Behavioral Finance- FIN 645

Behavioral Finance- FIN 645

Final Exam: Fall 2014; Dr. Joseph J. French
Caution:
Please note this is an individual exam only- and not a team or group effort. All relevant UMUC policies- and especially those related to Academic Honesty- will be in full force. So please keep that in mind at all times.
INSTRUCTIONS:
1.    Please answer all the following five (5) questions. If you are not using Excel files for any reasons and where calculations are involved, make sure to show your work for all the problems; otherwise, you may lose all the scores set aside for the affected questions/problems. For Excel files, assuming you set up your formulas correctly, I can always trace your work.
2.    For each question that requires calculations, you need to clearly state and reference your assumptions; or the source for any data/info used in your solutions. You may do this in a number of ways, including entering explanations right on your Excel sheets, or using a separate sheet for each problem; whichever is convenient to you. I need such info to be able to verify your calculations for accuracy, evaluation and partial grading where applicable. Needless to say you can not make assumptions that go against the facts and realities surrounding each question. Sizeable points will be taken off for providing unexplained numbers, calculations and responses.
3.    At submission time, you can submit a maximum of two (2) files for the entire exam- one Word file and one Excel file (if Excel is applicable to this exam at all).
4.    Please also remember to submit your group evaluation form is you have not already done so.
5.    There is a maximum of 100 points for this test. Scores for each question are shown at the end of each question. For qualitative questions, maximum allowed pages are also given at the end of each question.
6.    As stated in the syllabus, you will have until 11:59 PM EST on November 25th, to submit your answers.

I wish all of you the very best.

Continued on next pages

QUESTION 1.

The following quotation appeared in the Fortune magazine  “I have never asked to serve on a corporate board, never even hinted at wanting to be on one. And I have never asked to be on a compensation committee. I suspect that the reason I’ve been put on so many is that word gets around that I believe in paying people very, very well… I cannot sit and say to you what the right compensation number is. That’s the judgment call, the business judgment call. That’s what a board of directors does… What I know most of all is that when I see extraordinary effort and results out of a CEO, you can’t pay him enough.”
Evaluate the comments made by this particular director.  Make sure your responses are well organized and documented, using references/examples from any of the assigned readings on the topic for this class. Be well organized in your writing.

Maximum pages: four pages, double-space, size 12
Grade: 25

QUESTION 2.

Given the new economic and market realities prevailing since the 2008 great recession – including employment opportunities for yourself as a business executive – first list, and then explain in needed details the top four (4) Behavioral Finance lessons that you learned in this class that can be of value to you going forward. I emphasize going forward because my goal in this question is to see how you can apply the lessons learned in this course to make decisions that may face you at work now or in the future. This also means you must answer this question from the perspective of your job; your present job or a job that you envision you may have later on.
Make sure you answer this question in light of the post-2008 economic and financial realities. Don’t be afraid to “take risk” in answering this question; it may pay off in both grading and your future experiences! 🙂
Maximum pages: three pages, double-space, size 12; reference page(s) does not count in the maximum page limit.
Grade: 25

QUESTION 3.

Say the level of the market as measured by the Dow Jones Industrial Average is currently at 12,000.  A forecaster has made a prediction of 13,300 for the level of the market in one year, along with a 95% confidence interval whose lower bound is 12,500 and whose upper bound is 14,500.  You know from experience that this particular forecaster tends to be both excessively optimistic and miscalibrated.  Describe how you might debias this individual.  Give a numerical example (making up relevant numbers as appropriate).

Grade: 20.

QUESTION 4.

Lou Donaldson and his neighbor, both U.S. residents, are meeting at a local restaurant. During lunch, they discuss investing and Donaldson, age 45, makes the following statements:

1.    “My father was a buy-and-hold investor but I am an active trader. To keep trading costs low, I use an online brokerage firm. I have done well investing in technology companies because I know the industry.”
2.    “I am holding a large position in Omega Corporation with a large unrealized loss. Omega’s stock price declined last year when reported sales and earnings failed to meet analyst expectations. I took advantage of the decline to increase my position. Omega sales growth has continued to slow over the last year, but I believe the stock is still a good investment.”
3.    “I read a newspaper article reporting that commercial property values in the city have increased 14 percent annually since 2000. According to the article, the average commercial property in the city sold for $1.5 million last year. This makes me very happy because I just purchased a piece of commercial property last month. There is no doubt that it will be a good investment.”

Select the behavioral finance concept best exhibited in each of Donaldson’s three statements. Explain how the behavioral finance concept you selected affects Donaldson’s investment decision making.

Note: No behavioral finance concept can be used more than once.

Grade: 15.

QUESTION 5.

Joyce Siosan is a 42-year-old lawyer at a prestigious law firm. She is meeting with Joel Murray, a financial advisor, to organize her finances. During the interview process, Siosan tells Murray that she has been purchasing short-term, out-of-the-money call and put options. Siosan acknowledges these options have a low probability of paying off and that the expected return from her options trading is negative. However, she states that she is attracted by the possibility of high returns when she can exercise in-the-money options. At the same time, Murray notes that Siosan has been purchasing low-payoff earthquake insurance on her home, which is located in a low-probability earthquake zone.

A. Describe Siosan’s utility function. Contrast her utility function with that assumed in traditional finance theory.

Siosan purchases a new luxury vehicle every two years and takes expensive annual vacations. She has a reputation for paying the entire bill at the upscale restaurants where she dines regularly with her friends. Siosan’s annual consumption, options trading, and housing expenditures are paid for entirely out of her salary income and half of her modest annual bonus. She deposits the other half of her annual bonus and any other non-salary sources of income into her relatively small retirement account, which excludes her options trading. Siosan is reluctant to incur debt and has only a small mortgage on her home, despite the fact that she will soon be made a partner in her firm and will have much higher earnings. Murray believes that Siosan exhibits behavioral  biases that interfere with an optimal savings and consumption allocation. In particular, he thinks
that she is not saving enough for retirement.

B. Discuss how Siosan’s behavior reflects the bias of:
i. self-control.
ii. mental accounting.
Explain how a rational economic individual in traditional finance would behave
differently with respect to each bias.

Siosan’s retirement portfolio is allocated 50% to money-market securities and 50% to a few speculative stocks that she read about in an investment newsletter. Murray observes that Siosan’s retirement portfolio allocation is consistent with Behavioral Portfolio Theory and not consistent with a mean–variance framework.

C. Determine whether Murray’s observation about Siosan’s retirement portfolio allocation is correct. Justify your response with two reasons.

Grade: 15.

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