Problem Set 1

Behavioral Finance
Summer 2012
Prof. Dr. Alexander Klos

Problem 1: Twin Shares

In the “twin shares” example presented in the first class, price scenarios occurred where Royal
Dutch traded at a price 1.6 times as high as the price of Shell Transports. What portfolio should
you construct if you were confident that this “mispricing” would disappear soon? Why is holding
such a portfolio not a risk free arbitrage opportunity that can be exploited by arbitrageurs?

• Mispricing because cashflows are distributed at rate 1:1.5

• You should go short in Royal Dutch and buy 1.5 to 1.6 times as many Shell
shares than you sold RD shares.
• It‘s no textbook arbitrage opportunity because you do not know whether
the mispricing will disappear soon (noise trade risk)

Problem 2: Bayes’ Rule

You have a bag containing five white and/or black poker chips. Either four of the chips are white
and one is black (the good company/bag) or two chips are white and three are black (the bad
company/bag). Your a priori estimate of the probability that the company is good is 50%.
Now one chip is pulled out of the bag. It is white [black]. What is the updated probability that you
face the good company/bag (i.e. the bag with four white and one black chip)? Use Bayes rule to
formally derive the updated probability.

G = Good bag B = Bad bag

w = white chip b = black chip

p(G) = p(B) = 50%

p(w|G)= 0.8, p(b|G)= 0.2
p(w|B)= 0.4, p(b|B)= 0.6

p(G) ⋅ p(b | G) p(G) ⋅ p(b | G)

p(G | b) = =
p(b) p(G) ⋅ p(b | G) + p(B) ⋅ p(b | B)
0.5 ⋅ 0.2 0.1
p(G | b) = = = 0.25.
0.5 ⋅ 0.2 + 0.5 ⋅ 0.6 0.4

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Problem 3: Bayes’ Rule

The computer network of the WORM AG is suspected to be infected by a novel and extremely
dangerous virus. The IT-expert of the corporation judges the a priori probability for an infection to
be just 1%; nevertheless he decides to purchase a newly developed scanning tool that further
explores the problem. Because of the extremely tricky structure of the virus the scanning tool
cannot make definite statements about the infection though. The error rate is 5%, i.e. 5% of the
infected networks would be declared to be “clean”, and 5% of the clean networks would be
declared to be infected.
a.) Use the notation I (infected) and I (¬not infected) for the random variable "infection", and
D (virus detection) and D (¬no virus detection) for the random variable "scanning tool
detects virus". Formalize the three probability statements given in the text using this
notation.

p(I) = 1%, p(¬D|I) = 5%, p(D|¬I) = 5%

b.) What is the probability that the scanning tool will claim to have found the virus (assuming
that the probability judgment of the IT-expert about the a priori probability for an infection
is correct)?

p(D|I) = 1 - p(¬D|I) = 95%.

It follows: p(D)=p(I,D)+p(¬I,D) = p(I)*p(D|I)+ p(¬I)*p(D|¬I)

= 0,01 * 0,95 + 0,99 * 0,05 = 0,059

c.) When the scanning tool is used to check the network, it claims to have found the virus.
Given this signal, what is the probability that the network is indeed infected?

p(D I ) ⋅ p(I) 0 ,95 ⋅ 0 ,01

p(I D ) = = = 0 ,1610
p(D) 0 ,059

d.) When the IT-expert checks the scanning tool manual, he reads the following phrase: „… the
error rate of 5% just refers to not detecting infected systems. The error rate concerning
false alerts for clean systems is significantly lower… “ What impact on the a posteriori
probability of a virus infection has this new information? Please argue in general terms, do
not just work through a further numerical example.

The statement in the manual can be translated to: p(¬D|I)=5%, but p(D|
¬I)<5%.

The value of the expression p(D)=p(I,D)+p(¬I,D) = p(I)*p(D|I)+ p(¬I)*p(D|¬I)

decreases.

For decreasing p(D) the wanted a posteriori probability:

p(D I ) ⋅ p(I)
p(I D ) = increases.
p(D)

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 The new information from the manual has thus increased the probability for
a virus infection.

Problem 4: Bayes’ Rule

Rex is a smart fellow. He gets an A in a course 80% of the time. Still, he likes his leisure, only
studying for the final exam in half of the courses he takes. Nevertheless, when he does study, he is
almost sure (95% likely) to get an A. Assuming he got an A, how likely is it he studied?

If someone estimates the above to be 75%, what error are they committing? Explain.

∙ | 0.5 ∙ 0.95
| = = = 0.59375
0.8
Base Rate Fallacy
Note further that the signal is weak and therefore does not lead to a huge
change of the prior probability

Problem 5: Bayes’ Rule

Which description of Mary has higher probability?

1. Mary loves to play tennis.
2. Mary loves to play tennis and, during the summer, averages at least a game a week.

Explain your answer. Define the conjunction fallacy. How does it apply here? Assume for the
purpose of illustration that the probability that someone loves to play tennis is .2; the probability
that someone plays tennis once or more a week during the summer is .1; and the probability of
one or the other of these things is .22.

Description 1 has a higher probability (1. is a subset of 2.).

Conjunction Fallacy: A probability mistake that occurs when one believes

that a joint probability is higher than one of the simple probabilities.

Formal: p(x or y) = p(x) + p(y) – p(x,y)

p(Description 2)
= p(loves tennis) + p(at least a game per week) – p(loves tennis or at least a
game per week)
= 0.2 + 0.1 – 0.22 = 0.08

Problem 6: The Value of Stock Recommendations

Suppose there are two basic types of shares: winners, whose value rises; and losers, whose value
does not rise. Assume further that there are three possible analysts’ recommendations: buy, hold,

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and sell. A winner stock receives a buy recommendation 70% of the time, a hold recommendation
25% of the time, and a sell recommendation 5% of the time. A looser stock receives each
recommendation with equal probability.
a.) What is the posterior probability of holding a winner stock for each recommendation type,
i.e. p(Winner|Buy), p(Winner|Hold), and p(Winner|Sell)?

| ∙
| =
| ∙
| ∙ | ∙
0.7 ∙ 0.5
0.6774
0.7 ∙ 0.5 1/3 ∙ 0.5

" # | ∙
|" #
" #
0.25 ∙ 0.5
0.4286
0.25 ∙ 0.5 1/3 ∙ 0.5

##| ∙ 0.05 ∙ 0.5

| ##
## 0.05 ∙ 0.5 1/3 ∙ 0.5
0.1304

b.) Use a spreadsheet program to calculate the probability of a winner stock for n subsequent
buy, hold, or sell recommendations (n=2,…,10). Display your results graphically.

c.) Assume that analysts suffer from representative bias, i.e. they overreact to news. As a
consequence, a single recommendation is less precise than it could be with Bayesian
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 analysts. A winner stock receives a buy recommendation 50% of the time, a hold
recommendation 25% of the time, and a sell recommendation 25% of the time. Recalculate
the graph in b.) with these revised probabilities and interpret the results.

No difference in the information contents of hold and sell

recommendations; Signals are less informative; therefore, slower
convergence to 0 and 1.

Problem 7: Data Project – Class Room Experiment

Download the data from two class room experiment from the OLAT course website. Do the
responses show significant deviations from Bayes’ Law? Are there any other interesting results?

First Round:
30
20
Frequency
10
0

50 60 70 80 90 100
P

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Overall:
Classroom Experiment 12-Apr-2012

100
80
60
P
40
20
0

0 20 40 60 80 100
Bayes

Means Medians Identity

On average, our class is well calibrated!

(But there are some strange predictions at the individual level,
see EXCEL sheet)