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FINM3407 Behavioural Finance
Questions/Answers
Part A: Multiple Choice Questions
10 Multiple Choice Questions - 20 Marks, 2 marks per question.
Part B: Essay or Problem-Solving Questions
4 Essay or Problem Solving Questions - 20 Marks, 5 marks per question.
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Part a: Multiple Choice Questions - 20 Marks
Q1 - Q7 - 14 Marks @ 2 marks each
Tiffany Jordan is a hedge fund manager with a history of outstanding performance. For the past 10 years,
Jordan’s fund has used an equity market neutral strategy (long/ short strategy that strives to eliminate market
risk, i.e., beta should be zero) which has proved to be effective as a result of Jordan’s hard work. An equity
market neutral strategy normally generates large daily trading volume and shifts in individual security positions.
Jordan’s reputation has grown over the years as her fund has consistently beaten its benchmark. Employee
turnover on Jordan’s team has been high; she has a tendency to be quick to blame, and rarely gives credit to
team members for success. During the past twelve months, her fund has been significantly underperforming
against its benchmark. One of Jordan’s junior analysts, Jeremy Tang, is concerned about the underperformance
and notes the following:
• Observation 1: Certain positions are significantly under water, have much higher risk profiles, and have
been held for much longer than normal.
• Observation 2: The trading volume of the fund has decreased by more than 40 percent during the past
year.
• Observation 3: The portfolio is more concentrated in a few sectors than in the past.
Tang is worried that the portfolio may be in violation of the fund’s Investment Policy Statement (IPS). Tang
brings this to Jordan’s attention during a regular weekly team meeting. Jordan dismisses Tang’s analysis and
tells the team not to worry because she knows what she is doing. Jordan indicates that since she believes the
pricing misalignment will correct itself, the portfolio will not be able to take advantage of the reversion to the
mean if she sells certain losing positions. She reassures the team that this strategy has performed well in the
past and that the markets will revert, and the fund’s returns will return to normal levels.
Tang tactfully suggests that the team review the fund’s IPS together, and Jordan interrupts him and reminds
the team that she has memorized the IPS by heart. Tang contemplates his next step. He is concerned that
Jordan is displaying behavioral biases which are affecting the fund’s performance.
1. By taking credit for successes but assigning blame for failures, Jordan is most likely demonstrating:
A loss-aversion bias
B self-attribution bias
C illusion of knowledge bias
Answer: B is correct. Self-attribution is a bias in which people take credit for successes and assign
responsibilities for failure. Jordan attributes successful decisions to herself while poor decisions are at-
tributed to the team. Her self-esteem affects how she looks at success and failure. Self-attribution and
illusion of knowledge biases contribute to overconfidence bias, which Jordan clearly demonstrates later
when she tells the team that she knows what she is doing.
2. Which of Tang’s observations is least likely to be the consequence of Jordan demonstrating loss-aversion
bias?
A Observation 1
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B Observation 2
C Observation 3
Answer: C is correct. Loss aversion by itself may cause a sector concentration; however, a market neutral
strategy tends to focus on individual stocks without regard to the sector. The sector exposure would be
mitigated with the balancing of the individual long and short positions.
3. Which of Jordan’s actions least supports that she may be affected by the illusion of control bias?
A Her dismissal of Tang’s analysis
B Her routine of holding weekly team meetings
C Her comment on market turnaround and current holdings
Answer: B is correct. Holding weekly team meetings, which would indicate a willingness to listen to
feedback from others, is not representative of the illusion of control bias. The illusion of control bias is one
in which people believe they can control outcomes. Individuals exhibiting this bias display great certainty
in their predictions of outcomes of chance events and ignore others’ viewpoints. Jordan is sure that the
market will turn around even though it is out of her control. She chooses not to listen to Tang who is
questioning her viewpoint.
4. How does Jordan most likely demonstrate loss-aversion bias?
A Telling the team not to worry
B Reducing the portfolio turnover this year
C Deciding to hold the losing positions until they turn around
Answer: C is correct. Jordan’s behavior is a classic example of loss aversion: When a loss occurs, she holds
on to these positions longer than warranted. By doing so, Jordan has accepted more risk in the portfolio.
