Behavioural Finance

Question 1

What are the 3 different forms of market efficiency?

Answer 1

• weak form:prices reflect all past info (return)
• semi string form:prices reflect all past and publicly available info
• strong form efficiency:prices reflect all past, publicly available and private info

Question 2

What are the 3 assumptions of market efficiency?

Answer 2

• investors are rational
• they don’t make the same mistakes twice or follow the same biases
• even if they are irrational, arbitrageurs exist and exploit this to bring prices back to equilibrium

Question 3

What happens if the markets are inefficient? 3

Answer 3

• many investors must make irrational decisions
• the collective irrationality of these investors leads to optimistic or pessimistic market situations
• the situation is not corrected via arbitrage by rational investors

Question 4

What is behavioural finance?

Answer 4

The area of research that attempts to understand and explain how reasoning errors influence investor decision and market prices

Question 5

What are the 2 main foundations by Shleifer which behavioural finance is based on?

Answer 5

• deviations from market efficiency: limits to arbitrage, information imperfections
• investor psychology:heuristics and biases

Question 6

What are the 3 limits to arbitrage?

Answer 6

• fundamental risk:substitute securities are rarely perfect so it’s impossible to get rid of all fundamental risk(firm specific)
• noise trader risk:some information may not be relevant/meaningful. Worsening of misprision get could force arbitrageurs to liquidate early
• implementation costs and short sale constraints:might not have enough Shares to borrow when short selling or shares are too expensive

Question 7

Name 5 market anomalies

Answer 7

• calendar effect:firms perform better in January/returns are negative on Mondays
• small firm effect:small firms have higher risk adjusted returns that large
• post earnings announcement drift:abnormal share returns drift up/down for several months following news announcements
• value vs growth:high value stocks tend to outperform growth stocks
• momentum and reversal:stock prices go up in short term then they will go down in long term(opposite)

Question 8

What is price reaction to non information?

Answer 8

The same info can have different reactions at different times. E.g dot com bubble

Question 9

What are Fama’s views? 5

Answer 9

• market is efficient
• anomalies are chance results
• long term return anomalies are have results:they disappear if there are changes to the way they are measured
• long term return reversals are because of investor overreaction
• there is a random split between over/under reaction

Question 10

What are Barberis and Thaler’s views?

Answer 10

Prices don’t reflect fundamental risk

Question 11

What are schiller’s views? 4

Answer 11

• disagrees with fama
• excess market volatility anomaly:prices of stocks are made up of PV of all future dividends (all dividends should determine price)
• BUT prices are more volatile than dividends
• if market is efficient this shouldn’t happens

Question 12

What does efficient market hypothesis imply? 4

Answer 12

• price changes are random
• market prices are fair
• prices reflect all available info
• not possible to beat the market