Chapter 4: Challenges to market efficiency

1. Differentiate the following terms/concepts:

a. Momentum and reversal

Momentum exists when returns are positively correlated with past returns, while
reversal exists when returns are negatively correlated with past returns.

b. Value and growth stocks

Value stocks are defined to be stocks with prices that are low relative to such
accounting magnitudes as earnings, cash flows, and book value. Con- versely,
growth stocks (or glamour stocks) are stocks with prices that are high rela- tive to
earnings, cash flows and book value, at least in part because the market anticipates
high future growth.

c. Fundamental risk and noise-trader risk

Fundamental risk exists because of the potential for rational revaluation as new
information arrives. Noise-trader risk is the risk that “wrong” prices will become even
more wrong.

d. Carve-out and stub value

2. Refer back to the set of exchange rates in the “Support 3: There are no limits to
arbitrage” section earlier in the chapter. Describe a profitable arbitrage strategy if x =
105.

3. Arbitrage is limited because the wealth of arbitrageurs is limited. Discuss this

statement in the context of those who are managing their own money and those who
are managing other people’s money.

The statement that arbitrage is limited because the wealth of arbitrageurs is limited
is partially true. When managing their own money, individual investors may have
limited resources to engage in arbitrage activities. However, when managing other
people's money, such as in the case of hedge funds or institutional investors, the
amount of resources available for arbitrage activities is much larger. Therefore, the
limitation on arbitrage is not solely due to the wealth of the arbitrageurs, but also
due to other factors such as transaction costs, market liquidity, and regulatory
constraints.

In futures markets, one must contribute margin when prices move against you.41
Suppose the London contract goes up and the Frankfurt contract goes down,
implying that you must contribute cash in both markets. This is fine, if you are
managing your own money and are not wealth-constrained.42 But if you are
managing your own money and you are wealth-constrained, you might be forced to
liquidate your position at a loss because you are running out of money, even though
it is clear that your arbitrage trade will eventually be profitable.
What if you are managing other people’s money? Now because other people are
controlling your capital, you are subject to a different sort of wealth control.
Additionally, because they have the power to hire and fire, your horizon is of ne-
cessity short. In fact, many who are attempting to exploit arbitrage opportunities are
subject to this reality. They are managing money for individuals (e.g., those pooling
their money through mutual funds or hedge funds) or institutions (such as
endowments), many of whom will not have a clear idea of the issues involved.

4. What is data snooping? What sort of empirical evidence is useful for obviating this
critique?

data snooping is the act of analyzing a dataset “to death” so as to detect

“anomalies.”

5. What are the three supports on which market efficiency rests? Why is it that only
one of them is required?

Market efficiency theoretically rests on three supports: investor rationality, uncor-

related errors, and unlimited arbitrage. Only one support is required for market
efficiency. If all three fail, market efficiency can be called into question.

1. Differentiate the following terms/concepts:

1. Good company and good stock
2. Momentum-chaser and contrarian
3. International diversification and domes- tic diversification
4. Anchoring and herding

3. Home bias has a potential information- based explanation. Discuss.

4. In Canada there are two official languages, French and English. Some Canadian
cor- porations are headquartered in Quebec where French is the official language.
Most, however, are headquartered outside Quebec where English is dominant.
Would you ex- pect Quebecers to invest more in Quebec companies, and non-
Quebecers to invest more in companies based outside Quebec? Also, do you think
the first language of the CEO might matter in accounting for investor preferences?
Explain.

One reason why investors might hold more domestic securities is because they are
optimistic about their markets relative to foreign markets.

Another behavioral explanation is along the lines of comfort-seeking and familiarity.

for differential trading costs, if costs in one country are lower than in other countries,
this is a reason for all inves- tors to favor the low-cost country, but we do not see this
type of behavior. Addi- tionally, especially with the international system of dividend
withholding taxes and counterbalancing tax credits, there is little difference between
domestic and foreign tax burdens for most investors.
One reason why investors may favor local markets—where local is interpreted as
either domestic or close-to-home, but within the same country—is because they may
possess, or may feel that they possess, informational advantages. Gains from being
geographically close to a company may appear in improved monitoring capa- bility
and access to private information.

5. Anchors are ubiquitous in financial markets. Give some examples.

Ch9 Implication of behavior economics for Financial Decision Making

1. Differentiate the following terms/concepts:

1. Indirect and direct tests of relationship between overconfidence and trading

activity
2. Sensation seeking and overconfidence
3. Underdiversification and excessive trading
4. Statics and dynamics of overconfidence

2. Consider two investors (A and B) with the following demand curves for a stock:

A : p = 100 − q

B : p = 150 − 2q

a. At a price of $50, how much will A and B purchase?

b. If the price falls to $30, who will increase their holdings more? Explain.

c. On this basis, which investor seems to be more overconfident?

a. At a price of $50, investor A's demand curve would be p = 100 - q, so q = 50.

