BKM 11 Flashcards
Random walk
Stock price changes should be random and unpredictable
Efficient market hypothesis
The notion that stocks already reflect all available information
Weak-form hypothesis
Stock prices already reflect all information that can be derived by examining market trading data such as history of past prices, trading volume, or short interest.
Trend analysis is fruitless.
Semistrong-form hypothesis
All publicly available information regarding the prospects of a firm must be already reflected in a stock’s price
Strong-form hypothesis
Stock prices reflect all information relevant to the firm, even including information available only to company insiders.
Quite an extreme
Technical analysis
Search for recurrent and predictable patterns in stock prices
Resistance/support levels
Above which it is difficult for stock prices to rise, or below which it is unlikely for them to fall
Believed to be determined by market psychology
EMH and technical analysis
EMH implies technical analysis is without merit
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 and fundamental analysis
Most fundamental analysis is doomed to failure
Passive investment strategy
Makes no attempt to outsmart the market; proponents of EMH prefer this strategy as other efforts are wasted
Index fund
Fund designed to replicate performance of a broad-based index of stocks
Role for portfolio management in efficient market
Tailor portfolio to investor needs depending on factors such as age, tax bracket, aversion, etc.
Event study
Technique of empirical financial research that enables observers to assess the impact of a particular event on a firm’s stock price
Abnormal return (definition)
Difference between actual stock return and a benchmark
Abnormal return (formula)
e(t) = r(t) - a + br(M(t))
a = average rate of return with zero market return
Cumulative abnormal return
Sum of all abnormal returns over a given time period; event studies could be complicated due to leakage of information
SEC and availability of information
Dramatic increase in value with announcement date indicates these are indeed news to the market, not already reflected in the price
Three factors the imply EMH does not hold
Magnitude Issue
Selection Bias Issue
Lucky Event Issue
Magnitude issue
Small percentage increase could be large $-wise based on size of portfolio
Selection bias issue
Only investors who find an investment scheme that does not generate abnormal returns will report findings
Lucky event issue
Any bet on a stock is a coin toss, given EMH
Ex: Coin-flipper with 75% heads
Weak-form tests
Patterns in stock returns
Serial correlation
Tendency for stock returns to be related to past returns; positive over short horizons
Momentum effect
Good or bad recent performance of particular stocks continues over time; evidence of short- to intermediate-horizon price momentum in both aggregate and cross-sectional
Tests of long-horizon returns
Suggestions of pronounced negative long-term serial correlation in the performance of the aggregate market
Fads hypothesis
Stock market may overreact to relevant news
Reversal effect
Losers rebound and winners fade back
Stock market overreacts to relevant news
Market anomalies
P/E effect Small firm in January effect Neglected firm effect Liquidity effects Book-to-Market ratios Post-earnings announcement price drift
P/E effect
Low price-earnings ratio stocks have provided higher returns than high P/E portfolios;
Low P/E = higher expected returns, so returns are not properly adjusted for risk
Small-firm-in-January effect
Smaller-firm portfolios tend to be riskier;
Even when adjusted for risk (CAPM), still a consistent premium;
Concentrated in first 2 weeks of January
Neglected-firm effect
Information about smaller firms is less available; neglected firms might be expected to earn higher returns as compensation for risk associated with limited information
Liquidity effect
Small and less-analyzed stocks are less liquid; investors demand liquidity premium to invest in such stocks
Book-to-Market ratios
Ratio of book value of firm’s equity to market value of firm’s ratio; book-to-market ratio might serve as a proxy for a risk factor
Post-earnings announcement drift
Market adjusts to information only gradually, resulting in sustained period of abnormal returns
Insider transactions
To no avail; abnormal returns not of sufficient magnitude to overcome transaction costs
