Lecture 2

Question 1

What are the implications of efficient markets on valuation?

Answer 1

Any process of valuation becomes simply one of justifying the market price.

Question 2

What are the implications of inefficient markets on valuation?

Answer 2

The actual market price may deviate from the true value. Thus, the goal of valuation is to find a reasonable estimate of this true value.

Question 3

What is market efficiency?

Answer 3

A market is defined as efficient when the actual market price of an asset is an unbiased estimate of the true value of the asset.

Question 4

Does market efficiency imply that at each point in time the actual market price must be equal to the true value?

Answer 4

No. A market is efficient if all price errors are random (unbiased). Thus, deviations from the real values are possible as long as there is an equal chance that stocks are under or over-valued.

Question 5

At each point in time, which 3 things must hold to have efficient markets?

Answer 5

1) There is an equal chance of stock under/overvaluation. 2) The risk adjusted probabilties of up/down movements are equal. 3) Deviations are uncorrelcated with any observable variable.

Question 6

What kind of pattern best describes stock price movement?

Answer 6

Random walk with drift.

Question 7

What do we call the discount stock price/gain process and what does it mean?

Answer 7

A Martingale. It means a sequence of random variables whose conditional expectation is just the today value, hence is a definition of a fair game. Put simply, stock price reactions to news (bad or god) are with no delay.

Question 8

What does the equilibrium condition of financial markets state?

Answer 8

Excess returns (beyond a risk premium) are not predicatble. In other words, actual market prices embed all available information and they only change under new information arrival.

Question 9

Define the information set under each form of market efficiency.

Answer 9

Weak-form: IS includes only the history of the prices/returns. Semi-strong-form: IS includes all publicly available information known to all market participants. Strong-form: IS includes all information known to any market participant, this includes public and private (insider) information.

Question 10

What are the implications for trading under each form of market efficiency?

Answer 10

Weak-form; charts, statistical analysis and technical analysis won’t lead to a profit. Current prices reflect all past information. Semi-strong form: Fundamental analysis won’t lead to a profit. Current prices reflect all publicly available information. Strong-form: insider information won’t lead to a profit. Current prices reflect all public and private information.

Question 11

What is the main implication of full market efficiency?

Answer 11

The investor cannot consistently beat the market using a common investment strategy.

Question 12

What are 3 implications of efficient markets for active investment strategies?

Answer 12

1) Odds of finding a mispriced stock are 50/50 (random), equity research and stock valuation is a costly task with no benefits. 2) A strategy of randomly diversyfying across stocks or indexing to the market, carrying little or no information cost and minimal execution costs, would be superior to any other strategy that created larger information and execution costs. There is no value added by portfolio managers and investment strategists. 3) A strategy with minimum trading costs (creating a portfolio and not trading unless cash was needed) would always be superior to a strategy that requires frequent trading.

Question 13

What 3 things does the efficient market theory NOT imply?

Answer 13

1) Stock prices cannot deviate from true value (possible as long as they are random). 2) No investor will beat the market in any time period (prior to transaction costs and in any time period, approximately half of the investors should beat the market). 3) No group of investors will beat the market in the long term (again, probability theory suggests at least a half should, but due to luck).

Question 14

What moves markets toward higher/lower efficiency?

Answer 14

The actions of investors, sensing bargains and putting into effect different trading schemes trying to beat the market.

Question 15

What are the conditions for market efficiency?

Answer 15

1) Market inefficiency should provide the basis for a trading strategy to beat the market and earn excess returns. For this to hold true, the asset which is the source of inefficiency has to be freely traded. Transaction costs of executing the strategy need to be lower than the expected profits from the strategy. 2) There must be profit maximising investors who a) recognise and realise the potential of excess returns. b) can execute and replicate the trading strategy that beats the market and earns excess returns. c) have enough resources to keep trading until inefficiencly completely disappears (rational vs noise traders).

Question 16

What are the implications of the conditions for market efficiency?

Answer 16

1) The probability of finding inefficiencies in an asset market decreases as the ease of trading on the asset increases. 2) The probability of finding an inefficiceny in an asset market increases as the transactions and information cost of exploiting the inefficiecny increases. 3) The speed with which an inefficiency is resolved will be directly related to how easily the scheme to exploit the inefficiency can be constantly replicated by other investors.

Question 17

What type of investors will be more able to exploit small inefficiencies?

Answer 17

Investors who can establish a cost advantage (either in information collection or transaction costs). The higher the amount of these investors, the higher the efficiency of markets.

Question 18

What is the paradox of market efficiency?

Answer 18

To claim there is no possibility of beating the market in an efficient market, and then requiring profit-maximising investors to constantly seek out ways of beating the market and thus making it efficient. If markets were efficient, investors would stop looking for inefficiencies, which would lead to markets becoming inefficient again. An efficient market can be seen as a self-correcting mechaism, where infficiencies appear at irregular intervals.

Question 19

What is the idea that leads to possible empirical tests to check for the existence of market efficiency?

Answer 19

‘It is impossible to make economic profits by trading on the basis of the information set’. It means that abnormal returns should not be possibly made by trading on the information set.

Question 20

What are abnormal returns?

Answer 20

Abnormal returns = realised returns - normal returns. Where the realised returns are returns we observe in the market and normal returns (expected returns) are the reward for the risk of the investment and need to be estimated (we need a model, e.g. CAPM).

Question 21

What is the Efficient Market Hypothesis test (EMH)?

Answer 21

H0: E(ARt+1|It). That is, if using the information in the information set (It) the abnormal return is preditcable, than the hypothesis of market efficiency is rejected.

