For each of the following statements, state whether it is TRUE or FALSE, fully justifying your answer.

a) Prospect Theory explains why the same person might buy insurance and gamble, by proposing that people have a value function that is concave in gains and convex in losses.

b) An individual is more likely to buy than to sell stocks from the decile of stocks that, on a given day, have high trading volume.

c) It is possible to explain short-run momentum by assuming some traders erroneously believe in the law of small numbers Please answer the following questions on the volatility puzzle: a) What is the volatility puzzle? b) How could this puzzle be resolved without resorting to behavioural explanations? c) What are two behavioural explanations of this puzzle? Discuss in detail.

Question 3 [25 marks] One of the implications of the discounted utility model is that there should be no preference reversals. What does this mean?

Show why this is the case.

Also show how a quasi-hyperbolic discounting model can explain preference reversals.

Question 4 [25 marks] There are two assets in the market, and . With probability , asset will experience a total loss in value, otherwise it will retain its value. Similarly for asset . Furthermore, the returns of assets and are independent. You can make one of the following two choices: - Allocate 100% of your wealth to , or - Allocate 50% of your wealth to and 50% to .

What allocation do you choose if your preferences are represented by Expected Utility Theory?

What allocation do you choose if your preferences are represented by Prospect Theory, with no probability weighting?

Please carefully explain in detail your answer, calculation and rationale for each analysis.