12 Flashcards
Importance of fin. markets
Financial markets allow companies, governments and indiv. to increase their utility
− Savers can invest in financial assets so that they can defer consumption and earn a
return to compensate them for doing so.
− Borrowers have better access to the capital that is available so that they can invest in productive assets.
* Financial markets also provide us with information about the returns that are required for various levels of risk
Risk Premium
Extra return earned for taking on risk.
treasury risk (risk free)
Risk premium is the ret. over and above risk free rate.
Use of Variance and SD
measure the volatility of asset returns. The greater the volatility the greater the uncertainty
Capital Market Efficiency
-Stock prices are in equil. or fairly priced
-If this is true, then you should not be able to earn “abnormal” or “excess” returns.
* Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market( doesn’t exceed the app. dis. rate)
Efficient Market
Investors compete to seek out
positive NPV investments, such as
stocks that are too cheap
EMH
states that the “NPV of investing is
zero” (because investors collectively
price everything correctly)
What makes markets efficient?
- There are many investors out there doing research
− As new information comes to market, this
information is analyzed and trades are made
based on this information.
− Therefore, prices should reflect all available public information.
*Faster/ better information and trading could help. - If investors stop researching stocks, then the market will not be efficient
Common Misconceptions about EMH(hypothesis)
- Efficient markets do not mean that you can’t make money.
- They do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns.
- Market efficiency will not protect you from wrong choices if you do not diversify - you still don’t want to put all your eggs in one basket
Types of EMH
Strong form
Semistrong form
Weak form
Strong Form
-Prices reflect all info., including public and private.
* If the market is strong form efficient, then investors could not earn abnormal returns regardless of the info. they possessed.
* Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal returns.
What is private information?
1. Insider Information (illegal to trade on)
2. Privately obtained/analyzed
Semi Strong
- Prices reflect all publicly available info.
including trading information, annual reports, press releases, etc. - If the market is semistrong form efficient, then investors cannot earn abnormal returns by trading on public info.
- Implies that fundamental analysis will not lead to abnormal returns
Weak Form
- Prices reflect all past market information such as price and volume.
- If the market is weak form efficient, then investors cannot earn abnormal returns by trading on market information.
- Implies that technical analysis will not lead to abnormal returns, but fundamental research could work
- Empirical evidence indicates that markets are generally weak form efficient.
Summary of 3 forms
-Weak Form Efficiency – cannot win with past prices alone (Technical analysis won’t work)
-Semistrong Form Efficiency – cannot win with past prices and public info. (Fundamental and technical analysis won’t work)
-Strong Form Efficiency – cannot win with past prices, public info. and private information.
(Not even insider or unique information will work
Lessons for Investors
-Unless you have an edge trust that mkt price are close to correct
-Focus on fees don’t pay more for edge than add. return
-NPV can be zero, but you can still earn dis. rate and grow invest.
Lessons for Corporate managers
-focus on selecting and executing proj. with +NPV to create wealth. Corp. project are not efficient mkt.
-Avoid excessive focus on quarterly accounting results.
-Issue and repurchase equity and debt to
support corporate investment, not to ‘time the market’
disposition effect/ prospect theory
humans win small then ignore their losses
Momentum strategy
buying winners and selling losers
Value Strategy
They win by periodically rebuying cheaper earnings streams that get less cheap.
