4325 - Homework 1

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University of Minnesota-Twin Cities *

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4325

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Finance

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Apr 3, 2024

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docx

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H OMEWORK 1 B EHAVIORAL F INANCE Instructions: Type your answer in this Word document then submit via upload on Canvas! You may work in groups to complete the assignment, but please submit your own write-up. DO NOT LEAVE IT FOR THE LAST MINUTE, LATE SUBMISSIONS WILL NOT BE ACCEPTED. 1. After careful analysis of the data, you conclude that firms which hire Carlson graduates earn abnormal returns of +4% per year over the ensuing few years. As a student of behavioral finance, you believe this is mispricing and represents actual profit. You decide to invest your nest egg of $50,000 based on this conclusion and have two options.  Option 1: invest all $50,000 in one company that has just hired a Carlson graduate  Option 2: invest $5,000 in each of 10 different companies that just hired a Carlson graduate Which option is preferable? (Approximately three sentences total) Answer: The option that is more preferrable is option 2: invest $5,000 in each of 10 different companies that just hired a Carlson graduate. Option 2 is preferrable because investing in more than one company mitigates some of risk for the investment. The poor performance of one company is minimized by the positive returns of the others.

Behavioral Finance – Stuart Webb 2. A colleague wants to study the efficiency of markets. Specifically, he or she is suggesting a study to determine if mutual fund managers can earn abnormal returns. When analyzing these returns, should your friend examine performance gross of load fees and management fees, or net of these fees? Obviously, returns gross of fees will be higher than net of fees. (Approximately three sentences total) Answer: My friend should absolutely examine the performance of the fund managers by netting the fees. The net of the expenses reflects the actual returns the investor shall receive after all the fees and expenses are deducted. This is by far the more accurate measure of a mutual fund manager’s ability to earn returns, and advertise to potential investors.

Behavioral Finance – Stuart Webb 3. Two event studies were performed and the results are presented below. The graphs display Cumulative Abnormal Returns (CARs) from before the event to after the event.  Which figure (left or right) is consistent with semi-strong efficient markets? (assume the correct model of expected returns is used)  Now, what if the incorrect model of expected returns is used? Can we conclude anything about efficient markets from either figure? Your responses should be approximately 3 sentences in total. Answer:

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Behavioral Finance – Stuart Webb 4. After analyzing a sample of stock returns, you find that firms with high earnings-to-price ratios have higher subsequent returns, on average.  Give an explanation for this observation that is consistent with the Efficient Markets Hypothesis  Give an explanation of this observation that is not consistent with the Efficient Markets Hypothesis  Assuming the above observation is the result of mispricing, what long-short trading strategy would you implement? Justify (explain) your strategy. Your response should be approximately 10 sentences in total. Answer: This observation is consistent with the Efficient Markets Hypothesis because firms with high earnings-to-price ratios typically have higher returns. According to EMH, the stock prices reflect all the available information about it, so the positive information about the stock should be consistent with its admirable price. Although the Efficient Markets Hypothesis works with this assumption, there are some areas in which it is not consistent.