Answer the following questions, fully justifying your answers a) Consider an investor who has Prospect Theory preferences and exhibits probability weighting but doesnt exhibit diminishing sensitivity in gains losses or loss aversion He chooses between two assets (i) asset pays 1 or 9 relative to the reference point, with probabilities 0 9 and 0 1 respectively, and (ii) asset pays 0 relative to the reference point, with probability 1 What is the investors preference between the two assets What is driving his behaviour b) State which of the following (possibly none or more than one) is not evidence of insufficient diversification Home, local, and own company stock returns are positively correlated with labour income Over 30 of contributions in 401(k) plans are invested in employer stock Finnish investors are much more likely to hold and trade stocks of firms located close to them geographically US investors invest 94 of their portfolio in US stocks c) Assume that two companies, and , are newly included in the stock market index on the same day Furthermore, assume that company s stock has several close substitutes while company s stock doesnt What is likely to happen to the prices of the two stocks

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Answer the following questions, fully justifying your answers: a) Consider an investor who has Prospect Theory preferences and exhibits probability weighting but doesnt exhibit diminishing

Answer the following questions, fully justifying your answers:

a) Consider an investor who has Prospect Theory preferences and exhibits probability weighting but doesnt exhibit diminishing sensitivity in gains/losses or loss aversion. He chooses between two assets: (i) asset pays 1 or +9 relative to the reference point, with probabilities 0.9 and 0.1 respectively, and (ii) asset pays 0 relative to the reference point, with probability 1. What is the investors preference between the two assets? What is driving his behaviour?

b) State which of the following (possibly none or more than one) is not evidence of insufficient diversification.
1. Home, local, and own-company stock returns are positively correlated with labour income.
2. Over 30% of contributions in 401(k) plans are invested in employer stock.
3. Finnish investors are much more likely to hold and trade stocks of firms located close to them geographically.
4. US investors invest 94% of their portfolio in US stocks.
c) Assume that two companies, and , are newly included in the stock market index on the same day. Furthermore, assume that company s stock has several close substitutes while company s stock doesnt. What is likely to happen to the prices of the two stocks?