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Markets and Financial Investments > Equilibrium in Financial Markets - Tests of Market Efficiency and Annomalies > Flashcards

Equilibrium in Financial Markets - Tests of Market Efficiency and Annomalies Flashcards

1
Q

What is an anomaly?

A

Is a cross-sectional and time series pattern in security returns not predicted by a particular asset pricing model - leads to a persistent and predictable realization of abnormal returns

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2
Q

What constitutes an abnormal return?

A

The difference between the actual returns of a security/portfolio and the expected return

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3
Q

What is an excess return?

A

Difference between the actual return of a security and the riskless rate

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4
Q

What are the 4 tests of market efficiency?

A

1 - Time series properties of price changes
2 - Market reaction to information events
3 - Cross-sectional and seasonal anomalies
4 - Evidence on insiders, analysts and investment managers

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5
Q

For the test of Time Series Properties of Price Changes, what is the general approach?

A

Assess if stock prices are predictable -> change in periods of hours or days and if provide information for future prices

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6
Q

For the test of Time Series Properties of Price Changes, what are the main conclusions of the serial correlation?

A

-correlation between prices changes in consecutive periods
-serial correlation of zero implies investors can learn about future prices from past ones
- positive serial correlation viewed as evidence of price momentum - positive returns more likely to follow positive returns
-negative serial correlation viewed as evidence of price reversals
- there can be serial correlation without any opportunity to earn abnormal returns

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7
Q

What is a filter rule?

A

an investor buys an investment if the price rises x% from the previous low and holds the investment until the price drops x% from a previous high

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8
Q

For the test of Time Series Properties of Price Changes, what concerns the technical analysis and filter rules?

A

Investigating patterns based on historical trading data to identify the future movements of stocks or the market
Resistence and support levels should not easily be crossed
Trading strategies are serially correlated and there is price momentum

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9
Q

For the test of Time Series Properties of Price Changes, how do run tests work?

A

They are non parametric tests based upon a count of the number of runs -> the actual number is compared with the expected, assuming price changes are random. If the actual number is higher, there is evidence of a negative correlation in price changes

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10
Q

For the test of Time Series Properties of Price Changes, and the study of price changes for different periods, how does it go in the short term?

A

periods up to a month - there is evidence of reversals in stock prices - if returns have been positive recently, in the following months returns are more than likely going to be negative

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11
Q

For the test of Time Series Properties of Price Changes, and the study of price changes for different periods, how does it go in the short/medium term?

A

Evidence that prices tend to move in the same direction over horizons of months and underreact to information - momentum effect - negatively related to the market capitalization

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12
Q

Where is the momentum effect more pronounced?

A

Among low-volume winners and high volume losers

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13
Q

What are some of the possible reasons of momentum effect?

A

-Slow information diffusion - markets don’t absorve information right away
-Investors may be slow to react to new information

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14
Q

What may cause the slow reaction from investors which may be one of the causes for the momentum effect?

A

1-overconfidence - investors will think their information is very valuable and tend to disregard public information
2-conservatism bias - don’t revise their expectations as frequent as thei should
3-interaction of two classes of agents who process information in different ways - news watchers vs momentum traders (buy past winners and sell past losers)
4-disposition effect - tendency to stick to loosers and sell winning stocks. This happens because if they are overconfident they don’t want to admit they made a mistake in the past
5-anchoring on past prices - and don’t update their views as much as they should

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15
Q

A study concluded that momentum profits depend on the state of the market - where do they tend to exist (when is it more favorable)?

A

When markets are in a tendency to increase - bull markets; also up markets and high volume stocks

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16
Q

Why is price momentum related to the uncertainty in information?

A

the more uncertain the information, the bigger the momentum effect is, because prices will take longer to absorve that information (related to the limitations in interpreting information)

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17
Q

A study found that national cultures are important to explain the momentum effect, why?

A
  • individualism is positively associated with momentum profits - if investors are less individualistic, they’ll put less weight on information they come up with, and more on the consensus of their peers
    -the higher the level of overconfidence in a country, the more impact the momentum effect will have
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18
Q

When do momentum crashes occur?

A

When there has been a market decline and so market volatility is high

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19
Q

What does the effect of investor sentiment has to do with momentum effect?

A

news that contradict investor’s sentiment causes cognitive dissonance, slowing the diffusion of signals that oppose the direction of sentiment. This causes underreaction to negative info under optimism and to positive pieces of info under pessimism

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20
Q

regarding momentum effect, past winners can be classified into which two different categories?

A

-unconstrained past-winner stocks - high past returns reflect positive fundamental value stocks - underreaction produces momentum
-constrained winners - high past returns reflect a sentiment/disagreement shock - competition among optimistic investors combined with short-sale restrictions lead to a rise in the price and when optimism wanes, prices fall leading to negative returns

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21
Q

Regarding the study of price changes in the long term what are the main conclusions taken?

