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CAS Exam 9 > BKM Chapter 11 > Flashcards

BKM Chapter 11 Flashcards

1
Q

Efficient market hypothesis (EMH)

BKM - 11

A

stock prices reflect all available information at a given point in time

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2
Q

Cause of stock price changes under EMH

BKM - 11

A

release of new information

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3
Q

Main consequence of EMH

BKM - 11

A

stock prices should follow a random walk (e.g. random & unpredictable)

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4
Q

Support for EMH

BKM - 11

A

competition b/w investment firms (to identify & exploit mispricing) leads to investors immediately bidding up or forcing down prices

> > suggests stock prices reflect nearly all available information

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5
Q

Difference between an efficient market and an efficient portfolio

(BKM - 11)

A

efficient market = information rapidly reflected in stock prices

efficient portfolio = highest expected return for a given level of risk

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6
Q

Forms of the EMH (3)

BKM - 11

A
  1. weak-form
  2. semistrong-form
  3. strong-form
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7
Q

Difference between forms of the EMH

BKM - 11

A

meaning of “all available information”

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8
Q

Weak-form EMH

BKM - 11

A

stock prices reflect all information that can be derived from historical data

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9
Q

Implication of the weak-form EMH

BKM - 11

A

trend analysis is not worthwhile

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10
Q

Types of data considered in weak-form EMH (3)

BKM - 11

A
  1. past stock prices
  2. trade volume
  3. short interest
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11
Q

Semistrong-form EMH

BKM - 11

A

stock prices reflect all publicly available information related to a firm’s prospects

*implies weak-form EMH

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12
Q

Types of data considered in semistrong-form EMH (6)

BKM - 11

A
  1. product lines
  2. quality of management
  3. balance sheet composition
  4. patents held
  5. earnings forecasts
  6. accounting practices
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13
Q

Strong-form EMH

BKM - 11

A

stock prices reflect all information relevant to a firm, including information only available to company insiders

*implies semistrong- and weak-form EMH

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14
Q

Common aspect of all forms of EMH

BKM - 11

A

prices should reflect available information

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15
Q

Technical analysis

BKM - 11

A

search for recurrent and predictable patterns in stock prices

*only works if stock prices are slow to respond to market forces of supply and demand

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16
Q

Technical analysis & efficient markets

BKM - 11

A

if markets are truly efficient, technical analysis will not work (b/c stock prices already reflect all available information)

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17
Q

Resistance levels in technical analysis

BKM - 11

A

values at which it is difficult for stock prices to rise above/fall below (driven by market psychology)

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18
Q

Self-destructing nature of price patterns

BKM - 11

A

once a useful price pattern is discovered, it is soon invalidated once it is exploited by many traders

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19
Q

Fundamental analysis

BKM - 11

A

using a firm’s earnings and dividend prospects + expectations of future interest rates to determine stock prices

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20
Q

Buy decisions in fundamental analysis

BKM - 11

A

if PV(future payments) > current stock price, then buy

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21
Q

Fundamental analysis & efficient markets

BKM - 11

A

under EMH, fundamental analysis will not work since it relies on publicly available information and it is unlikely for evaluations to be significantly different b/w competing firms

22
Q

Critical element of success for firms in fundamental analysis

(BKM - 11)

A

superior firm analysis relative to other firms (e.g. more accurate projections)

23
Q

Are small investors better off using active or passive portfolio management?

(BKM - 11)

A

passive strategy

24
Q

Advantage of using index funds in a passive strategy

BKM - 11

A

minimizes trading costs/management fees

25
Q

Reasons portfolio management is still necessary in an efficient market (3)

(BKM - 11)

A
  1. portfolio must be well-diversified to eliminate firm-specific risk (select stocks that provide strong diversification)
  2. optimal securities depend on the tax bracket of the investor (preferences for low-yield, tax-exempt bonds to minimize taxes)
  3. must consider the risk profile of the individual investor (e.g. age or other sources of income)
26
Q

Event study

BKM - 11

A

method to measure the impact of an event/release of new information on stock prices

27
Q

Steps in an event study (2)

BKM - 11

A
  1. find a benchmark return to represent what the stock price would have been in the absence of the event
  2. calculate the abnormal return due to the event
28
Q

Possible benchmark returns for an event study (3)

BKM - 11

A
  1. broad market index (e.g. S&P 500)
  2. narrow broad index down to firms of similar size, beta, etc.
  3. use an asset pricing model to estimate an expected ROR (e.g. CAPM)
29
Q

