Behavioural Finance

QUESTION 1.

Consider a person with the following value function under prospect theory:

            v(w) = w^.5               if w  0

                    =  -2(-w)^.5        if w < 0

a.       Is this individual loss averse? Explain

b.      Assume that this individual weights values by probabilities, instead of using prospect theory weighting function. Which of the following prospects would be preferred?

            P1(.8, 1000, -800)

            P2(.7, 1200, -600)

            P3(.5, 2000,-1000)

Note: Points will be taken off for responses that lack organization and order.

Grade: 25

QUESTION 2.

“Since capital budgeting decisions involve the estimation of a project’s future cash flows and the rate at which they should be discounted is still a relatively subjective process, the behavioral traits of managers still affect this process.” Discuss this statement and suggest how managers can better improve their ability to eliminate biases in their forecasting.

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Note: Points will be taken off for write-ups that lack organization and order.

Maximum pages: 2-3 pages, double-space, size 12.

Grade: 25