Behavioural Finance Topic 4

Question 1

Random walk

Answer 1

Price changes are random and unpredictable, new information causes them to change
Random walk is a result of prices that always reflect current knowledge

Question 2

Efficient market hypothesisq

Answer 2

Stocks already reflect all available information

Question 3

3 degrees of efficiency

Answer 3

1. Weak form efficiency
2. Semi strong form efficiency
3. Strong form efficiency

Question 4

Weak form efficiency

Answer 4

The only information set is market trading data, eg prices, volumes,reported short interest

Question 5

Semi strong form efficiency

Answer 5

Prices impound both past prices and all other public information. Eg financial reports, other financial information released by firms, macroeconomic information, anything else publicly available that is relevant to the stock

Question 6

Strong form efficiency

Answer 6

This incorporates information from weak and semi strong forms, as well as an element of private or insider information. The insid with knowledge signals as soon as attempt to trade on it is made, so no abnormal profit results.w

Question 7

Implications of efficient market hypothesis

1. Technical analysis
2. Fundamental analysis

Answer 7

1. Technical analysis: bAsed on the idea that it is possible to discover patterns in price data which convey clear trading signals
2. Fundamental analysis: analysis of economic data about a firm and its environment in order to assess whether that firms stock is currently overpriced or underpriced.

Question 8

Active portfolio management

Answer 8

1. The attempt to earn abnormal returns on the basis of forecasts a out the future
2. Attempt to identify mispriced stocks and/or practice market timing or sector selection
3. If EMH is true for all stocks at all times any attempt at active management would fail

Question 9

Event study

Answer 9

Describes a technique of empirical financial research that enables the observer to assess the impact of a particular event on a stocks price. A technique for examining market reactions to and abnormal returns around specific information releases which may be value-relevant, eg macroeconomic announcements or firm specific announcements

Question 10

Measure the impact of an event by…

Answer 10

Estimating the abnormal return of the asset at the time the event becomes known to the market.
This can be impacted by leakage

Question 11

Cumulative abnormal return

Answer 11

The sum of all abnormal returns over the time period of interest. An attempt to cover leakage

Question 12

Issues in testing for market efficiency

Answer 12

1. Te magnitude of market efficiencies may be so small in terms of return (although large in terms of cashflows) that it may not be easy to observe.
2. The investment processes selected to be published may not include those that are profitable (and therefore retained as proprietary)
3. The publication of lucky events as skill can disguise the true level of efficiency

Question 13

Weak form tests

Answer 13

1. Momentum effect: good or bad recent performance of stocks or markets continues over an intermediate horizon.
2. Reversal effect: over long horizons the best performing stocks subsequently underperform, the reversal effect. The market overreacts to news. Should give rise to the contrarian investor.

Question 14

Weak form tests: Turn of year effect

Answer 14

January returns higher than December due to firms selling stocks in December to realize tax losses, then repurchase in January.
In Australia research suggests that’s
1. There is a pronounced January effect
2. It is driven by smaller firms
3. There is no overall July effect
Therefore tax loss selling is only a partial explanation of the turn of the year phenomenon

Question 15

Weak form tests: Weekend effect

Answer 15

Mondays tend to be a wearer return, though perhaps firms with bad news to report do so on a Friday, and mondaybis a response to the announcement

Question 16

Semi strong form test: P/E effect

Answer 16

Low PE stocks earn higher returns than higher PE stocks

Question 17

Positive serial correlation is…

Answer 17

Positive returns follow positive returns

Question 18

Negative serial correlation is…

Answer 18

Positive returns tend to follow negative returns

Question 19

Semi strong form tests also known as ……. Literature

Answer 19

Anomalies literature

Tests of semi strong form of the EMH

Question 20

Semi strong form test: small firm effect

Answer 20

Portfolios of small firms outperformed portfolios of large firms (Keim, 1983)
High excess return related to portfolio size rather than beta. Could be explained by:
1. Small firms are “neglected”, relatively little information about them, therefore risk is higher than that indicated by beta
2. Small firms tend to be low priced firms, so a small movement on the exchange can represent a large change for the firms
3. Short trading history, meaning market cannot yet accurately assess risk
4 excess returns on a small firm occur over the early part of January

Question 21

Strong form tests: inside information

Answer 21

Stock prices rise when insiders intensively buy, and stock prices fall when insiders intensively sell.
In the US trades by insiders are a matter of unlicensed record
In a strong form efficient market, any attempt to trade n the basis of inside information immediately communicates that information to the market preventing insiders from profiting from their private information
Empirical evidence suggests strong form does not hold - else insiders would not achieve abnormal returns

Question 22

Irrationalities: information processing

Answer 22

1. Forecasting errors (eg too much weight to recent events when forecasting)
2. Overconfidence
3. Conservatism (being slow in responding to news)
4. Representativeness (inferring a pattern from a small sample as if it is representative of the population

Question 23

Irrationalities: behavioral biases

Answer 23

1. Framing (choices are affected by the context in which the question is posed)
2. Mental accounting (considered a sub part of framing where we compartmentalise total portfolio and make decisions regarding separate components
3. Regret avoidance (unconventional decisions cause greater regret than more common investment choices)
4. Prospect theory, adds to the regular convex shape the utility models the possibility that there is also a decreasing impact on utility from incremental losses

Question 24

Technical Analysis and EMH

Answer 24

Technical analysis: involves search for recurrent and predicatable patterns in stock prices in order to enhance returns.
EMH suggests this is of no value because any information that was ever available forn analysing prices has already been reflected in the marekt price.

Question 25

Fundamental analysis and EMH

Answer 25

Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates and risk evaluation of the firm to determine proper stock prices.
EMH: no investor can earn excess returns from trading rules based on publicly available information. Only analysts with superior insight can achieve the highest returns.

Question 26

ole/responsibilities of portfolio managers in efficient market environment

Answer 26

1. identify risk/return objectives given investor constraints
2. tailoring portfolio to client needs - understand return requirements and risk tolerance
3. examine investors constraints, inluding liquidity, time horizon, laws and regulations, taxes and unique preferences and circumstances such as age and employment