QEUSTION I: DISPOSITION EFFECT AND PROSPECT THEORY.

$(2$ points$)$ What is a disposition effect?

$(2$ points$)$ What is the prospect theory?

$(2$ points$)$ How does the prospect theory explain the disposition effect?

QUESTION II: PROFESSIONAL ARBITRAGE.

In the professional arbitrage model we discussed in class, the investors who have no

knowledge about the value of the assets delegate their money to the fund managers or

arbitrageurs who have accurate knowledge about the true value of the assets. Nevertheless,

the investors are unsure about the skill of the arbitrageurs and rely on the past performance to

make the inference. There are also noise traders in the market whose trading in the assets is

driven by their fluctuating sentiment$.$ Please answer the following questions:

$(3$ points$)$ Under what situations the arbitrageurs want to invest all the money in the

risky asset instead of holding some cash?

$(3$ points$)$ Do the arbitrageurs always make money? Explain.

$(3$ points$)$ Is it true that the further the asset price is away from fundamentals, the

stronger is the stabilizing effect of the arbitrageurs? Explain.