Therefore, investor A would purchase 50 shares. Investor B's demand curve would
be p = 150 - 2q, so q = 50. Therefore, investor B would also purchase 50 shares.
b. If the price falls to $30, investor A's demand curve would be p = 100 - q, so q =
70. Therefore, investor A would increase their holdings by 20 shares. Investor B's
demand curve would be p = 150 - 2q, so q = 60. Therefore, investor B would
increase their holdings by 10 shares. Therefore, investor A would increase their
holdings more.
c. Based on the slopes of their demand curves, investor B seems to be more
overconfident. Investor B's demand curve has a steeper slope (-2) than investor
A's demand curve (-1), which means that investor B is more sensitive to changes
in price. This suggests that investor B may be more overconfident in their ability to
predict the market and make profitable trades. However, it's important to note that
demand curves alone cannot determine an investor's level of overconfidence, as
there are many other factors that can influence an investor's behavior.
3. Discuss what the evidence (using naturally occurring data, survey data, and
experimental data) suggests about the relationship among overconfidence, trading
activity, and portfolio performance.

CH.10 INDIVIDUAL INVESTORS AND THE FORCE OF EMOTION

1. In housing markets, there is a positive correlation between prices and trading

volume. When there is a housing boom, many houses sell at, or even above,
the prices asked by sellers. In times of bust, homes sit on the market for a
long time with asking prices that exceed the prices that can reasonably be
expected. How can this be explained?
2. Some investment banks engage in proprietary trading, which means that the
firm’s traders actively trade financial securities using the bank’s money, in
order to generate a profit. To offset a slowdown in one division, traders in a
profitable division might more actively engage in proprietary trading. Do you
think this practice is wise?

4. This morning I woke up in a sour mood because my favorite team lost its game
yester- day. Then I had to wait an extra-long time in line for coffee. It started to rain,
and I forgot my umbrella in the car. When I arrived at my office (finally), I found that a
stock I held in my portfolio was falling in value, so I sold. Is this evidence that mood
moves markets?

one person who is in a very sour mood may engage in risky behavior like driving
recklessly or drinking too much alcohol. Another person who is not having a good
day may shy away from risk more than usual and simply withdraw from others. The
evidence does not provide compelling evidence that a buoyant mood consistently
leads to lower risk aversion or that a poor mood consistently leads to increased risk
aversion, particularly in a financial context.

CH11/SOCIAL FORCES: SELFISHNESS OR ALTRUISM?

3. Your firm has built a manufacturing plant not too far from a large European
city. You are a member of a management team that is charged with designing
employment contracts that promote high effort among the employees. What
factors might you bring to the attention of the team? Would your answer
change if the manufacturing plant is located near a fairly isolated village in a
de- veloping nation?
 factors that might promote high effort among employees could include offering
competitive wages and benefits, providing opportunities for career
advancement and professional development, creating a positive work
environment, and implementing performance-based incentives. Additionally, it
may be important to consider cultural factors and local labor laws when
designing employment contracts. If the manufacturing plant is located near a
fairly isolated village in a developing nation, additional factors may need to be
considered. For example, it may be important to provide training and education
to employees who may not have had access to formal education in the past. It
may also be important to consider the impact of the plant on the local
community and to engage in responsible corporate citizenship.

5. The highly successful online auction site eBay has attracted millions of buyers and
sellers. In these faceless exchanges, trust on both sides of a transaction could be of
con-cern. One action eBay has taken to promote trust in exchanges is to allow
feedback. Why is this so important and effective?

Feedback is important and effective on eBay because it allows buyers and sellers to
rate their experiences with each other. This helps to build trust between parties who
may not have any prior relationship or knowledge of each other. By allowing users to
see the feedback and ratings of others, eBay creates a system of accountability that
encourages both buyers and sellers to act in good faith. This can help to reduce the
risk of fraud and other types of misconduct on the platform.

CH.12

3.Your firm, which specializes in complex elec- tronic products, has grown rapidly
and you are now incorporating. Even after incorpo- ration, a large percentage of
the stock will be held by the founders, including you. Your colleague recommends
a large corpo- rate board made up exclusively of outsiders.

She is very concerned about the sensational- ized corporate scandals in recent
years. Do you agree with her recommendation? Explain.

Most boards are combinations of insiders and outsiders. Inside directors are
managers or executives of the company, whereas outside directors are not
employees. Advantages of inside directors include their privileged access to firm-
specific information, dedication to the firm, and bet- ter expertise relating to the firm’s
activities. Advantages of outside directors include their broad backgrounds,
independent evaluations, and shareholder orientation.8 Research into the link
between firm performance and the proportion of outside di- rectors finds little
evidence that board composition is related to the performance of a corporation in
cross-sectional analyses of actual firm data.