A

We can see that there is evidence of price overreaction and mean reversion - past winners will underperform past loosers - they got overvalued and will return to the mean

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22
Q

The presence of momentum in the short/medium term and mean reversion in the long term are contradictory. How can we reconcile these two?

A

1) Behavioral models - conservatism and representativeness bias; overconfidence and self-attribution bias; existence of feedback traders and news watchers; and aversion effect
2)Momentum Life Cycle Hypothesis - low volume stocks have a very low search, so they are cheap. At a certain point they will call the atention of investors, getting a higher demand and will enter the stage of low volume winners. The price will increase, atracting more investors, increasing the volume of trading, entering the stage of high volume stocks. At a certain point, these stocks will be overvalued and will disapoint -> price will go down -> high volume loosers - a lot of investors trading those stocks, but with low return, and will end up again as low volume loosers

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22
Q

What are event studies?

A

A study on the market reaction to public information and the existence of abnormal returns after the disclosure of information - if the markets are efficient in the semistrong form - the price reaction must be instantaneous and not biased

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22
Q

What are the main evidence from earnings announcement studies?

A

-evidence of underreavtion to news -> positive excess returns after positive announcements and negative excess returns around negative announcements PEAD
-unexpected high returns outperform unexpectedly poor earnings
-evidences of insider trading
-timed earnings reports - time to process the information
-positive relation between PEAD and the level of individualism in a country

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23
Q

What are the main critiques of event studies?

A
  • long term event studies suffer from the joint hypothesis problem
  • short term event studies are only able to detect special forms of inefficiency
  • we can get false negatives
  • event study methods exhibit a bias toward detecting effects
    -event studies try to capture the linear impact of information when the market may be driven by the nonlinear processes
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23
Q

What regards the joint hypothesis problem?

A

We don’t know what model to use, if it’s the correct one

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24
Q

Emprirical evidence shows that there is a continuation of prices in the short term. They behave consistently with the underreaction to information in the short term. This underreaction manifests in what two ways?

A

1) underreaction to private information - price momentum - positive correlation between individual returns and the market as a whole
2) underreaction to public news events - abnormal returns in case of PEAD

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24
Q

What is a speculative bubble?

A

Refers to a situation where the market prices of financial assets are higher than their fundamental value. Normally they end in a crash, but the bubble can deflate bit by bit

24
Q

What are the main effects of speculative bubbles?

A

-Sharp variations in investors’ wealth (may loose a lot of value due to crashes)
-Loss of confidence in financial markets
-Misallocations of social resources with overinvestment in specific sectors
-Perverse incentives for corporate management and incentives for fraud

25
Q

What are the main causes of speculative bubbles?

A

1) Rational bubble models - investors buy stocks that they know are overvalued but they think another investor will buy them at an even higher price. They are rational in their own way
2) Behavioral models - like cognitive biases affecting investors; strengthening of positive feedback strategies (trend is your friend); limits to arbitrage
3) Macroeconomic credit models - bubbles usually follow expansionary monetary policies

25
Q

What is the goal of the cross-sectional and seasonal anomalies in testing market efficiency and anomalies?

A

To design portfolios containing stocks with specific characteristics in order to identify the features of the undervalued stocks and the overvalued stocks - buy the first and sell the seconds

25
Q

What are the types of cross sectional anomalies?

A

-Small firm effect
-Value effect

25
Q

What are the possible explanations for the small firm effect?

A

-trading costs to invest in small stocks are significantly higher than those that occur fo the largest stocks - premiums may be estimated without taking this into account
-CAPM may not be the best model to estimate the risk of small stocks because betas underestimate the their true risk
-investor’s sentiment -> smaller stocks are harder to value and may be more affected by sentiment factors

25
Q

What is the small firm effect?

A

Studies suggest that small firms have higher returns than larger firms with similar risk

26
Q

how does the small firm effect contradict the CAPM?

A

High betas tend to mean higher risk and higher returns, but looking at the small firm effect, we can see a negative relation between beta and stock returns after controlling for firm size

26
Q

What are growth stocks?

A

firms that tend to generate substantial cash flows and whose cash flows are expected to grow faster than those of the competitors

26
Q

What are value stocks?

A

firms with cyclical and traditional businesses with low prospects for earnings growth

27
Q

What is the value effect?

A

Studies show that value stocks systematically outperform growth stocks with the same level of risk

28
Q

What are some possible explanations for the value effect?

A

-Effect may result from taxation (higher on value stocks because of the higher dividend yield that has to be compensated by a higher return)
-CAPM doesn’t capture all the relevant risk factors
-> beta is a static factor
-> PBV may me correlated with the sensitivities of stocks to risk factors not captured by proxies for the market portfolio
-> a low PBV may be used as a measure of a nonobservable risk to the investors

28
Q

Counter-arguments suggest that value strategies are not fundamentally riskier than growth strategies. What does this suggest for conclusion in explanation of the value effect?

A

Value stocks are undervalued in the market, while growth stocks are overvalued

28
Q

What are the main behavioral explanations for value stocks?

