Chapter 1 Flashcards
- What are weak, semi-strong, and strong form market efficiency?
Weak form- all past information is full reflected, past info cant be used to predict future prices. So you cannot do technical analysis. Can do fundamental analysis.
Past+Public Semi-strong- all publicly available information is fully reflected you cannot do fundamental analysis but there is still some insider information which is of value
Past+Public+Insider Strong- all information pub or prvt is reflected in securities prices. Insider information is of no value
- Prices= fundamental/intrinsic value
- Pub info in prices
- Non reaction to non/insider info
- What is the joint hypothesis problem? Why is it important?
It refers to the issue that tests of market efficiency entail two hypotheses: markets are efficient, and a fair return model is accurate. Rejection could mean either the market is not efficient, the return model is faulty, or both, making it hard to pinpoint the exact issue.
- Mkts are efficient
- Returns can be calculated using an asset pricing model, CAPM
- http://www.e-m-h.org/joint.html
- If the efficiency test fails then it is either that the market is inefficient or capm fault results or both. We never know
- So as such market efficient can never be rejected
- Limits to arbitrage
Limits to arbitgae will stop rational investors from bringing back the prices to normal and violate the assumption of EMH;
If irrational strategies are correlated, smart investors will exploit attractive investment opportunities and bring prices back
The limit to arbitrage theory explains why the deviations in stock prices (mispricing) cannot simply be corrected by rational investors, at least not quickly
3 reasons:
i. Fundamental risk
a. An investor notices that Ford is underpriced so they buy it but are scared that one bad news can cause the stock to fall.
b. Then arbitrager can short another motor stock but stocks are hardly ever perfectly substitutable.
c. But the arbitrageur is vulneravle to firm specific bad news.
d. But Substitute even after exiting can be mispriced if industry is mispriced.
ii. Noise trader risk
a. Experienced and knowledagble traders can lose out in the market due to excess noise (misinformation ) in the market.
b. It cannot be diversified away and they cannot wait out this wave of misinformation asthey don’t have log horizons like professional money managers.
c. When the majority of market participants are noise traders and act together (herding behavior), they make the same systematic error at or around the same time. This increases mispricing and hence produces more risks to all the market participants as well as some risky opportunities (Shfrin, 2007). However, the risk factors and costs involved create a limit to arbitrage. Consequently, stock prices will not be corrected, at least not quickly.
iii. Implementation Costs
a. There are a lot of costs associated with trading:
Commission, bid ask spread, short sale constraints, borrowing fees. Legal constraints
b. So even if they try to find and learn about mispricing the costs are high
c. Forced liquidations means abritagurs have short horizons and cannt analysemuch
- What is earning announcement drift? Why is it considered to be market anomaly
Post announcement earnings drift is the tendency for a stock’s cumulative abnormal returns to drift in the direction of an earnings surprise for several weeks
The cumulative average excess return falls when there is a negative earnings surprise and vice versa.
There is a slower response to extreme earnings surprises as compared to average surprises.
So this is an anomaly because we can predict future returns based on past events because of the pattern of reaction/response.
- What are small firm effect and value premium? Why are they considered to be market anomaly?
Small firm effect is that smaller firms give better returns as compared to bigger firms. It was concentrated in January because of:
- What is momentum and reversal? Describe the typical patterns. Why are such patterns considered to be market anomalies?
Momentum stock- returns positively correlated with past returns
Reversal stock- returns negatively correlated with past returns
Such patterns are considered market anomalies because they challenge the efficient market hypothesis (EMH), which posits that asset prices fully reflect all available information and follow a random walk, making it impossible to consistently outperform the market. Momentum and reversal patterns suggest that past prices contain information that can be exploited to predict future price movements, contrary to the principles of EMH.
LONG TERM REVERSAL- Winner/Loser Effect, when winner and loser portfolios are analysed in the long run 3-5 years then there’s a reversal in their returns.
MEDIUM TERM MOMENTUM- there’s a positive return in the medium term when investing in winner portfolio
Following the (J,K) strategy of holding for K months the stocks that did best in the previous J months.
Horizon dependent correlations/patterns:
- Short term (one month): reversal
- Medium term (3-12 month): momentum
- Long term (3-5 years): reversal
- Explain the Royal Dutch/Shell case. Which of the three factors might limit the arbitrage and why (fundamental risk, noise trader risk, and implementation risk)?
Another example illustrating the limits to arbitrage is the historical deviation between the stock prices of Royal Dutch and Shell. Despite theoretical expectations, where a market-neutral strategy would converge the prices to a 6:4 ratio, the actual prices deviated persistently. The joint company was held 60% by Royal Ducth and 40% by Shell, so all sets of cashflows are effectively split then 60:40 but that wasn’t the case. This deviation suggests that noise trader risk, leading to short-term losses for investors attempting arbitrage, may have limited the effectiveness of arbitrage in correcting the prices.
d it shows that despite the fact that a misprice security has a perfect substitute, arbitrage was still limited because (i) arbitrageurs are risk averse and have short horizons and (ii) the noise trader risk is systematic, or the arbitrage requires specialized skills, or there are costs to learning about such opportunities
- Explain the S&P index inclusions case. Which of the three factors might limit the arbitrage and why (fundamental risk, noise trader risk, and implementation risk)?
Index effects stem from a stock’s addition to or deletion from prominent market indices
When yahoo added to S&P 500, its price jumped 24%and it was permanent. The share price changes even if the fundamentzldoesn’tt, so it is a mispricing.
Further literature also spoke about arbitrage is harder and riskier when the subsitutue stock was worse in return. It makes sense because purchasing another undervalued stocks with weak fundamentals wont make sense.
) find that during 1989-2000, a stock’s price would increase by an average 5.45% on the day of the announcement that the stock would be added to the index, and a further 3.45% from the announcement day to the day of the actual addition. Conversely, a stock’s price would decrease by an average 8.46% on the day of the announcement that the stock would be deleted from the index, and a further 5.97% from the announcement day to the deletion day. These effects are economically significant.
Fundamental risk (fundamentals don’t change but price changes/over/undervalued)
Noise trader risk (mispricing because of inclusion but no actual change in company)
- Explain the internet carve-outs case (3Com and Palm). Which of the 3 factors will limit abritarge?
3Com sold 5% of its wholly owned subsidiary Palm Inc. in an initial public offering, retaining ownership of the remaining 95%.
After the IPO, a shareholder of 3Com indirectly owned 1.5 shares of Palm.
So after selling 5% they also though of spinning off Palm (95%) and giving the 95% shareholders (3com shareholders) 1.5 share of Palm.
If rational investors
3com=1.5*Palm+residual value
After closing of IPO after 1st day,
Palm= 95 euro
3com= 81
Implied residual value= less than 0 , value of resididual 3com was -22 bn
3com mkt valuation – Palm= 60/share
Lower bound 3com=142
So we see that Palm is priced 95 but it is supposed to be say 50, then they want to short palm at 95 to buy back at 50, but the shorting was too high but there wasn’t enough Palm stocks to buy or very high borrowing rate which made the arbitrage limited and mispricing persitant. Only make sense if you had the shares.
Implementation cost
- What is joint hypothesis problem when testing market efficiencies? Are there any examples that we can circumvent this problem?
It involves the difficulty in distinguishing whether market inefficiencies arise from the market itself or from the models used to assess fair returns. Circumventing this problem involves developing models that precisely isolate market inefficiencies without relying on specific return models.