Loss-aversion bias is one in which people exhibit a strong preference to avoid losses versus achieving gains.
One of the consequences of loss aversion bias is that the financial management professional (in this case,
Jordan) may hold losing investments in the hope that they will return to break-even or better.
5. Which of the following emotional biases has Jordan most likely exhibited?
A Endowment
B Regret aversion
C Overconfidence
Answer: C is correct. Jordan exhibits overconfidence in several ways. She ignores the analysis done by
Tang. This may be because Jordan believes she is smarter and more informed than her team members,
which is typical of an individual with an illusion of knowledge bias. The certainty she demonstrates
that the market will revert is evidence of overconfidence. Her overconfidence is intensified by her self-
attribution bias, which is demonstrated through her dealings with her team when she blames them for
losses while taking credit for the gains. Finally, her portfolio’s underperformance against the benchmark
is a consequence of overconfidence bias.
6. Which one of the following biases did Jordan not demonstrate?
A Self-attribution
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B Representativeness
C Illusion of knowledge
Answer: B is correct. Nowhere in the scenario did it mention that Jordan classified certain information
into a personalized category. Representativeness bias is a cognitive bias in which people tend to classify
new information based on past experiences and classifications. Jordan is not relating the certainty about
the future or her decision to hold losing positions back to something she has done or experienced in the
past.
7. Which of Tang’s findings is not a typical consequence of self-control bias?
A Failure to explore other portfolio opportunities
B Asset allocation imbalance problems in the portfolio
C A higher risk profile in the portfolio due to pursuit of higher returns
Answer: A is correct. Failing to explore other opportunities is a demonstration of status quo bias, not
self-control. Self-control bias occurs when individuals deviate from their long-term goals, in this case, the
investment policy statement, due to a lack of self-discipline. Jordan is not adhering to the strategy which
has been successful in the past. The consequences of self-control bias include accepting too much risk
in the portfolio (C) and asset allocation imbalance problems (B) as Jordan attempts to generate higher
returns.
Q8 - Q10 - 6 Marks @ 2 marks each
8. An investor reviews a stock’s historical performance from the past two weeks and decides it will continue
to perform well in the future, without considering the short timeframe as a limitation. This is an example
of?
A. Disposition effect
B. Conservatism bias
C. Representativeness bias
D. Regret avoidance
E. Mental accounting
Answer: C. Representativeness bias
9. John holds onto a stock that has been underperforming for several months, unwilling to realize the loss.
His behavior most closely represents which of the following behavioral characteristics?
A. Disposition effect
B. Conservatism bias
C. Representativeness bias
D. Regret avoidance
E. Mental accounting
Answer: A. Disposition effect
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10. Which of the following statements best describes a potential consequence of high-frequency trading (HFT)
in relation to market efficiency?
A. HFT always enhances market efficiency by providing necessary liquidity at all times.
B. HFT has no impact on market efficiency since it merely uses algorithms for trading decisions.
C. Some believe HFT can challenge market efficiency by causing market disruptions and creating an
uneven playing field.
D. HFT improves market efficiency by eliminating the need for human decision-making in trading.
Answer: C. Some believe HFT can challenge market efficiency by causing market disruptions and creating
an uneven playing field.
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Part B: Essay/Problem Solving Questions
Question 11 - 5 Marks
An individual has the utility function:
u(w) = w0.6
where w is wealth.
a. Using the expected utility, order the following prospects in terms of preference, from the most to the least
preferred (3 marks):
P1(0.9, 1, 500, 800)
P2(0.6, 1, 800, 700)
P3(0.7, 2, 500, 400)
b. What is the certainty equivalent for prospect P2 (2 marks)?
c. Without doing any calculations, would the certainty equivalent for prospect P1 be larger or smaller? Please
provide a brief reason, and then show a full numerical proof of your answer. (0 mark) Extra Practice
Question ONLY?
