BEHAVIORAL FINANCE EXAM (HEC, MIF, Landier 2021)

Student Name/ID:

You have one hour and thirty minutes in total after opening this file.

Answer directly in the word file and send answers to [email protected] as soon as you are done.
Allocate your time wisely. This exam is open books/notes and calculators are allowed. Provide clear
and concise answers. Please, make assumptions if needed: to guarantee fairness, I will not answer
individual emails unless a really major issue appears.

A. QUIZZ [25 pt]

IS EACH OF THE FOLLOWING SENTENCE TRUE or FALSE ? (no justification needed: just
answer TRUE/FALSE)

1. If there are some investors in the market who are irrational (biased), the market cannot
be efficient.

FALSE – If there is no limit to arbitrage, any demand shock is absorbed by arbitrageurs, and
the market could be efficient.

2. The disposition effect is consistent with prospect theory.

TRUE.

3. In a “short-squeeze”, what happens is that stock prices suddenly go down, due to

arbitrageurs increasing their short positions.

FALSE. in fact stock prices go up as arbitragers buy the stock to cover their short positions

4. Consider two lottery: (a) (1/2: $100, 1/2: $300), and (b) (3/4: $100, 1/4: $500). An
individual with a Prospect theory utility function (as calibrated by Kahneman and Tversky)
prefer (a) over (b).

TRUE. This is due to the concavity of prospect utility in the domain of gains (risk-aversion).

5. The fact that some fund managers have outperformed the market for decades is evidence
that the market is not efficient.

FALSE – It could be due to luck (there are many fund managers!).

6. Over-reaction to news can explain the existence of the Post Earnings Announcement Drift
(PEAD).

FALSE. PEAD is inconsistent with over-reaction. It is consistent with sticky expectations

(under-reaction).

7. Overconfident traders trade less, because they are very confident in the future returns of
their portfolio.

FALSE. Overconfident traders trade more because they tend to believe that they are better
than others and can make profit from trades.

8. Stocks that are followed by more inattentive analysts have lower abnormal returns in the
profitability anomaly.

FALSE. Higher inattention = more under-reaction = larger abnormal return

9. The equity premium puzzle is about why stock-market returns are too volatile relative to
the realized volatility of earnings or dividends.

FALSE. It is about why stock returns tend to be so high on average.

10. The value strategy bets on the mean reversion of stock prices.

TRUE

11. It is profitable for long-term shareholders of a company that the company buys back
shares when managers know the stock-price is below fundamental value.

TRUE. It is de facto like the company is performing a profitable arbitrage strategy on behalf
of its shareholders (at least long-term shareholders).

12. Consider two lottery: (a) (1/2: -$100, 1/2: -$300), and (b) (3/4: -$100, 1/4: -$500). An
individual with a Prospect theory utility function (as calibrated by Kahneman and Tversky)
prefer (a) over (b).

FALSE. Agent prefers (b) over (a) due to the convexity of prospect utility in the domain of
losses (risk-seekingness).

13. If the cost of capital of polluting companies has become higher, this implies that
investors with a greener carbon footprint can expect higher expected returns.

FALSE. Cost of capital= expected equity returns

14. Extrapolative beliefs could explain why a bubble emerges.

TRUE.

15. Consider some rational investors which have different priors. After observing a large
amount of similar information, their beliefs should diverge more.

FALSE. The beliefs converge after a long series of informative signals.

16. If short selling is frictionless (i.e. feasible at no cost), disagreement among investors
should (in theory) not distort prices.

TRUE.

17. More asymmetric information among rational investors is expected to increase volume.

FALSE. “no trade theorem”: asymmetric info creates a suspicion that other traders are trying
to take advantage of their private information.

18. Large inflows into ESG funds are likely to decrease the cost of capital of companies with
poor ESG ratings.
FALSE. In fact the opposite hods: This comes from price impact from the inflows (which
might be temporary) and from other investors asking a higher premium for being more
concentrated into dirty stocks (which is a permanent effect). This is a simple supply/demand
effect.

19. Confirmatory bias implies that we do not get convinced often enough by the opinions of
others.

TRUE. Confirmatory biased agents put too much weight on their priors and tend to discard
opposing views to theirs.

20. The level of“Short interest”in a stock reflects the quantity of short positions that have
been taken in that stock.

TRUE

21. When a company issues stock, one can usually expect positive abnormal returns in
months following announcement.

NO. It’s the opposite, as companies time their own stock: they opportunistically tend to
issue at a high level of their valuation.

22. Over-confident people tend to provide confidence intervals that are too large compared
to what a rational person would do.

NO. It’s the opposite

23. The publication in the media of salient news regarding a stock typically creates a spike in
disagreement, which is on average followed by negative abnormal returns.

YES: higher disagreement leads to overpricing (optimists “make the price”), which reverts
over the long-run

24. ESG ratings from various providers are known to be highly correlated between each
other

No, it’s quite the opposite (ant it is problematic)

25. overconfident CEOs tend to make value-destroying acquisitions, especially when they
have internal cash available.

Yes, it’s an empirical finding by Tate and Malmendier and it is explained by their theory:
overconfident CEOs are reluctant to use external financing (especially equity) as they feel
these securities are undervalued by the market, such that they “leave money on the table”
when issuing debt or equity. This is not a pb with internal cash.

B. PAPER ANALYSIS. [25 pt]

The following questions are related to the working paper “Reactions to News and Reasoning
By Exemplars”, which you have access to as a separate file. You will be evaluated on your
ability to browse through the paper and grasp the content relevant for questions: I do not
expect you to have the time to read the paper extensively. You should focus more on the
intuitions and empirical tests and spend little time on theory and data sections.
When relevant, indicate what page/table/figure of the paper motivates your answers.

1. [3pt.] The RBE agents update signals in a Bayesian way. TRUE or FALSE? Briefly explain.

FALSE.

2. [4pt.] The trading volume is lower for more extreme event-types, because the RBE
investors disagree less with rational arbitrageurs. TRUE or FALSE? Briefly explain.

FALSE. More extreme events => more RBE effect => more disagreement => higher trading
volume

3. [3pt.] Empirically, the event followed with most drift is the “Annual Meeting”. TRUE or
FALSE? Briefly explain

TRUE. Figure 3.

4. [3pt.] Figure 7 shows that more return-extreme events are followed by more post-event
reversal. TRUE or FALSE? Briefly explain

TRUE. Figure 7.

5. [4pt.] In a frictionless world where there are no limits to arbitrage, we should (according
to the theory proposed in the paper) not observe any abnormal trading volume, even if
there are some RBE investors in the market. TRUE or FALSE? Briefly explain

FALSE. We will not observe distortion in asset prices, but we will still observe large trading
volume because the RBE traders still trade aggressively against arbitrageurs.

6. [4pt.] One concern of the paper is that results may be driven by simple returns dynamics
unrelated to corporate news. For example, there could simply be strong reversals to large
returns in general. Then more extreme event-types would mechanically have more
reversals, regardless of the theory investigated by the paper. What test(s) do the authors
propose to address the concern?

They run regressions on the full firm-day panel, which includes the unconditional market
response to non-vent-day returns. Page 21-22.

7. [4pt.] Based on the evidence in the paper, propose a profitable trading strategy based on
CEO/CFO changes. (Just provide a brief qualitative description, no need for details, no more
than 100 words)

Roughly: At the end of date t (where t is the CEO/CFO change announcement day), buy
negative return stocks and short positive return stocks. Holding it for 90 days.