what financial frictions might responsible for the persistence (make sure and cite frictions that apply to the anomalies in part ‘b’)? Note: Points will be taken off for write-ups that lack organization and order. Maximum pages: 4 pages, double-space, size 12. Grade: 30 End!

Paper for above instructions

Behavioral Finance – FIN 645 Midterm Exam

Question 1: Overconfidence and its Impacts on Financial Markets

Overconfidence is a common cognitive bias where investors overestimate their knowledge and predictive abilities, often leading to irrational behavior in financial markets. This phenomenon can manifest in several ways, primarily through overtrading, underestimating risks, and the illusion of control.
1. Overtrading
Overconfidence often leads investors to believe that they can time the market effectively, prompting frequent buying and selling of stocks. This overtrading can result in excessive transaction costs, which erode profits and lead to suboptimal portfolio performance. A study by Barber and Odean (2000) found that overconfident investors tend to trade 45% more than less confident individuals, ultimately yielding worse returns due to market volatility and trading fees (Barber & Odean, 2000).
2. Underestimating Risks
Overconfident investors frequently underestimate the risks associated with their investments. This miscalculation can lead to poor investment choices, such as concentrating too much capital in highly volatile assets. For example, during the technology bubble of the late 1990s, many investors ignored warning signs and continued pouring money into overvalued tech stocks based on inflated expectations of future returns, contributing to significant market losses when the bubble burst (Shiller, 2000).
3. Illusion of Control
The illusion of control refers to the belief that individuals can manipulate or influence outcomes through their decisions, leading to overconfident behavior. Investors exhibiting this bias often hold strong misconceptions about their ability to predict market movements based on their research or instinct. This behavior hinders their willingness to adequately diversify their portfolios, increasing vulnerability to adverse market events. A study by Lichtenstein and Fischhoff (1977) demonstrated that individuals have a tendency to overestimate their ability to influence outcomes, leading to increased investment risk (Lichtenstein & Fischhoff, 1977).
In summary, overconfidence can have detrimental effects on financial markets by encouraging overtrading, underestimating risks, and fostering an illusion of control. Each of these irrational behaviors contributes to market inefficiencies and can lead to substantial financial losses for investors.

Question 2: Psychological Phenomena in Analyst Behavior

The behavior of analysts reacting to Intel's and eBay's announcements in the early 2000s can be analyzed within the framework of several psychological phenomena that influence decision-making in the financial sector.
1. Herding Behavior
Analysts’ quick downgrades of Intel's stock after negative news exemplified herding behavior, where individuals follow the actions of others rather than evaluating information independently. This collective reaction to Intel's downward revision in future revenue estimates showcases how analysts, much like investors, may conform to the opinions of their peers to avoid being distinct in their judgments (Bikhchandani et al., 1992).
2. Anchoring and Adjustment
Analysts' initial estimates of Intel's performance likely served as anchors that limited how they adjusted their forecasts in response to new information. When Intel announced that its growth would be lower than expected, analysts anchored their projections to the previous higher estimates, leading to drastic downgrades that may not have reflected a rational assessment of Intel's true value (Tversky & Kahneman, 1974).
3. Framing Effects
The way information regarding Intel's revenue guidance was presented influenced analysts' perceptions and responses. The framing of news—whether viewed as a catastrophe or a minor setback—could significantly affect analysts’ decisions. For instance, analysts preferring to view Intel's announcement as a substantial warning led to extreme downgrades, while others might have interpreted it as a manageable revision (Tversky & Kahneman, 1981).
Regarding James Stewart's assessment of eBay, his inclination to consider eBay stock attractive despite a recent decline can be linked to cognitive dissonance. As investors, individuals often hold conflicting beliefs about reality versus their speculative enthusiasm, impacting future investment decisions (Festinger, 1957). Stewart seemed to reconcile any cognitive conflict by emphasizing eBay's long-term potential rather than being swayed by short-term price movements.
When comparing Intel’s and eBay's situations, both firms experienced analysts responding negatively to earnings guidance falling short of projections, leading to significant stock price drops. However, the magnitude of retraction varied, with Intel experiencing a 30% plunge compared to eBay’s 21% decline. The reaction was intensified at Intel due to its market dominance and following; the timeframes in which both experiences unfolded also differed, reflecting the varying volatility of tech stocks over time.

