Reading 13: A Survey of Behavioral Finance －LOS a behavioral, classic, finance, agents, caused

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 3: Behavioral Finance
Reading 13: A Survey of Behavioral Finance
LOS a: Critique the classic objection to behavioral finance that rational agents will quickly undo any dislocations caused by irrational traders.

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According to behavioral finance, security prices can deviate from their fundamental value. Which of the following transactions is most closely related to the response from the proponents of the efficient markets hypothesis to the behavioral finance claim?

A) An enhanced index trade.

B) A pair trade.

C) A core satellite trade.

D) A portable alpha trade.

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Answer and Explanation

According to the proponents of the efficient markets hypothesis, any mispricing in the market will be quickly corrected by rational investors. They will use a pair trade to go long underpriced securities and short similar, overpriced securities.

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The stock of Boulware Metals is trading at $43. Its intrinsic value is $40. The price of Dunn Aerospace is $50. Its intrinsic value is $52. According to behavioral finance, which of the following scenarios will occur?

A) Investors will not exploit the mispricing because of risk and transactions costs.

B) Investors will short Boulware and go long Dunn.

C) Investors will go long Dunn but not short Boulware.

D) Investors will short Boulware but not go long Dunn.

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Answer and Explanation

Boulware Metals is overpriced and Dunn Aerospace is underpriced. According to behavioral finance however, rational investors will not exploit mispricing in the market because the risk and transactions costs of doing so may be too high.

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Behavioral finance suggests that securities may become mispriced in the market. The proponents of the efficient markets hypothesis state that rational investors will exploit any mispricing that occurs, thus correcting the mispricing. How would the proponents of behavioral finance respond?

A) The proponents of behavioral finance have not yet formulated a response.

B) That the mispricing can persist.

C) That although mispricing will eventually be corrected, there is a substantial delay before it occurs.

D) That the mispricing will worsen, especially for stocks that are undervalued.

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Answer and Explanation

According to behavioral finance, rational investors will not exploit mispricing in the market because the risk and transactions costs of doing so may be too high. Thus mispricing can persist.