Chap 9

Question 1

Investor Behavior and Security Prices

Answer 1

Overconfidence:

Self-attribution bias

Loss Aversion

Overreaction

Underreaction

Belief perseverance

Anchoring

Familiarity Bias

Question 2

Behavioral finance:

Answer 2

market participants make systematic mistakes when they invest, and those mistakes create persistent inefficiencies in the market

Question 3

Anchoring:

Answer 3

Individuals attempting to predict or estimate some unknown quantity place too much weight on information that they have at hand, even when that information is not particularly relevant.

Investors tend to predict faster (slower) sales growth when they know the past growth rate has been high (low).

Investors estimate future market returns anchored on the market’s recent past returns.

Question 4

Self-attribution bias (Investor Behavior)

Answer 4

Investors tend to take credit for successes and blame factors out of their control for failures.

These biases may cause investors to trade too often, leading to higher transaction costs and much lower returns.

Question 5

Loss Aversion (Investor Behavior)

Answer 5

the tendency to exhibit risk-averse behavior when confronting gains and risk-seeking behavior when confronting losses

Question 6

Efficient Markets Hypothesis (EMH):

Answer 6

stock prices (and prices in other financial markets) rapidly incorporate new information.

Investors should not expect to earn abnormal returns consistently.

Question 7

Breadth of the Market

Answer 7

Looks at number of stock prices that go up (advances) versus number of stock prices that go down (declines).

The number of advances and declines reflects the underlying sentiment of investors.

–The market is strong when advances outnumber declines.

–The market is weak when declines outnumber advances.

Data on advances and declines are widely available.

Question 8

Market Volume

Answer 8

Obvious reflection of the amount of investor interest in stocks.

Increasing volume during a rising market is a positive sign that the upward movement in stocks will continue.

When stocks have been moving up and volume begins to drop off, that may signal the end of the bull market.

Easy statistic to track; reported by numerous sources

Question 9

Momentum

Answer 9

tendency for stocks that have gone up recently to keep going up or the tendency for stocks that have gone down to continue going down

Question 10

Weak Form EMH:

Answer 10

Past data on stock prices are of no use in predicting future stock price changes.

Stock prices move at random

Investors should purchase a diversified portfolio and hold it

Question 11

Abnormal return (alpha):(formula)

Answer 11

Abnormal return (or alpha) = Actual return - Expected return

Question 12

Levels of the EMH

Answer 12

Weak Form EMH

Semi-Strong Form EMH

Strong Form EMH

Question 13

Market Anomalies’s effects : ((Size Effect)

Answer 13

Small firms tend to earn positive abnormal returns of as much as 5% to 6% per year.Small firms may offer higher returns than larger firms, even after adjusting for risk

Question 14

Short Interest

Answer 14

the number of shares of stocks sold short in the market at any point in time.

–The more stocks that are sold short, the higher the short interest

Question 15

New Highs-New Lows (Trading Rules)

Answer 15

Measures the difference between stocks reaching a 52-week high and stocks reaching a 52-week low.

A 10-day moving average is plotted on a graph to view trends.Used as a signal to buy or sell stocks.

Market is strong when highs outnumber lows.

Market is weak when lows outnumber highs.

Question 16

Representativeness:

Answer 16

cognitive biases that occur because people have difficulty thinking about randomness in outcomes.

Question 17

Odd-Lot Trading

Answer 17

Many small traders deal in transactions of fewer than 100 shares, or odd-lots

Question 18

Market Anomalies’s effects : (Calendar Effects)

Answer 18

Stock returns may be closely tied to the time of year or time of the week.

Example: January effect (the tendency of small-cap stocks to outperform large-cap stocks by an unusually wide margin in the month of January)

Question 19

Definition of Market Anomalies:

Answer 19

patterns observed in the market that seem inconsistent with the EMH.

Question 20

Efficient market:

Answer 20

a market that rapidly and fully incorporates new information.

Question 21

Overconfidence: (Investor Behavior)

Answer 21

Investors tend to be overconfident in their judgement or ability and this leads them to underestimate risks.

Question 22

Strong Form EMH:

Answer 22

There is no information, public or private, that allows investors to consistently earn abnormally high returns

Question 23

Random walk hypothesis:

Answer 23

the theory that stock price movements are largely unpredictable.

–Studies of stock price movements indicate that they do not move in neat patterns.

