Finance Biases

Question 1

What is the disposition effect bias?

Answer 1

A: The disposition effect is a behavioral finance concept that refers to the tendency of investors to sell assets that have increased in value too quickly, while holding on to assets that have decreased in value for too long.

Question 2

What is the underdiversification bias?

Answer 2

Underdiversification bias in finance refers to the tendency of investors to hold a portfolio of investments that is not sufficiently diversified, which can increase the risk of their overall portfolio and lead to suboptimal investment outcomes.

Question 3

Give an example of an underdiversification bias

Answer 3

Home bias: Investors may be biased towards investing in assets that are familiar to them, such as companies based in their home country or region, leading to a lack of diversification across sectors and geographies.

Question 4

Give an example of an underdiversification bias

Answer 4

Home bias: Investors may be biased towards investing in assets that are familiar to them, such as companies based in their home country or region, leading to a lack of diversification across sectors and geographies.

Question 5

Familiarity bias

Answer 5

Familiarity bias in finance refers to the tendency of investors to favor investments that they are familiar with or have personal experience with, even if those investments may not be the most appropriate for their investment goals or risk tolerance.

Question 6

Relative wealth concerns

Question 7

Beta for risk-free investment is :

Answer 7

zero

Question 8

The correlation of a stock with itself is equal to :

Answer 8

1

Question 9

What is the market portfolio?

Answer 9

A portfolio that includes all publicly traded stocks

Question 10

How is the investment in each security in a value-weighted portfolio determined?

Answer 10

Proportional to the market value of the security’s outstanding shares

Question 11

What is the DJIA (Dow Jones Industrial Average)?

Answer 11

A portfolio of 30 large industrial stocks

Question 12

What are index funds and exchange-traded funds (ETFs)?

Answer 12

Funds that invest in market indexes and represent ownership in a portfolio of stocks

Question 13

How is the risk-free rate determined in the CAPM model?

Answer 13

By using the yields on U.S. Treasury securities

Question 14

What is the market risk premium?

Answer 14

The expected excess return of the market portfolio

Question 15

What is the market risk premium?

Answer 15

The expected excess return of the market portfolio

Question 16

How has the market risk premium changed over time?

Answer 16

It has decreased due to financial innovations reducing the costs of diversifying

Question 17

What is the purpose of determining a security’s beta in the CAPM?1

Answer 17

To measure the sensitivity of the security’s returns to market returns.

Question 18

How is beta typically estimated?

Answer 18

By analyzing two to five years of historical returns.

Question 19

What does a high beta value indicate for a stock?

Answer 19

The stock’s returns are more sensitive to market risk, hence more volatile

Question 20

How can the relationship between a security’s returns and the market be visually represented?

Answer 20

By analyzing the excess return of the security and the market.

Question 21

What does the best-fitting line in the scatterplot of excess returns represent?

Answer 21

The security’s estimated beta.

Question 22

What does a positive covariance between a security’s returns and the market imply?

Answer 22

The security’s returns move in the same direction as the market’s returns.

Question 23

What does beta measure in the CAPM?

Answer 23

The percentage change in the return of a security for a 1% change in the return of the market portfolio.

Question 24

What does firm-specific risk represent?

Answer 24

Risk that is not related to the market as a whole and is diversifiable.

Question 25

Which risk is considered the appropriate measure of risk for a well-diversified investor?

Answer 25

Market risk captured by beta.

Question 26

How does estimating beta based on historical sensitivity assume stability?

Answer 26

Beta remains relatively constant over time for most firms.

Question 27

What is the interpretation of the stock’s alpha (ai)?

Answer 27

Risk-adjusted measure of the stock’s historical performance

Question 28

Why is it difficult to estimate alphas with much accuracy?

Answer 28

Alphas have very little persistence

Question 29

What does beta measure?

Answer 29

A security’s sensitivity to market risk.

Question 30

How is beta typically estimated?

Answer 30

By regressing a stock’s excess returns against the market’s excess returns

Question 31

What does the intercept of a regression of a stock’s excess returns against the market’s excess returns represent?

Answer 31

The stock’s alpha.

Question 32

What is the relationship between betas and alphas over time?

Answer 32

Betas tend to remain stable, while alphas are persistent.

Question 33

Why is estimating the beta of individual debt securities challenging?

Answer 33

Debt securities do not have a market portfolio to compare against.

Question 34

What does the Capital Asset Pricing Model (CAPM) help identify?

Answer 34

Investments with similar risk

Question 35

What does the Security Market Line equation of the CAPM provide?

Answer 35

The cost of capital of an investment opportunity.

Question 36

What does the CAPM equation for the cost of capital (Security Market Line) state?

Answer 36

The cost of capital of an investment opportunity

Question 37

How can the equity cost of capital be calculated for valuing a share of stock?

Answer 37

) By using the CAPM equation with the stock’s beta.