1. Below lists a number of possible facts about investor or price behavior. Please ar-

ticulate how you would make money by exploiting these mistakes and the reasoning

behind your strategy. The first one is given as an example.

(a) Fact: most retail investors naively buy stocks of companies that make products

they are familiar with (e.g. McDonald's) and ignore companies they never

heard of.

Answer: this will tend to make less popular stocks undervalued and pop-

ular stocks overvalued. Therefore, I would exploit this by going long the

unpopular stocks and short the popular ones.

(b) Fact: many investors prefer "lottery stocks": companies that have low prices

but have a small probability of price suddenly jumping up by a lot. (Their

payoff is similar to lottery). Please explain how you would exploit this fact.

(c) Fact: corporate bonds have credit ratings that indicate their default risk. The

most highly rated is AAA (almost no default risk), followed by AA, A, BBB,

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BB, B, and C. Bonds with ratings at or better than BBB is called "investment

grade"; worse bonds are called "high yield" or "junk bonds". Many institu-

tional investors (e.g. pension funds) are legally prohibited to hold high-yield

funds. Note that credit ratings do go up or down over time. If a bond gets

downgraded from BBB to BB, all those funds will have to sell.

(d) Fact: company insiders (e.g. CEOs) often have a better idea whether their

stock is over- or under-valued and will trade accordingly to gain profits for

themselves. Insider trading is publicly disclosed in SEC form 4 - therefore, we

know who bought and sold.