Estimating alpha and beta with event studies

BKM - 11

A

should be estimated using data sufficiently separated in time from the event so they are not impacted by event-period abnormal performance

30
Q

Impact of information leakage on an event study

BKM - 11

A

flawed event stud because it does not recognize the change in prices ahead of the event caused by leakage

31
Q

Cumulative abnormal return (CAR)

BKM - 11

A

sum of all abnormal returns over the period where the market is responding to new information

(captures the impact of the event + information leakage)

32
Q

Common uses for event studies (2)

BKM - 11

A

used:
1. by the SEC to assess violation of insider trading or other securities laws

  1. in fraud cases to assess damages
33
Q

Issues that make it challenging to determine if markets are truly efficient (3)

(BKM - 11)

A
  1. magnitude issue
  2. selection bias issue
  3. lucky event issue
34
Q

Magnitude issue in determining if markets are efficient

BKM - 11

A

small increases in performance are difficult to detect against market fluctuations

35
Q

Selection bias issue in determining if markets are efficient

(BKM - 11)

A

more likely to observe failed techniques because investors who can consistently beat the market would not publicize their techniques

36
Q

Lucky event issue in determining if markets are efficient

BKM - 11

A

luck of an individual investor winning more or less frequently than would be implied by the average results

37
Q

Tests of weak-form EMH & conclusions (2)

BKM - 11

A
  1. patterns in stock returns - short-term momentum (representing market over-reaction) followed by long-term reversals (representing correction of past errors)
  2. predictors of broad market returns - more likely predictors such as dividend yield are proxies for changes in market risk premium

(alternative interpretation to #1 could be that market risk premiums are changing over time)

38
Q

Serial correlation of stock returns

BKM - 11

A

measures correlation of consecutive return periods

positive serial correlation: positive returns tend to follow positive returns

39
Q

Market anomalies

BKM - 11

A

easily accessible statistics that seem to predict abnormal risk-adjusted returns

40
Q

Tests of semistrong-form EMH

BKM - 11

A

studies of efficient market anomalies

41
Q

Disadvantages of evaluating risk-adjusted returns

BKM - 11

A

actually evaluating 2 things:

  1. the EMH
  2. the risk adjustment procedure used
42
Q

Market anomalies associated with semistrong-form EMH (5)

BKM - 11

A
  1. small-firm effect
  2. neglected firm effect
  3. liquidity effect
  4. book-to-market ratios
  5. post-earnings-announcement price drift
43
Q

Small firm effect market anomaly

BKM - 11

A

smaller firms (= low market capitalization) produce higher returns than larger firms even after risk adjustment

44
Q

Neglected firm effect market anomaly & explanation

BKM - 11

A

smaller firms ignored by investment firms have higher returns

> > explanation: lack of information can be seen as a form of risk premium

45
Q

Liquidity effect market anomaly & explanation

BKM - 11

A

small/neglected firms tend to have less liquid stocks

> > explanation: lack of liquidity can be a form of risk premium

46
Q

Book-to-market effect market anomaly & potential explanations (2)

(BKM - 11)

A

firms with high book-to-market ratios have higher returns

> > explanations:
1. high book-to-market firms are relatively under-priced

  1. book-to-market is a proxy for a risk factor impacting market returns
47
Q

Post-earnings-announcement price drift market anomaly

BKM - 11

A

abnormal returns continue to rise/fall gradually after the announcement (which should not happen in an efficient market)

48
Q

Strong-form tests of EMH (3)

BKM - 11

A
  1. whether outsiders can profit following insiders’ trades
  2. market anomalies & data mining
  3. market bubbles
49
Q

Different interpretations for market anomalies (2)

BKM - 11

A
  1. effects are related to risk premiums rather than market inefficiencies (e.g. proxies for risk factors)
  2. market inefficiencies: investment analysts extrapolate past performance leading to over/under pricing and prices eventually self-correct
50
Q

Argument that market anomalies are related to data mining

BKM - 11

A

false patterns appear to show predictive power that isn’t really there

51
Q

Possible explanations for stock price increases following changes in market analyst recommendations (2)

(BKM - 11)

A
  1. analysts have unique insights and are revealing new information when upgrading a stock
  2. demand increases because of the upgrade (stock price change is driven by demand not new information)
52
Q

Better indicator of skill in managing funds compared to alphas & rationale

(BKM - 11)

A

increase in amount of funds under management - skilled mutual fund managers attract new funds and the cost of managing those funds drives alphas to 0

CAS Exam 9 (26 decks)

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