EC7094 (Behavioral Finance) Final Exam 2021/22

Instructions. This exam has two parts, each worth 50% of the marks. Part
A has 5 questions on behavioral decision theory. Part B requires you to give
short answers to 3 questions on the rest of your syllabus. Both parts have equal
marks of 50 each. Please do all questions.

Time: 2 hours + 45 minutes including time for submitting the online

exam

You will not be able to submit after the allotted time. No excuses for late
submissions will be accepted, so do not leave it until the last minute to submit.
Any scripts received after the deadline will not be marked and will be awarded
a mark of 0. Answers to be handwritten on normal paper. You cannot use the
pro formas on Blackboard.
This exam has 3 pages in total.
Submitting your work
Please scan your answers into one document or if you cannot scan your
answers, photograph each page of your answers and put photo images into one
word document (see guidance on InfoHub)
Submit via Turnitin portal in Assessment and Feedback section of Black-
board
Remember to open and check your scanned pdf/word document before you
submit as we can only mark what we receive. If we can’t read it or parts are
chopped off, we cannot give it any marks, and we cannot accept additional pages
after the deadline.
If you have any trouble submitting your work via Turnitin on the day: email
ulsb.pgstudy@le.ac.uk with your full script attached (to prove that you have
completed it all on time) WITHIN the allotted time period and ask for their
help to upload to Turnitin
Do not email me on the day of the test as I will not be available. If you feel
there is an error on the exam, then do the best that you can on the exam and
send me an email after the exam.

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 Part A (50 marks): Students should answer all questions.

All questions in Part A are worth 10 marks each.

Q1 (10 marks). [10 marks] What restrictions need to be imposed on the real-
valued parameters a, b in the function w(p) = apb such that w(p) is a probability
weighting function?
1.2
Q2 (10 marks). Consider the Prelec function w(p) = e−0.4(− ln p) . Consider
only interior fixed points (so ignore the fixed points w(0) = 0 and w(1) = 1).
Let pe be the probability corresponding to the point of inflection and p∗ the fixed
point. What is the relation between pe and p∗ ?

Q3 (10 marks). Consider the choice between the following two lotteries.

L1 = (0, 0.2; 200, 0.8) ; L2 = (0, 0.6; 300, 0.4) .

Now consider a choice between another pair of lotteries

L3 = (0, 0.6; 200, 0.4) ; L4 = (0, 0.8; 300, 0.2)

Suppose that a decision maker prefers the lottery L1 to the lottery L2 and
derives zero utility from an outcome of zero. If the decision maker follows
expected utility theory, which lottery among L3 and L4 will the decision maker
choose?

Q4 (10 marks). A decision maker follows prospect theory and faces the
lottery L = 5, 13 ; 15, 31 ; 35, 13 . The reference point of the decision maker is 25.

The utility function for outcomes of the decision maker is piecewise linear and
given by
x if x ≥ 0,
v (x) = (1)
−2.0 (−x) if x < 0.
0.65
The probability weighting function is w(p) = e−0.5(− ln p) (i.e., β = 1 and
α = 0.5). What is the certainty equivalent of the lottery to the decision maker,
assuming that the certainty equivalent is negative. What are the risk attitudes
of the decision maker taking the relevant expected value to be that of lottery in
incremental form?

Q5 (10 marks). An individual is observed to buy home insurance. He also

visits a casino occasionally. When he loses some money in the casino, he has
a habit of betting more money to try to recover the money that he loses. He
rarely succeeds. But he continues to engage in this behavior. How can you
use the decision theories that you have learnt in this course to explain these
observations?

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 Part B (50 marks): Students should answer all questions.

For the non-numerical questions in Part B, I expect you to write no more

than a few short paragraphs in response to each question. I am mainly looking
to see if you provide the correct intuition and logic to answer the question, using
your knowledge and understanding of the behavioral economic models that have
been taught in this module.

Q6. [15 marks] Explain the answers to these questions based on heuristics
that people might employ.
(a) Why do some people become scared of flying after they observe a plane
crash, even if statistically the probability of another crash is still the same?
Which heuristic explains the behavior of people?
(b) A used car salesman has the following typical strategy for selling cars.
His car is really worth £5000. But he starts his negotiations with a buyer by
asking for a starting price of £6000. He then negotiates the price down to £5750
at which point the buyer is happy to buy the car. What heuristic is the salesman
exploiting?
(c) Why are many stock market traders who earned exceptionally high re-
turns last year, likely to earn lower returns this year? Furthermore, those who
earned very poor returns last year are likely to earn better returns this year.
What statistical phenomena can explain this finding?

Q7. [20 marks] There are two boxes, B1 and B2. Box B1 contains 4 red
balls and 2 green balls and box B2 contains 4 green and two red balls. Nature
selects box B1 with a probability 1/3 and box B2 with a probability 2/3. One
of the two boxes is selected at random and a ball is selected at random from it.
Suppose that the randomly ball selected is red.
(a) What is the probability that it was selected from box B1?
(b) What is the probability that it was selected from box B2?
(c) Compare the results in parts (a) and (b) and explain the answer.
(d) Suppose that subjects neglect base rates as they often do in the evidence
on human behavior. What is the answer that such subjects are likely to give to
part (a)?

Q8. [15 marks] Is the assumption of instantaneous flow of information in

financial markets consistent with the empirical evidence? What are the conse-
quences of gradual flow of information?

End of Exam