Behavioural and Experimental Finance

Question 1

1. A)Your friend who works for the management of a large beverage corporation in Never-Ever land decided to create prediction market to predict which new beverage the company should market next summer. His agreement with the CEO was that the company will promote the beverage that will receive the highest price in the prediction market 3 months from now. He created a contract on each particular suggested beverage. The owner of the contract will receive "1" if the model will be the winning model and will receive "0" otherwise. All of the employees of the research department, (15 employees), are supposed to participate.
2. You listen carefully to your friend and explain to him that there are several potential problems in his prediction market design that he should think through more carefully. Please describe at least 3 problems with the above design.
3. B)Assume that in Never-Ever land two paintings by famous artist with identical characteristics were put up for sale. However, one of the paintings had previously been sold in a "hot" market for a high price and the other had been sold in a "cold" market for a low price. If the market is rational, would the painting that previously sold in the "hot" market necessarily fetch a higher price at the auction? What biases that were discussed in class may cause the painting that previously sold in the "hot" market indeed to be sold at a higher price at the auction?

Question 2

On December 4th 1998, creative computer sold 20% of its online auction subsidiary "Ubid" in an IPO with intention to spin-off remaining 80% to shareholders of Creative in June 1999.

One can show that given the ratio of the numbers of shares, each shareholder of Creative Computer will get about 0.715 shares of Ubid.

On December 9th 1998, Creative computer closing price was $22.75 and Ubid close was $35.6875.

1. A)According to traditional finance theory and assuming no frictions (transaction costs, taxes, or any other limitations) and full certainty (spin-off June 1999) what should be the relationship between the price of Creative computers and Ubid. Is this consistent with the December 9th 1998 prices?
2. B)You run ABC hedge fund, according to traditional finance theory and assuming no frictions (transaction costs, taxes, or any other limitations) and full certainty - what should you immediately do (describe your strategy)?
3. C)Assume real market conditions. Which frictions/ risks can limit your ability to execute your strategy (from B)? Name at least 2 frictions.
4. D)Summarize your answers (A, B and C) and relate them to the "Market Efficiency Hypothesis".