3. “A Survey of Behavioral Finance” (Study Session 9)
a) discuss “fundamental” and “noise trader” risk that may be present in implementing a
trade designed to profit from a mispricing of an asset;
b) discuss the costs of implementing a trade designed to profit from a mispricing of an
asset;
c) explain what conditions are sufficient to limit arbitrage and allow deviations from
fundamental value to persist.
Guideline Answer:
Part A
Both Lavinsky and Blake face noise trader risk. Noise trader risk arises from the possibility that
the mispricing being exploited worsens in the short run.
For Lavinsky, the risk is that the investors who have depressed the price of CRO will become
even more pessimistic about CRO, worsening the undervaluation in the short run. Or,
conversely, investors become irrationally optimistic about ATL.
For Blake, the risk is that, even though KNV is a perfect substitute for CRO, the investors who
have caused KNV to trade at a discount relative to CRO become even more pessimistic about
KNV, further widening the discount. Or conversely, investors in CRO become less irrationally
pessimistic.
Part B
Lavinsky, but not Blake, faces fundamental risk. Fundamental risk arises from the possibility
that, when securities are imperfect substitutes, additional relevant information/news will
adversely effect a position.
Lavinsky’s position involving ATL and CRO protects Lavinsky somewhat from adverse news
about the airline industry as a whole. ATL is an imperfect substitute for CRO, however, so he
still faces the risk associated with his position being vulnerable to news that is specific to ATL or
CRO. In particular, adverse news about only CRO, or positive news about only ATL, may result
in smaller profits or even losses from his position.
Blake’s position involves two securities that are perfect substitutes.
Part C
An opportunity to exploit a mispricing does NOT exist, because the implementation costs (110
bps*) of exploiting the mispricing exceed the one percent (100 bps) divergence that now exists
between CRO and KNV.
*35 bps each for taking positions in CRO and KNV = 70 bps, plus 40 bps for borrowing CRO
stock to short, for a total implementation cost of 110 bps
LEVEL III, QUESTION 11
Topic: Equity Analysis-Alternative Investments
Minutes: 19
Reading References:
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