Final Exam of Behavioral Finance
FSS 2011
This exam consists of 5 questions and has to be completed in 60 minutes. The maximum number of
points achievable is 60. Each problem includes a point specification that you can use as an
approximation on how many minutes to spend on the problem.
Notes:

Please make sure that you write down your name and your student ID on each answer
sheet.

The exam consists of 5 questions from different topics.

You may use a non programmable calculator without text memory.

As a Master student, you can answer the questions of this exam only in English.

This exam consists of 5 pages including the cover sheet!
Good luck!
Hyperbolic Discounting
(13 pts)
An investor has to choose between the following two alternatives: Alternative A (200,
800, 1800, 2000) [which means you get 200 in t=0, 800 in t=1 etc.] and alternative B (400,
500, 900, 0). The formulas for hyperbolic and exponential discounting are
and
, respectively.
a) Explain differences between the hyperbolic and the exponential discounting functions
verbally and support your arguments with a figure. Explain the graph you are using.
(5 pts)
Over short periods, the hyperbolic discounting function discounts stronger than the
exponential function while discounting weaker than the exponential function over long
periods. As a consequence, the hyperbolic discounting function leads to time-inconsistent
preferences meaning that preferences can change over time.
b) Calculate the weights wt for the hyperbolic discount function. Assume r =2.
(2 pts)
w0=1, w1=0.25; w2=0.111, w3=0.0625
c) Assuming hyperbolic discounting, which alternative has a higher present value?
(3 pts)
vH(Alternative A)=725
vH(Alternative B)=625
d) At what value of q for the exponential discount function do both discounting functions
lead to the same present value for alternative B? Assume r=2.
(3 pts)
vH(Alternative B)=625= vE(Alternative B)=400/q0 + 500/q1 + 900/q2
q1=3.4
q2=-1.17
Consequently, the value for q where both functions lead to the same value is 3.4.
Save More Tomorrow
(6 pts)
Describe the SMarT concept (Save More Tomorrow) and explain how different aspects of
SMarT are related to behavioral biases. Think of how it helps to avoid problems that
normally result from behavioral biases when making retirement savings decisions but also
think of behavioral biases that are used to accomplish the SMarT plans goals.
SMarT aims at helping those employees to increase their saving rates in retirement saving
plans who want to increase them but who are not able to do so. The basic idea is to give
employees the possibility to commit themselves today to increase their saving rate later
on. This counters missing self-control. Saving rates are increased with money from the
next pay raise. This makes use of illusion of money and it avoids loss aversion. This
procedure is repeated up to a pre-specified maximum making use of inertia and the statusquo bias. Employees also have the possibility to change the saving rate or to opt out of the
program at any time. In this case, inertia is used as a positive factor. The concept is easy
to understand and thus it also fits bounded rationality.
Employee Stocks
(3 pts)
Why does it make sense for an employee to sell his employee stocks when the retention
period has passed?
The correlation between the employee stocks and the employee’s human capital is very high.
For a bad development of the firm both the value of his shares and the value of his human
capital (safety of employment, probability of a pay raise) will drop. For reasons of
diversification, it makes sense to sell the stocks after the retention period.
Guest lecture Klaus Kaldemorgen (8 pts)
a) Name and explain the two main risks when buying a US firm as a German investor. What
is different and what is alike compared to investing in a French firm?
(3 pts)
-
Currency risk, does not exist when investing in Germany/France
Firm-specific risks
A loss can be encountered even when the stock itself appreciates. A gain can result even if
the firm was a bad choice and when it has depreciated.
[Correlations could also be different. Alternative answer]
b) Think of an appropriate example and use it to describe “Sector allocation” and “Stock
picking” as two sources of Alpha (overperformance above a benchmark). Which one
contributes on average more to the overall Alpha of a fund? Link your answer to what you
have learned about correlations.
(5 pts)
-
Sector allocation: The question of whether to buy automotive stocks or chemicals
Stock picking: The question of whether to buy BASF or Bayer
Sector allocation is more important because correlations within sectors are much higher
than between sectors. Consequently, firms from the same sector will have more similar
stock price developments.
Event Studies (30 pts)
1. Name and briefly illustrate the steps for implementing event studies. (5 pts)
1. Identify the event of interest
e.g. Share repurchases/dividend payments/…
2. Define the event window
Event window: several days around the event date (symmetric/asymmetric)
3. Selection of the samplesize
Avoid selection bias, eliminate or adjust sample
4. Compute the appropriate return measures
Average abnormal return or cumulative abnormal return
5. Analyze results
Short horizons vs. long horizons
2. The listed X-AG has a ß of 0.9. The average return of the X-AG over certain estimation
periods was 7% per period. Please calculate the cumulative abnormal return of the X-AG over
the next four periods using
(i)
the mean adjusted return period. (2.5 pts)
(ii)
the market adjusted return period. (2.5 pts)
(iii)
the market model method. (5 pts)
Period
1
2
3
4
RX
9%
-4%
-7%
14%
(i)
AR1:
AR2:
AR3:
AR4:
CAR:
9% - 7% = 2%
-4% - 7% = -11%
-7% - 7% = -14%
14% - 7% = 7%
2% - 11% - 14% + 7% = -16%
(ii)
AR1:
AR2:
AR3:
AR4:
CAR:
9% - 7% = 2%
-4% - (-5%) = 1%
-7% - (-10%) = 3%
14% - 15% = -1%
2% + 1% + 3% - 1% = 5%
(iii)
AR1:
AR2:
AR3:
AR4:
CAR:
9% - 4% - 0.9(7% - 4%) = 2.3%
-4% - 4% - 0.9(-5% - 4%) = 0.1%
-7% - 4% - 0.9(-10% - 4%) = 1.6%
14% - 4% - 0.9(15% - 4%) = 0.1%
2.3% + 0.1% + 1.6% + 0.1% =4.1%
RM
7%
-5%
-10%
15%
RF
4%
4%
4%
4%
3. The study of Michaely/Thaler/Womack (1995)
(i)
Describe the abnormal returns of companies which omit or initiate dividends in
different points of time and relate the return to the Efficient Market Hypothesis. (9
pts)
Before the event:
Omission:
Initiation:
negative
positive
semi-strong form (investors anticipate
omission/initiation)
Or:
strong form (insider trading)
Around the event:
Omission:
Initiation:
negative
positive
semi-strong form (new information revealed)
After the event:
Omission:
Initiation:
negative
positive
EMH does not give an explanation
(ii)
How do Michaely/Thaler/Womack implement a trading strategy based on their
findings? (3 pts)
-
(iii)
Buy a long position in initiating companies and offset this investment with a
short position in the index.
Sell the stock of omitting companies and invest the proceeds in an index long
position.
Hold the positions for one year.
Illustrate how the “clientele effect” can give a rationale explanation for the
findings of Michaely/Thaler/Womack. (3 pts)
-
Different investor groups might have different attitudes towards dividends
Dividend initiation/omission may hence cause a change in stockholders
owning the company
The changes in ownership structure may be gradual, so price shifts may be
gradual