A

-Noise traders models and the limits of arbitrage - noise traders drive prices away from their fundamental values and the arbitrageurs are not able to correct the market prices
-Representativeness bias and agency problems - too attached to recent events and believe good firms equal good investments

28
Q

Comparing dividend yield and beta, what can we conclude regarding stability?

A

The stocks with the highest dividend yield have a smaller beta wich indicates that they are more stable over market cycles

28
Q

How are value and momentum strategies correlates?

A

Negatively - the momentum effect tends to be stronger for growth stocks than value stocks

28
Q

How is volume related with momentum and value strategies?

A

Momentum strategies perform better among high stocks and value strategies perform better among low-volume stocks

29
Q

What are seasonal anomalies?

A

periods of time when returns tend to be significantly higher or lower

29
Q

What is the january effect?

A

A seasonal anomaly in which returns on stocks in january are higher than in other months (and tends to predict the return for the next 11 months)

29
Q

In which stocks do we tend to see a stronger january effect?

A

Small capitalization stocks - small-firm effect

29
Q

What is the December effect?

A

A seasonal anomaly related with the january effect, in which winner stocks present higher returns in december (not many investors selling winner stocks - price rises)

29
Q

What are the 5 possible causes of the January effect?

A

-tax-loss selling hypothesis - investors sell stocks in december then buy them back in january causing abnormal returns
-liquidity hypothesis - extra income, new money enters the market at the beggining of the year pressuring the prices up
-window-dressing hypothesis - ratio buy/sell decreases in the last days of the year and rises in the following months
-risk-based explanations (higher risk in january (explaining with market efficiency)
-behavioral explanations

30
Q

What are the causes of the December effect?

A
  • tax related selling - postpone the realization of capital gains and payment of taxes as much as possible
30
Q

What is the September effecrt?

A

Seasonal anomaly that says that september is the worst month of the year and maybe only monthe to have negative returns

30
Q

What are the possible causes of the september effect?

A

-May be related to the approach of winter and the depressing effect of rapidly shortening daylight (doesn’t explain it in the south)
-Family’s nedd to sell stocks in order to pay for their vacations and school expenses

30
Q

What is the day of the week effect?

A

Seasonal effect in which we observe different returns depending on the day of the week - monday worst and friday best - this has reversed in recent years

30
Q

What is the weekend effect?

A

Seasonal anomaly in which we observe the tendency os stocks to exhibit relatively large returns on fridays compared to mondays - affects more small stocks

30
Q

What are the 5 possible explanations for the weekend effect?

A

-Processing hypothesis - weekend gives time to process the information increasing or decreasing trading
-pattern of information flows - companies tend to announce bad new on fridays and during the weekends
-behavior of short sellers - nontrading hours introduce risk as short sellers are unable to trade
-Blue Monday hypothesis - investors are less optimistic on mondays
-microstructure of the markets - bid-ask bounce

30
Q

What is the Holiday effect?

A

seasonal anomaly in which we have abnormal stock returns before/after holidays

31
Q

What is the time of the month effect?

A

Seasonal anomaly in which we have differences between the first half and the last half of the month

31
Q

What is the last day of the month effect?

A

returns on the last day of each month have been strong

31
Q

What kind of seasonal anomalies do we have? (8)

A

-January effect
-December effect
-September effect
-Day-of-the-week effect
-Holiday effect
-Weekend effect
-Time of the month effect
-Las day of the month effect
-Turn of the month effect

31
Q

What is the turn of the month effect?

A

Patterns on the last days and the first days of any month

31
Q

What is the earnings announcement premium and dividend month premium?

A

Is the effect of stocks getting higher returns during months when earnings are announced than during non-announcement months

31
Q

What are the 2 significant seasonal anomalies in portugal?

A

-The pre-holiday effect
-The turn of the month effect

31
Q

If there are patterns and anomalies, how do investors not exploit these inefficiencies?

A

1) investors suffer from model risk and don’t know the nature of the anomalies
2) The exploit of inefficiencies is riskier
3) anomalies are enhanced by market-wide sentiment
4) investors may not consistentle follow any specific investment strategy
5) individual and institutional investors make systematic judgment errors

31
Q

Some scholars say that insider traders are able to beat the market without inside information. Then how?

A

They use public information very well

31
Q

What do investment analysts do?

A

They provide recomendations and price targets - have market timing and stock-picking abilities - positively biased

31
Q

What are the faces of analyst coverage?

A

1 - excessive analyst coverage raises investor optimism causing share prices to trade above fundamental value
2 - weak analyst coverage causes stocks to trade below

32
Q

What are investment managers?

A

Supposedly better informed and better overall investors

32
Q

Assuming that most funds underperform, why are the vast majority of mutual fund assets invested in actively managed funds?

A
  • investors are willing to accept poor average performances if mutual funds outperform in recessionary periods when marginal utility is high
  • retail investors are able to select the mutual funds that will perform better
    -some unsophisticated investors are ignorant of the underperformance

Markets and Financial Investments (7 decks)

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