EMH and EPP

Question 1

Thaler (1999)

Answer 1

Evidence that should worry Efficient market advocates: Volume, Volatility, Dividends, Equity Premium Puzzle, Predictability

Question 2

Thaler (1999)

Answer 2

Conclusion: We can enrich our understanding of financial markets by adding a human element.

Question 3

Thaler (1999)

Answer 3

The end of Behavioural finance: He predicts in the not too distant future the term ‘behavioural finance’ will be correctly viewed as a redundant phrase.

Question 4

Samuelson (1965)

Answer 4

Stock prices should follow a random walk for an efficient market if rational competitive investors require a fixed rate of return. (EMH)

Question 5

Fama (1970)

Answer 5

Argues that in an efficient market prices reflect all there is to know about a capital asset.

Question 6

Sharpe, Lintner, Black

Answer 6

CAPM provides a route for testing the EMH.

Question 7

Michael Jensen (1978)

Answer 7

“the efficient market hypothesis is the best established fact in all of social sciences”

Question 8

Shiller (1981)

Answer 8

Aggregate stock prices appear to move much more then can be justified by changes in intrinsic value - stock market volatility to be far greater than can be justified by changes in dividends.

Question 9

De-Bondt and Thaler (1985)

Answer 9

For each year from 1933 portfolios are formed of the best and worst performing stocks over the previous three years. EMH suggests both portfolios will perform equally well on average. (Long-Run Reversion)

Question 10

Kamstra, Kramer and Levy (2000)

Answer 10

Changes in Daylight Savings Time

Question 11

Banz (1981) and Reinganum (1981)

Answer 11

Evidence that the CAPM
- Understates cross-sectional average returns of NYSE and AMEX listed firms.
- Overstates those of firms with high market values of equity.
- Effect concentrated in January
Both effects, however, now seem to have disappeared.

Question 12

October 19th 1987

Answer 12

Doubts about EMH - S&P 500 falls by 22.6%

Question 13

Cutler et al (1991)

Answer 13

Examine the 50 largest one day stock price movements in the US after WW2- most occurred on days with no major announcements

Question 14

Roll (1984)

Answer 14

Orange juice futures

Question 15

Fama (1998)

Answer 15

Argues against behavioural finance,

Question 16

Thaler (1999)

Answer 16

Argues against behavioural finance - it will soon die out.

Question 17

Kahneman and Tversky (1979)

Answer 17

Paper represents a critique of expected utility theory as a descriptive model of decision making under risk, and develops an alternative model, called prospect theory.

Question 18

Kahneman and Tversky (1979)

Answer 18

Several classes of choice problems in which preferences systematically violate the axioms of EUT. Certainty Effect, Reflective Effect, Isolation Effect

Question 19

De Bondt (1998)

Answer 19

Behaviour of small investors who manage their own equity portfolios.

Question 20

De Bondt (1998)

Answer 20

Many people:

1) Discover naive patterns in past price movements
2) Share popular models of value
3) are not properly diversified
4) Trade in suboptimal ways

Question 21

De Bondt (1998)

Answer 21

Four Classes of Anomalies

1) investors perception of the stochastic process of asset prices
2) investors perception of value
3) the management of risk and return
4) Trading practices

Question 22

De Bondt (1998)

Answer 22

Popular methods of spotting trends and turning points in stock prices; average rules, trading range break rules, filter rules.

Question 23

De Bondt (1998)

Answer 23

Why does it matter if small investors do not behave as expected.

1) substandard financial management directly effects peoples well being.
2) Investors behaviour likely affects what happens in markets.

Question 24

Mehra and Prescott (1985)

Answer 24

Examine how large the risk aversion parameter, a, needs to be to explain the observed equity premium.

• They find that to account for the observed equity premium the risk aversion parameter needs to be in the range of 30-40
• Use the Expected Utility representation of the investment decision. There is an option to try and alternative decision-making model - Prospect Theory.

Question 25

Arrow (1971)

Answer 25

Empirical estimates of (a) are in the neighbourhood of 1-2.
- Arrow argues on theoretical grounds that a “must hover around 1, being , if anything , somewhat less for low wealths and somewhat higher for high wealths.

Question 26

Benartzi and Thaler (1995)

Answer 26

Myopic Loss Aversion - The less regularly people monitor their portfolio the more equity they will hold.

Question 27

Thaler et al. (1997)

Answer 27

Support for myopic loss aversion comes from an experiment by Thaler et al (1997). The subjects have to divide an investment between two funds

• Fund A: behaves like bonds
• Fund B: behaves like equity (and does better on average)

Subjects allocate month by month , others annually, others 5 year time frame.

Question 28

Thaler et al. (1997)

Answer 28

Also tests for loss aversion. They run a condition called “inflated monthly”
In this condition they increase the level of returns (holding the variance constant) to eliminate the possibility of losses.
Under loss avers, this should increase willingness to take risk, so less should be invested int eh bond fund.

This prediction is borne out.

Question 29

Eugena Fama

Answer 29

Extreme risk aversion: “a large equity premium is not necessarily a puzzle; high risk aversion may be a fact. roughy speaking, a large equity premium says that consumers are extremely avers to small negative consumption shocks. This is inline with the perception that consumers live in morbid fear of recessions even though, at least in the pos war period, recessions are associated with small changes in consumption.