Assignment_4_solution - 1 2 3 4 5 Two reasons why people...

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Unformatted text preview: 1) 2) 3) 4) 5) Two reasons why people trade too much: Overeonfidence — investors believe their ability is higher than they truly are, and as a result, they always believe that their ideas are right and are willing to bet on them. This overconfidence easily allows someone to trade on their ideas. gLowered) Friction — When it is not as easy to trade, i.e. when “friction” to trade exists, an investor will likely have more time to assess/verify their ideas (ex: talking to someone, reading the news, calm their minds, etc.). With the advent of online trading, trading has become easier. Investors can immediately trade on their ideas online H it is too easy. Source: Odean, Terry. “What I know about how you invest” Accessed at: According to Odean, when a person trades too much, their portfolio returns are actually worse in comparison to a Buy-and-Hold strategy (Odean’s studies have found that the portfolio returns from trading underperform by 1-2% on average in comparison to the buy—and-hold returns). /\ 90—year old person, who has already lived most of his/her life, would probably have a utility function for wealth that is very flat beyond a certain amount. The person is likely already satisfied with returns that can cover their living expenses and allows comfortable living. For example, the utility for $1 billion is likely not significantly higher than the utility for some couple thousand dollars. Due to this, high returns are not of interest to a 90-year old, rather, stable low-risk returns are preferred. One reason why I feel that behavioural finance can do this is because a substantial portion of the market is really based on people and their decisions. Thus, studying the behaviour of investors must have some use in understanding the market. One reason why I feel that behavioural finance cannot do this is because behaviours and risk tolerance varies from individuals to individuals. I believe it will be very difficult, if not impossible, to explain the financial market events based on such a wide spectrum of possible behaviour profiles. This means that in comparing two scenarios, where the first one pays higher dividends on some periods, but both pay the same dividend for the rest of the periods, the first one is preferred. This is why dividends are relevant; it has more value. However, with different dividend policies, a firm is simply establishing trade-offs between dividends at one date and dividends at another date. As discovered by Modigliani and Miller, homemade dividends can offset such trade- offs and construct the desired dividend policy, rendering indifference between dividend policies. Thus, dividend policies are irrelevant. 6) IfI was a bond holder ofa company, and a liquidating dividend is issued, I would treat this news negatively and would probably quickly sell off my bonds. There is negative information content in such an announcement. Liquidating dividends are essentially distribution to shareholders from the capital of the firm. Such a distribution usually means that the company has poor earnings that are inadequate to pay dividends, or the company is ‘milking the property’ in the face of financial distress. This distribution reduces the claims of bondholders if the company goes bankrupt, and should be treated as bad news for bondholders. 7) I would prefer the company to repurchase my stock for the following reasons: 0 Providing stock dividends requires extra flotation cost, effectively reducing the available ‘rewards’ 0 Cash dividend is taxed o Repurchase of stock is usually done at a price decently above current market prices 0 Although the repurchase would result in capital gains for me, I may have capital loss credits from other investments to avoid paying tax for the capital gains. 8) If the tax system is working appropriately such that dividends are taxed the same way as capital gains, then we should have no preference over the two types of gains. However, in reality, people do prefer one over the other: 0 For individuals in high-tax brackets, they would prefer capital gains over dividends. Since they only benefit moderately from the dividend tax credit, the effective tax rate on capital gains is lower as the gains are only taxed when shares are sold. 0 For individuals in the low-tax bracket, they would benefit more from the dividend tax credit, so low-to-medium dividend payouts are preferred. 0 For corporations, since they can exclude 100% of dividend income from taxes (and not capital gains), they would prefer dividends. o For tax-free institutions (such as pension funds), no taxes are paid on dividends or capital gains. If they prefer current income, then they would prefer dividends. 9) One recent trend in finance is the increasing number of hedge funds established. Hedge funds are important to the investments field as: 0 They are alternate forms of investment rather than traditional long-only investment funds 0 They are engaged in a wider range ofinvestrnent and trading activities. 0 Hedge fund returns usually have low correlation to traditional asset returns. L 0 Hedge funds also seek to achieve positive returns, even in trendl‘ess or down markets 0 Trading from hedge funds add liquidity to the market 0 Many hedge funds attempt to minimize risk ...
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This note was uploaded on 11/16/2011 for the course ACTSC 372 taught by Professor Maryhardy during the Spring '09 term at Waterloo.

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Assignment_4_solution - 1 2 3 4 5 Two reasons why people...

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