Class 12: Market Efficiency

Question 1

What’s alpha in the stock market?

Answer 1

Alpha refers to excess returns earned on an investment above the benchmark return.

It’s the difference between what the stock actually returns (reality) and what’s expected to return (model).

α_i⇒α_Tesla | r_i⇒r_Tesla | β_i⇒β_{Tesla All this is for the same stock, in this case Tesla}

Question 2

If markets are efficient what’s the alpha?

Answer 2

If markets are efficient, meaning correctly priced, then ALPHA=0 . Think of it as NPV=0 . You can make money easily, but it’s more difficult to add value. Stocks with positive alpha is under-valued.

Question 3

What happens to a stock price with positive alpha? what’s the expected return on a stock with positive alpha?

Answer 3

POSITIVE ALPHA:

The stocks with expected return higher than the CAPM return, have a positive alpha (left of the CAPM line). With positive alpha, people buy, people go LONG. If people buy, then price goes UP, if price goes up then expected returns go DOWN. The expected return then goes back to the model, to the market price, so at that point alpha becomes zero again.

Question 3

When the price of a stock goes down… what happens to the expected return?

Answer 3

If a stock is undervalued, when the price is down, expected return goes UP

Question 4

What happens to a stock price with negative alpha? what’s the expected return on a stock with negative alpha?

Answer 4

NEGATIVE ALPHA= stock is overvalued:

The price goes up too much. The stocks with expected return lower than the CAPM return, have a negative alpha. They are overvalued, the price is high so people start shorting, the price then goes DOWN so the expected return then goes back UP. And over time the expected return goes back up to the model, and the alpha is zero again.

Question 5

What’s arbitrage?

Answer 5

It’s a riskless profit. Arbitrage is an investment strategy in which an investor simultaneously buys and sells an asset in different markets to take advantage of a price difference and generate a profit.

Two identical assets should trade at the same price, if that’s not the case then arbitrage. You long the cheap one and short the expensive one.