Question 3: Bias Identification in Professor French

1. Confirmation Bias
In the provided scenario, Professor French displayed confirmation bias by ignoring the potential adverse effects of the impending tax on the South African stock market while validating the optimistic perspective presented by another student. This narrative alignment led him to reinforce his belief in the profitability of South African investments without incorporating contradictory evidence (Nickerson, 1998).
2. Base Rate Fallacy
When Professor French declared MMM a growth company solely based on the recent quarterly growth rates, he fell prey to the base rate fallacy. He failed to evaluate the overall data, trends, or the company's historical performance in a broader context, ultimately leading to an erroneous categorization that overlooks fundamental variations and market conditions (Kahneman, 2011).
3. Hindsight Bias
Professor French's emotional ties to Boeing, where he holds a significant portion of his portfolio due to his father's employment, illustrate hindsight bias. This bias stems from the comfort of believing he can predict future outcomes based on past relationships or knowledge, ignoring the objective assessment of Boeing's market position (Roese & Vohs, 2012).

Question 4: Financial Anomalies

1. Definition of Anomaly in Finance
An anomaly in finance is a pattern or trend that deviates from standard assumptions of market efficiency, often contradicting the Efficient Market Hypothesis (EMH). Anomalies suggest that some portfolios can yield abnormal returns or that asset prices deviate from their intrinsic value for extended periods (Fama, 1970).
2. Examples of Anomalies
- January Effect: Historically, small-cap stocks tend to outperform larger counterparts in January, attributed to year-end tax-loss selling followed by subsequent buying (Keim, 1983).
- Momentum Effect: Stocks that have performed well in the past are likely to continue performing well in the short term, while failing to account for fundamental changes driving returns (Jegadeesh & Titman, 1993).
- Value Effect: Companies that are undervalued (low price-to-earnings ratios) tend to outperform overvalued (high price-to-earnings ratios), challenging the assumption that market participants always act efficiently (Fama & French, 1992).
3. Expectations of Anomalies in Efficient Markets
If markets are efficient, existing anomalies should disappear following their discovery. Investors would quickly exploit mispricings, eliminating abnormal returns and aligning prices with underlying values.
4. Financial Frictions Causing Anomaly Persistence
Financial frictions, such as transaction costs, behavioral biases, and market segmentation, hinder the correction of anomalies. Investors may prefer to hold onto underperforming stocks due to loss aversion, leading to the persistence of pricing inefficiencies (Shleifer & Vishny, 1997). Moreover, limits on short selling or information asymmetries can create challenges for investors seeking to profit from these anomalies (Miller, 1977).

References

1. Barber, B. M., & Odean, T. (2000). Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. The Journal of Finance, 55(2), 773-806.
2. Bikhchandani, S., Hirshleifer, D., & Welch, I. (1992). A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades. Journal of Political Economy, 100(5), 992-1026.
3. Fama, E. F. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal of Finance, 25(2), 383-417.
4. Fama, E. F., & French, K. R. (1992). The Cross-Section of Expected Stock Returns. The Journal of Finance, 47(2), 427-465.
5. Festinger, L. (1957). A Theory of Cognitive Dissonance. Stanford University Press.
6. J. H. (1993). Returns from Investing in Equity Mutual Funds 1971 to 1991. The Journal of Finance, 48(2), 483-498.
7. Kahneman, D. (2011). Thinking, Fast and Slow. Farrar, Straus, and Giroux.
8. Keim, D. B. (1983). Size-Related Anomalies and Stock Return Seasonality: Further Empirical Evidence. The Journal of Financial Economics, 12(1), 13-32.
9. Lichtenstein, S., & Fischhoff, B. (1977). Do Those Who Know More Also Know More About How Much They Know? The Calibration of Probabilities. Organizational Behavior and Human Performance, 20(2), 159-183.
10. Miller, E. M. (1977). Risk, Uncertainty, and Divergence of Opinion. The Journal of Finance, 32(4), 1151-1168.