CHAPTER 22
BEHAVIORAL FINANCE:
IMPLICATIONS FOR FINANCIAL
MANAGEMENT
Answers to Concepts Review and Critical Thinking Questions
1. The least likely limit to arbitrage is firm-specific risk. For example, in the 3Com/Palm case, the
stocks are perfect substitutes after accounting for the exchange ratio. An investor could invest in a
2. Overconfidence is the belief that one’s abilities are greater than they are. An overconfident financial
manager could believe that they are correct in the face of evidence to the contrary. For example, the
3. Frame dependence is the argument that an investor’s choice is dependent on the way the question is
posed. An investor can frame a decision problem in broad terms (like wealth) or in narrow terms
4. A noise trader is someone whose trades are not based on information or financially meaningful
analysis. Noise traders could, in principle, act together to worsen a mispricing in the short-run. Noise
5. As long as it is a fair coin the probability in both cases is 50 percent as coins have no memory.
6. Taken at face value, this fact suggests that markets have become more efficient. The increasing ease
with which information is available over the Internet lends strength to this conclusion. On the other
CHAPTER 22 B-355
7. The statement is false because every investor has a different risk preference. Although the expected
9. Behavioral finance attempts to explain both the 1987 stock market crash and the Internet bubble by
9. Behavioral finance states that the market is not efficient. Adherents argue that: 1) Investors are not
10. Frame dependence means that the decision made is affected by the way in which the question is
asked. In this example, consider that the $78 is a sunk cost. You will not get this money back
whether or not you accept the deal. In this case, the values from the deal are a gain of $78 with 20