5. The largest U.S. bankruptcy occurred in 2002 with the fall of Worldcom, Inc. Its
out- side directors paid out of their own pockets to settle securities lawsuits, as did
Enron di- rectors. While the Worldcom directors may not have played an active role
in the flagrant accounting fraud, they were criticized for other choices they made.
Research the events surrounding Worldcom and the role played by its board. What
do you think their biggest mistakes were?
Worldcom was a telecommunications company that was once the second-largest
long-distance phone company in the United States. In 2002, the company filed for
bankruptcy after it was revealed that it had engaged in accounting fraud, inflating
its earnings by over $11 billion. The board of directors of Worldcom was criticized
for several mistakes that contributed to the company's downfall. One of the biggest
mistakes was the lack of oversight and accountability. The board failed to ask
tough questions and challenge the management team, which allowed the fraud to
go undetected for years. Another mistake was the board's failure to ensure that
the company had adequate internal controls and risk management processes in
place. The board did not adequately monitor the company's financial reporting and
auditing processes, which allowed the fraud to continue unchecked. The board
was also criticized for its lack of independence. Several board members had close
ties to the CEO, Bernie Ebbers, and were not truly independent. This lack of
independence made it difficult for the board to challenge the CEO and hold him
accountable for his actions. Overall, the biggest mistake made by the Worldcom
board was the failure to provide effective oversight and governance. The board did
not fulfill its fiduciary duty to shareholders and allowed the company to engage in
fraudulent activities that ultimately led to its downfall.

CH15

3. You work for Toxic Waste, Inc. Given the evidence that the market can respond
well to a company name change, suggest a new company name to the CEO, and
explain why you think it might positively impact the share price.

a wrong name will create a negative image of the business in the business
environment
"zero waste" the company consider rebranding itself as an environmentally
responsible and sustainable organization. This could positively impact the share
price by attracting socially responsible investors and customers who prioritize
sustainability.

4. Suppose a particular investment is believed by management to be a negative-

NPV undertaking, but many shareholders believe otherwise, holding the view that
investments of this type are value-creating. What should be done? Discuss in the
context of the heu- ristic model presented in the chapter

In the context of the heuristic model presented in the chapter, the management
should communicate the negative-NPV undertaking to the shareholders and provide
them with the relevant information and analysis to support their decision-making. The
shareholders should also be encouraged to consider the long-term implications of
their investment decisions and not solely rely on heuristics or biases.

If the shareholders still believe that the investment is value-creating despite the
negative-NPV analysis, the management should consider alternative ways to finance
the investment. For example, the company could issue new shares or debt to raise
the necessary funds, rather than using its existing cash reserves. This would allow
the shareholders who believe in the investment to invest more in the company, while
also reducing the risk for those who do not.

Alternatively, the management could consider implementing a shareholder voting

system, where shareholders can vote on whether or not to proceed with the
investment. This would allow for a democratic decision-making process and ensure
that the interests of all shareholders are taken into account.

Ultimately, the decision should be based on a rational evaluation of the investment's

potential risks and returns, rather than heuristics or biases. The management should
ensure that all shareholders have access to the relevant information and analysis,
and that the decision-making process is transparent and fair.

5. A company has 1,000,000 shares outstanding trading at $15 apiece. Managers

believe that the discount rate appropriate for the risk borne is 15% and total cash
flows, expected to be $1 million next year, will rise by 5% per year indefinitely.
Discuss a strategy that is beneficial to the current shareholders.

One strategy that could be beneficial to the current shareholders is for the company
to use its cash flows to repurchase its own shares. This would reduce the number of
shares outstanding, which would increase the earnings per share (EPS) and
potentially increase the share price.

Assuming that the company uses all of its $1 million cash flows to repurchase
shares, it could buy back 66,667 shares at the current market price of $15 per share.
This would reduce the number of shares outstanding to 933,333 and increase the
EPS from $1 to $1.07 ($1 million cash flows divided by 933,333 shares outstanding).

If the market recognizes the increased EPS and values the company at a price-to-
earnings (P/E) ratio of 15, the share price could increase to $16.05 ($1.07 EPS
multiplied by 15 P/E ratio). This represents a 7% increase from the current share
price of $15.

Furthermore, as the company continues to grow its cash flows by 5% per year, it
could use a portion of those cash flows to continue repurchasing shares, further
increasing the EPS and potentially increasing the share price.

Overall, a share repurchase strategy could be beneficial to the current shareholders

by increasing the EPS and potentially increasing the share price, while also reducing
the number of shares outstanding and increasing the ownership percentage of the
remaining shareholders.