Investment and Risk Management 2024-2025 Tutorial 2 Solutions PDF

**Investment and Risk Management 2024-2025** **Tutorial 2 solutions -- Concept of Market Efficiency and Behavioral Finance** 1. **C is correct.** Today's price change is independent of the one from yesterday, and in an efficient market, investors will react to new, independent information...

**Investment and Risk Management 2024-2025** **Tutorial 2 solutions -- Concept of Market Efficiency and Behavioral Finance** 1. **C is correct.** Today's price change is independent of the one from yesterday, and in an efficient market, investors will react to new, independent information as it is made public. 1. **A is correct.** Reducing the number of market participants can accentuate market imperfections and impede market efficiency (e.g., restrictions on foreign investor trading). 1. **A is correct.** According to theory, reducing the restrictions on trading will allow for more arbitrage trading, thereby promoting more efficient pricing. Although regulators argue that short selling exaggerates downward price movements, empirical research indicates that short selling is helpful in price discovery. 1. **C is correct.** Regulation to restrict unfair use of nonpublic information encourages greater participation in the market, which increases market efficiency. Regulators (e.g., US SEC) discourage illegal insider trading by issuing penalties to violators of their insider trading rules. 1. **A is correct.** Restricting short selling will reduce arbitrage trading, which promotes market efficiency. Permitting foreign investor trading increases market participation, which makes markets more efficient. Penalizing insider trading encourages greater market participation, which increases market efficiency. 1. **B is correct.** A security's intrinsic value and market value should be equal when markets are efficient. 1. **B is correct.** The intrinsic value of an undervalued asset is greater than the market value of the asset, where the market value is the transaction price at which an asset can be currently bought or sold. 1. **B is correct.** The market value is the transaction price at which an asset can be currently bought or sold. 1. **A is correct.** The weak-form efficient market hypothesis is defined as a market where security prices fully reflect all market data, which refers to all past price and trading volume information. 1. **B is correct**. In semi-strong-form efficient markets, security prices reflect all publicly available information. 1. **B is correct.** If all public information should already be reflected in the market price, then the abnormal trading profit will be equal to zero when fundamental analysis is used. 1. **B is correct.** The strong-form efficient market hypothesis assumes all information, public or private, has already been reflected in the prices. 1. **B is correct.** Costs associated with active trading strategies would be difficult to recover; thus, such active trading strategies would have difficulty outperforming passive strategies on a consistent after-cost basis. 1. **B is correct.** In a semi-strong-form efficient market, passive portfolio strategies should outperform active portfolio strategies on a risk-adjusted basis. 1. **B is correct.** Technical analysts use past prices and volume to predict future prices, which is inconsistent with the weakest form of market efficiency (i.e., weak-form market efficiency). Weak-form market efficiency states that investors cannot earn abnormal returns by trading on the basis of past trends in price and volume. 1. **C is correct.** Fundamental analysts use publicly available information to estimate a security's intrinsic value to determine if the security is mispriced, which is inconsistent with the semi-strong form of market efficiency. Semi-strong-form market efficiency states that investors cannot earn abnormal returns by trading based on publicly available information. 1. **C is correct.** If markets are not semi-strong-form efficient, then fundamental analysts are able to use publicly available information to estimate a security's intrinsic value and identify misvalued securities. Technical analysis is not able to earn abnormal returns if markets are weak-form efficient. Passive portfolio managers outperform fundamental analysis if markets are semi-strong-form efficient. 1. **A is correct.** Operating inefficiencies reduce market efficiency. 2. **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 attributed 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. 3. **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. 4. **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. 5. **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. 6. **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. 7. **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. 8. **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.