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Question 1

What is an efficient market

Answer 1

Prices fully reflect all available information

Question 2

What is an inefficient market

Answer 2

Prices reflect only some information but not all

Question 3

What are the foundations of market efficiency

Answer 3

Rationality
Independent deviations from rationality
Arbitrage

Question 4

What is rationality in foundations of market efficiency

Answer 4

Assumes all investors are rational therefore, when new information is released in market, they will adjust their estimates of share price in a rational way

Question 5

What is independent deviations from rationality in foundations of market efficiency

Answer 5

Accepts that some investors do not act fully rationally however, supposes that about as many individuals are irrationally optimistic as irrationally pessimistic therefore, these countervailing irrationalities will move market in a manner consistent with market efficiency

Question 6

What is arbitrage in foundations of market efficiency

Answer 6

Process through which an investor can buy an asset or combination of assets at one price and concurrently sell at a higher price, thereby earning profits without investing any money or being exposed to any risk

Question 7

What would the combined actions of many investors engaging in arbitrage result in

Answer 7

Rapid price adjustments that eliminate any arbitrage opportunities

Question 8

In efficient markets, is it possible to earn abnormal returns

Answer 8

No. Arbitrage activities will quickly eliminate arbitrage opportunities available in market thereby promoting market efficiency

Question 9

What is abnormal return

Answer 9

Returns that are in excess of return required for risk assumed

Question 10

What are the 3 forms of efficiency

Answer 10

Weak form – past prices

Semi strong Form – public information

Strong Form – all information

Question 11

What is the random walk theory

Answer 11

Security prices change randomly with no predictable trends or patterns. Movement of stock prices is random. 

Question 12

What are technical analyst’s

Answer 12

Investors who attempt to identify undervalued stocks by searching for patterns in past stock prices. Forecast stock prices based on watching fluctuations in historical prices. 

Question 13

What are fundamental analysts

Answer 13

Investors who attempt to find mispriced securities by analysing fundamental information such as accounting data and business prospects. Research value of stocks using NPV and other measurements of cash flow

Question 14

What are the common misconceptions of market efficiency

Answer 14

Dart throwing just as effective as stock pricing – wrong. Investors still have to worry about risk and diversification

Price fluctuations are predictable – wrong. Prices are random because new information is released randomly

Markets can’t be efficient because only a subset of shareholders trade – wrong. Only a subset of investors are needed to take advantage of arbitrage opportunities

Question 15

What is rationality in behavioural challenge of market efficiency

Answer 15

Behavioural view is not that all investors are irrational but that some perhaps many are

Question 16

What is independent deviations from rationality in behavioural challenge of market efficiency

Answer 16

Deviation from rationality are not random and likely to cancel each other out. In contrary, psychologists argue that individuals deviate from rationality in accordance with a number of basic principles, most relevant to finance representativeness and conservatism

Question 17

What is arbitrage in behavioural challenge of market efficiency

Answer 17

Arbitrage strategies might involve too much risk to eliminate market efficiencies. An investor buying an under priced asset and selling overpriced one doesn’t have sure thing. Deviation from parity could actually increase in the short run meaning losses for arbitrageur. Therefore, risk consideration might force arbitrageurs to take positions that are too small to move prices back to parity

Question 18

What are the four important implications for corporate finance

Answer 18

Accounting and financial choices

Timing of debt and equity issues

Speculation

Using information in market prices

Question 19

What does efficient market hypothesis not say

Answer 19

Prices are uncaused

Investors are foolish and too stupid to be in market

All shares have same expected returns

There is no upward trend in share prices

Investors should throw darts to select shares

Question 20

What does efficient market hypothesis say

Answer 20

Prices reflect underlying value

Financial managers cannot time equity and bond sales

Managers cannot profitably speculate

Managers cannot boost share prices through creative accounting