Reference no: EM133714801

Assignment: Behavioral Finance

Question A

Overconfidence (that is excessive optimism) is very commonly observed in human beings. Overconfidence leads to which types of irrational of behavior in financial markets? List 3 and explain in detail.

Question B

Details (from Behavioral Corporate Finance, Seohee Park)

Between March and July 2000, Intel's stock price rose rapidly, to the point where in July Intel's market capitalization was above $500 billion, making it the largest firm in the world. Then on Thursday, September 21, 2000, Intel issued a press release indicating that its revenue for the third quarter would grow between 3 percent and 5 percent, not the 8 to 12 percent that analysts had been forecasting.

In response to this news, Intel's stock price dropped by 30 percent over the next five days. Intel's chairman, Craig Barrett, commented on the reaction, stating: "I don't know what you call it but an overreaction and the market feeding on itself." An academic study found that at the time, virtually none of the analysts following Intel used discounted cash flow analysis to estimate the fundamental value of Intel's stock. Instead, the study points out that analysts react to bad news in the same way that a bond-rating agency reacts to bad news. Just as a bond-rating agency would downgrade the firm's debt, analysts downgrade their stock recommendations. After Intel's press release, approximately one-third of the analysts following the firm downgraded their recommendations. Some of the recommendation changes were extreme. Notably, the cumulative return to Intel's stock, relative to the S&P 500, displayed a negative trend for the period September 2000 through September 2002.

In what some might see as a replay of history, consider an event that took place at the online firm eBay during January 2005. Between the end of 2002 and the end of 2004, eBay's shares increased by over 200 percent. During December 2004, eBay's stock price peaked at $118, and its forward P/E ratio was 73. At the time, the firm's market value was $81.7 billion. Fourth-quarter earnings for eBay grew by 44 percent to $205.4 million, or 30 cents a share.

Just as Intel had announced that its earnings growth would be lower than forecast, eBay's actual earnings for the fourth quarter of 2004 fell a penny below analysts' consensus forecasts. Meg Whitman, eBay's CEO, stated that future earnings would be lower because of higher advertising costs and reinvestment.

In response, eBay's stock price fell from $103 to $81 per share. The firm's market value fell to $56 billion. Many analysts immediately downgraded eBay's stock. Rajiv Dutta, eBay's CFO, issued a public statement to say that his concern was managing eBay's long-run prospects, not its stock price.

On January 26, 2005, James Stewart wrote about eBay in his Wall Street Journal column "Common Sense." Stewart indicated that he would consider purchasing eBay stock in the wake of its decline. While acknowledging that eBay could not grow at a stratospheric rate forever, Stewart noted that eBay is in the process of transforming world commerce and has a natural monopoly. Were he to own just one Internet stock, Stewart said, eBay would be that stock.

Task

I. What psychological phenomena may have influenced the analysts, both generally and in their reaction to Intel's announcement in September 2000?

II. Does James Stewart's assessment of eBay reflects any psychological phenomena, discuss.

III. Discuss in what ways the events described at Intel and eBay are similar and in what ways are they different?

Length: 3 pages.

Question C

Bias Identification, identify the biases and/or heuristics displayed by Professor French

I. Professor French tells you that South Africa's stock market undervalued and suggests that it is a good investment. You discover that South Africa is about to impose a new tax on security transactions, which will results in lower liquidity. The next class you bring this to Professor French's attention. Simultaneously, another student mentions that as commodity prices recover South Africa's stock market will rise sharply. Dr. French ignores the information you provide and congratulates the other student on excellent research. Which type of bias is Professor French displaying? Explain briefly.

II. While reviewing the most recent four quarters of earnings estimates for MMM, Professor French notices that earnings growth rates were 15% per quarter. He announces to the class that MMM is a growth company. Which type of bias or heuristic is Professor French falling victim too? Explain briefly.

III. Professor French's father works for Boeing. Professor French holds 18% of his portfolio in Boeing. Which type of bias or heuristic is Professor French displaying? Explain briefly.

Length: 2 pages.

Question D

I. Explain what is meant by an anomaly in finance?

II. Give 3 examples of anomalies uncovered by academic research in the past two decades (make sure and explain these anomalies in detail including references).

III. If markets are efficient what would you expect to happen to these anomalies after they were discovered?

IV. If the anomalies persist what financial frictions might responsible for the persistence (make sure and cite frictions that apply to the anomalies in part ‘b')?

Length: 4 pages.