Question 22

Define the Join-Hypothesis Problem (JHP)?

Answer 22

A test of EMH contains a joint hypothesis: that markets are efficienct, and that we choose the right model for risk. Thus, the evidence of abnormal returns in a EMH can indicate that: markets are inefficient or that the model used to compute expected returns is wrong, or both!

Question 23

What are the 3 big categories of tests for market efficiency?

Answer 23

1) Tests for predictability = test for weak efficiency. 2) Event studies = test of semi-strong efficiency. 3) Test for private information = test of strong efficiency.

Question 24

What are the 2 types of tests for predictability?

Answer 24

1) Time-series predictability: can we forecast equity returns? If so, why? Information set is either past returns or other public information. 2) Cross-sectional predictability: why are returns of 2 stocks different? What are the characteristics (factors) driving these difference? Are there stock characteristics that allow us to predict different returns on different assets? This can be done by creating porftolios of firms possesing the selected factors and examining their returns over a given time period.

Question 25

What are the 7 steps of a test of predictability?

Answer 25

1) Define the variable on which the firms will be classified (e.g. size, B/M, momentum). 2) Collect the data on the variable for every firm in the defined universe at the start of the testing period. 3) Rank firms into portfolios based upon the variable. 4) Collect the returns for each firm in each portfolio for the testing period, and compute the returns for each portfolio. 5) Estimate the risk of each portfolio (single/multiple beta) by either taking the average of betas or regressing the portfolios return against market returns over a prior time period. 6) Compute the excess returns and standard errors earned by each portfolio. 7) Use statistical tests to check if the excess returns are different from zero. The extreme portfolios can be matched against each other to see whether they are statistically different.

Question 26

What is a common feature in stocks over the medium-long term?

Answer 26

Mean reversion. News is incorporated only slowly into prices, which tend to exhibit positive autocorrelations over the time horizon. Current good (bad) news have power in predicting positive (negative) returns in the future.

Question 27

What is a common feature in stocks over the shorter time periods?

Answer 27

Momentum. Securities that have had a long record of good news tend to become overpriced and have low average returns afterwards.

Question 28

Market anomalies represent the clash of two religions. Which 2?

Answer 28

They can be evidence against market efficiency. OR they can be risk-factors and markets are efficient. JHP prevents a clear answer to this.

Question 29

Define event studies based on a) time frames studied and b) information event types?

Answer 29

a) Shor-run event studies: a few days post information release. Long-run event studies: up to a year post informaiton release. b) Market-wide events (macro-economic announcements) or Firm Specific (earnings/dividends announcements).
The objective is to check if the event causes stock prices to move abnormally.

Question 30

Describe the 5 steps of an event study.

Answer 30

1) Define day ‘zero’ the day the information is released. 2) Calculate daily returns around day zero (e.g. for ±30 days prior and post the event). 3) For the event window calculate the market daily returns. 4) Define abnormal returns as the difference between the market daily returns and the expected returns (e.g. with CAPM). 5) Calculate average abnormal returns and standard errors earned by each portfolio over all N events in the sample and for all N reference days.

Question 31

The cumulative abnormal returns (CAR) on day 1 past information release can be? (4 scenarios)

Answer 31

1) If no news: AAR =0 2) Efficient reaction = stock price maintains its level post announcement at t=1. 3) Under-reaction = stock price drifts further up after the event at t=1. 4) Over-reaction = stock price drifts lower after the intital spike due to the event.

Question 32

Which statistic do we need to calculate to check for statistical significance of the abnormal returns? How do we do that?

Answer 32

T-statistic. Divide AAR with their STD and check its absolute value for statistical significant (t-stat above its critical value) with a given certainty level.

Question 33

What are the 2 important assumptions when doing an event study?

Answer 33

1) Whether to collect daily/weekly/longer/shorter interval returns around the event. The more precise, the more likely that shorter time intervals are needed. 2) How many days of returns after/before the announcement has to be considered as part fo the ‘event window’. The more precise the identification, the shorter the time window needed.

Question 34

What happens to the stock price of a company that announced the issuance of stock options? Why?

Answer 34

Stock price increases. Because options increase the available choices for investors and increase the flow of information to financial markets, which leads to lower stock price volatility. Countervailing force are speculators whih can increase stock price volatility.

Question 35

What happens to stock prices after stock splits? Why?

Answer 35

Stock prices increase. Because due to the split, the stock is more accessible to all investors. Interestingly, the price reaction happens before the announcement. But typically, information on stock splits is not available before the announcement date. Could it be due to insider information or selection bias?

Question 36

What happens to stock prices after earnings annoucements? Why?

Answer 36

There exists a pre-announcement drift (insider information?). This is a violation of strong form of ME). There is also a post-announcement drift. Due to under/over reaction to the new information (violation of semi-strong EM).

Question 37

What is the Grossman-Stiglitz Paradox?

Answer 37

In the case of strong-form efficiency: no one has an incentive to expend resources to gather information and trade on it. Reality is that many financial institutions spend money to collect information. If follows that markets cannot be strong-form informationally efficicent, since agents who collect costly informaiton have to be compensated with trading profits.

Question 38

When/for who does it make sense to collect costly information to trade on it?

Answer 38

For big companies and agents/investors who manage a lot of money.

Question 39

Do fund managers and big companies outperform the market?

Answer 39

On average no. Almost noone has been able to consitently outpeform the market.

Question 40

What is the conclusion of all the evidence presented for and against market efficiency?

Answer 40

Markets are efficiently inefficient.