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Answer - Question 11
a. Using the expected utility, order the following prospects in terms of preference, from the most to the least
preferred:
i. P1(0.9, 1, 500, 800):
U(P1) = 0.9× 15000.6 + 0.1× 8000.6 = 77.945
ii. P2(0.6, 1, 800, 700):
U(P2) = 0.6× 18000.6 + 0.4× 7000.6 = 74.242
iii. P3(0.7, 2, 500, 400):
U(P3) = 0.7× 25000.6 + 0.3× 4000.6 = 87.459
Order based on utility:
Given the computed utilities, the prospects in descending order of preference (from most to least preferred) are:
P3 > P1 > P2
So, based on expected utility theory, the individual would prefer prospect P3 the most, followed by P1, and
then P2.
b. Certainty equivalent for P2: Use the derived utility from above for P2 to find the wealth level w such that:
w0.6 = U(P2)
Determining the Certainty Equivalent for P2:
Given:
U(P2) = 74.242
We need to find the wealth level w such that:
w0.6 = 74.242
To determine w:
w = 74.242
5
3
Using the given exponent:
w = 85.8931.66
Computing w:
w ≈ 1311.4431
Thus, the certainty equivalent for P2 should indeed be approximately $1311.4431.
*Note: The certainty equivalent is defined as that wealth level that leads the decision-maker
to be indifferent between a particular prospect and a certain wealth level. The utility of the
certainty equivalent is equal to the expected utility of the prospect.
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c. Without calculations, the certainty equivalent for P1 would be larger than that for P2 if U(P2) < U(P1).
A higher expected utility means the person values the prospect more and would need a higher
certain amount to be indifferent between the two.
Now, for the computed utilities:
i. U(P1):
U(P1) = 0.9× 15000.6 + 0.1× 8000.6 = 77.945
ii. U(P2):
U(P2) = 0.6× 18000.6 + 0.4× 7000.6 = 74.242
iii. U(P3):
U(P3) = 0.7× 25000.6 + 0.3× 4000.6 = 87.459
Order based on utility:
P3 > P1 > P2
Determining the Certainty Equivalent for P1:
Given:
U(P1) = 77.945
We need to find the wealth level w such that:
w0.6 = 77.945
Computing w:
w ≈ 1422.265
From Part b, we obtained that the Certainty Equivalent for P2 is $1311.443, which is smaller than the Certainty
Equivalent of $1422.265 for P1.
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Question 12 - 5 Marks
Consider an individual with the following value function under prospect theory:
v(z) =
z0.9 when z ≥ 0−2(−z)0.9 when z < 0
This individual has the following weighting function:
π(pi) =
pδi
(pδi + (1− pi)δ)
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δ
where we set δ = 0.7.
a. Which of the following prospects would they choose? (2 Marks)
PC = (0.002,−4000)
PD = (−4)
Compare the value of each prospect.
b. Repeat the calculation but using probabilities instead of weights. What does this highlight?
(3 Marks)
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Answer - Question 12
a. Calculate V (PC):
Using the given value and weighting functions:
w1 =
(0.998)0.7
(0.9980.7 + (1− 0.998)0.7)1/0.7 = 0.9824
w2 =
0.0020.7
(0.0020.7 + (1− 0.002)0.7)1/0.7 = 0.01269
V (PC) = w1 × 0 + w2 × (−2× (−(−4000))0.9) = 0.9824× 0 + 0.01269× (−2× 40000.9) = −44.29
For PD:
V (PD) = (0× 0) + (1×−2(4)0.9) = −6.9644
Based on the values of V (PC) and V (PD) by using the weighting function, V (PD) is preferred.
b. Using probabilities instead of weights:
V (PC) = 0.998× 0 + 0.002× (−2× 40000.9) = −6.9809
V (PD) = −2(4)0.9 = −6.9644
Again, based on these values, decide which is preferred V (PC) is preferred.
This difference illustrates how Prospect Theory can lead to different choices depending on whether we ac-
count for decision weights or just use probabilities. The decision weights account for the fact that individuals
often over- or under-weight probabilities compared to their objective values, leading to different decisions than
if we just consider the probabilities themselves.