–This random pattern is a natural outcome of markets that are highly efficient and respond quickly to new information.

Question 24

Belief perseverance:

Answer 24

Investors tend to ignore information that conflicts with their existing beliefs.

Investors who believe a stock is good and purchase it may later tend to discount any signs of trouble.

In many cases they even avoid gathering new information for fear it will contradict their initial opinion.

Question 25

Narrow Framing:

Answer 25

investors tend to analyze a situation in isolation, while ignoring the larger context

Question 26

Confidence Index:

Answer 26

one measure that attempts to capture the tone of the market through bond returns.

–A ratio that reflects the spread between the average yield on high-grade corporate bonds relative to the yield on average- or intermediate-grade corporate bonds

Trend of “smart money” is revealed in the bond market before it shows up in the stock market.

–A rise in the confidence index today foreshadows a rise in the stock market

Question 27

Measuring the Market

Answer 27

The Confidence Index

Market Volume

Breadth of the Market

Short Interest

Odd-Lot Trading

Question 28

Short Interest interpretations:

Answer 28

Measure of Future Demand for Stock

Measure of Present Market Optimism or Pessimism

Question 29

Market technicians:

Answer 29

analysts who believe it is primarily supply and demand that drive stock prices and use a variety of mathematical equations and measures to assess the underlying condition of the market

Question 30

Technical analysis:

Answer 30

The practice of searching the historical record of stock prices and returns for patterns. If these patterns repeat, investors who know about them and can spot them early may have an opportunity to earn better-than-average returns.

Question 31

Familiarity Bias:

Answer 31

Investors buy stocks that are familiar to them without regard to whether the stocks are good buys or not.

May lead investors to hold underdiversified portfolios.

Question 32

Semi-strong Form EMH:

Answer 32

Investors cannot consistently earn abnormally high returns using publicly available information.

Any price anomalies are quickly discovered and the stock market adjusts

Question 33

Arbitrage: (in EMH)

Answer 33

type of transaction in which an investor simultaneously buys and sells the same asset at different prices to earn an instant, risk-free profit.

In the “real world” if price differences exist, arbitragers exploit those differences and through their buying and selling transactions push the prices closer together until no arbitrage opportunity remains

Question 34

Advance-Decline Line (Trading Rules)

Answer 34

Difference between stocks closing higher (advance) and stocks closing lower (decline) than previous day; difference plotted on a graph to view trends.

If the graph is rising, the advancing issues are dominating the declining issues and analysts conclude the market is strong.

Technicians use the A-D line as a signal to buy or sell stocks

Question 35

Market Anomalies’s effects :

Answer 35

Calendar Effects

Small-firm Effect (Size Effect):

Post Earnings Announcement Drift (or Momentum)

Question 36

Theory of contrary opinion:

Answer 36

uses the amount and type of odd-lot trading as an indicator of the current state of the market and pending changes

Assumes that small traders will do just the opposite of what should be done:

•Panic and sell when market is low.•Speculate and buy when market is high.

–When there is a significant difference between odd-lot purchases and sales, this can signal a bull or bear market is about to end

Question 37

Moving average:

Answer 37

mathematical procedure that records the average value of a series of prices, or other data, over time.

Smooths out a data series and make it easier to spot trends.

Computed over time periods of 10 to 200 days.

Plotting the stock price and the moving average line together helps technicians make buy and sell decisions about a stock

Question 38

The advance decline line (formula)

Answer 38

advance decline line = number of issues advancing - # of issues declining

Question 39

X days moving average (x=10)

Answer 39

= 1/10 €n pj (j=n-9)

= 1/10 (each daily price + …)

Question 40

To determine the best time to get into the market, many investor use :

Answer 40

Technical analysis

Question 41

Technical analysis consider the stock market to be weak when volume (______) in a rising market and (_______) during a decline market

Answer 41

1. Decrease

2. Increase

Question 42

The (_____) hypothesis holds that future price movements are unpredictable

Answer 42

Random walk

Question 43

Balance volume (formula)

Answer 43

OBV (t+1) = OBV t + total volume if price rose

OBV (t+1) = OBV t + total volume if price fell

Question 44

Conversion price formula

Answer 44

Conversion price formula = par value of convertible bond / convention ratio

Question 45

Accrued interest to be paid

Answer 45

= semiannual payments x (# of months held by seller / 6)