Reading 13: A Survey of Behavioral Finance －LOS c including, profit, designed

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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 c: Evaluate the implementation costs and risks, including fundamental risk and noise trader risk, associated with trades designed to profit from asset mispricings.

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Which of the following is the best definition of a mispriced asset?

A) Market price deviates from the Capital Asset Pricing Model price.

B) Market price deviates from the Gordon Dividend Discount Model price.

C) Market price deviates from Analyst's Consensus Model price.

D) Market price deviates from the present value of an asset's future cash flows.

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Answer and Explanation

Although the present value of cash flows can be calculated using CAPM or Gordon Dividend Discount Model inputs, the best definition for a mispriced asset is that the market price deviates from the present value of the assets future cash flows.

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Which of the following best represents an example of noise trader risk? A stock:

A) becomes less out-of-favor with investors.

B) decreases in price due to firm-specific fundamental problems.

C) becomes more out-of-favor with investors.

D) decreases in price due to industry-specific fundamental problems.

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Answer and Explanation

A stock that becomes more out-of-favor with investors probably decreases in value due to non-financial or non-economic fundamental pressures. This reaction is an example of noise trader risk.

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Which of the following best represents an example of fundamental risk?

A) A firm announces earnings that are less than expected due to a decrease in industry-wide sales.

B) A firm announces earnings that are less than expected due to an adverse impact on sales resulting from fears of international terrorism.

C) A firm announces earnings that are less than expected due to the results of a national election.

D) A firm announces earnings that are less than expected due to production process problems.

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Answer and Explanation

The effects of industry-wide sales, international terrorism, and a national election all have the potential to adversely impact the firm. However, their characteristics are more systematic in nature, and the effects can be hedged somewhat by taking appropriate precautions. Process problems are more firm specific, and are less likely to be able to be hedged away.

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Which of the following is NOT a condition that serves to limit arbitrage opportunities relating to securities mispricing? The existence/possibility of:

A) a risk averse arbitrageur.

B) early position liquidation.

C) a sufficiently comparable security.

D) systematic risk.

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Answer and Explanation

The existence of sufficiently comparable securities allows arbitrageurs to reduce their risk by hedging mispricing situations. The other three conditions tend to limit arbitrage opportunities.

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Which of the following does NOT tend to allow deviations from fundamental value to persist?

A) Perfect security substitutes.

B) Systematic risk.

C) Short time horizon.

D) Risk averse arbitrageur.

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Answer and Explanation

The existence of perfect security substitutes affords arbitrageurs opportunities to hedge transactions taken in the existence of perceived mispricing.

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Which of the following does NOT limit arbitrage and does NOT allow deviations from fundamental value to persist? The existence/possibility of:

A) highly correlated securities.

B) lack of firm-specific risk.

C) early liquidation.

D) a risk averse arbitrageur.

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Answer and Explanation

The existence of highly correlated securities affords arbitrageurs the ability to hedge their positions more effectively. This makes it possible to create positions allowing them to take advantage of mispricing opportunities.

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Which of the following best prevents arbitrage profits from being taken?

A) Lack or perfect security substitutes, high implementation costs, presence of noise traders.

B) Abundance of perfect security substitutes, low implementation costs, absence of noise traders.

C) Lack of perfect security substitutes, low implementation costs, presence of noise traders.

D) Abundance of perfect security substitutes, high implementation costs, absence of noise traders.

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Answer and Explanation

A lack of perfect security substitutes will make it difficult for an arbitrageur to hedge fundamental risk. High implementation costs will lower or eliminate potential arbitrage profits. The presence of noise traders will potentially increase the mispricing, not decrease its existence.

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Which of the following best increases the probability pricing deviations will persist?

A) Diversifiable fundamental risk, no short-sale constraints, long holding periods.

B) Undiversifiable fundamental risk, short-sale constraints, long holding periods.

C) Undiversifiable fundamental risk, short-sale constraints, short holding periods.

D) Diversifiable fundamental risk, no short-sale constraints, short holding periods.

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Answer and Explanation

Undiversifiable fundamental risk creates a situation where not even a large amount of small investors each taking small positions will cause mispricing to disappear. Short-sale constraints will increase the difficulty to hedge a position, and short holding periods will result in closure of positions prior to mispricing being eliminated.

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