Lecture 2 (intro to behaviour finance market microstructure) Flashcards
What is an efficient market?
An efficient market is one that cannot be beaten and therefore implies holding the market index
What are the 4 reasons as to why prices are efficient
1) investors are rational, evaluating information probabilistically
2) prices settle at equilibrium
3) instantaneous price change only when new information arrives
4) prices follow a random walk and are non-random, do not trend
How does a stock move in RANDOM price movement?
Prices should move in step fashion
How does a stock move in NON-RANDOM price movement?
Prices should move in waves
Name 4 aspects that EMH implies
1) it should rule out the possibility of trading systems
2) No one should be able to consistency beat the market
3) No payoff for information gathering and processing
4) With no new info, prices should oscillate in random and unbiased fashion
Name 2 false notions of market efficiency
1) Price movements are random and at rational values at all times
2) No one can beat the market: however this has been proven otherwise by practitioners (ex: Warren Buffet)
Name one aspect under SEMI-STRONG form efficiency that is evidence in favour of EMH
Prices should neither overreact or under react to news, a security’s price adjusts quickly and accurately to news.
Name one aspect under WEAK form efficiency that is evidence in favour of EMH
Stale, past information already public should have no predictive power - TA fails and does not generate superior risk adjusted returns
Name one aspect under CAPM & APT risk factors that is evidence in favour of EMH
To challenge EMH it must be demonstrated that gains are excessive after adjusting for risk
What are the 3 critiques that can be made about EMH assumptions
1) investors are rational (prices adjust instantaneously, quickly to new info)
2) investors errors are uncorrelated (prices follow a RW & returns are normally distributed)
3) Arbitrage forces are possible (If valuations of irrational investors turn out to be biased, then arbitrage forces prices back to equilibrium)
What are some problems with the idea that assumption that investors are rational
-investors are not as rational as you they appear
-price adjustment to equilibrium can be gradual, can under and over react
-Investors departures from rationality: inaccurate risk assessments, they make behavioural mistakes, commit poor probability judgements.
What are some problems with the idea that assumption that investors errors are uncorrelated
-the assumption is contradicted by psychological research showing that investors tend to make similar errors and do not deviate from rationality randomly
-errors can be correlated: a bad buy often times leads to a bad sell, herding, follow the leader, “window dressing”, retail clients act irrationally
What are some problems with the idea that assumption that arbitrage forces are possible
-arbitrage activities are more limited then it seems
-Improper use of leverage
-lack of perfect substitute to hedge
-cannot always borrow securities at will for short sells
What are the 3 empirical challenges to EMH
1) Excessive price volatility
2) Predictability studies with stale/past info
3) Predictability studies with excess risk-adjusted returns
Describe excessive price volatility in the 3 empirical challenges to EMH
-Prices are more volatile than fundamentals warrant
-Some price movements cannot be explained by financial analysis
Describe predictability studies with excess risk-adjusted returns in the three empirical challenges to EMH
-Contradict the semi-strong EMH, which implies that no abnormal returns can be made by acting on publicly available technical and fundamental information
-Serveral studies have shown that excess risk adjusted returns are possible using past fundamental infromation
what is bridging the gap?
Empirical studies need to prove why TA works and explain why does EMT/RWT not always hold, hence the into of a new model called behavioural finance
What is behavioural finance analysis or (BA)
-The study of how psychology affects finance and investment decisions
-Explains why investors depart from full rationality using elements of cognitive psychology, economics and sociology
What are limits of arbitrage?
Lack of perfect substitutes
What is limits of rationality?
Inefficiencies will occur but under what circumstances? Human judgment errors
What are the 10 psychological factors, judgement & cognitive errors all investors make
1) Conservatism bias
2) Confirmation Bias
3) Anchoring
4) Optimism/overconfidence
5) Crime of small numbers
6) Imitative behaviour/herding
7) Mental accounting
8) Ponzi schemes/bubbles
9) Self attribution
10) Prospect theory
What is CONSERVATISM BIAS under the 10 psychological factors, judgement & cognitive errors all investors make
-Too little weight given new information
-Your prior beliefs are not modified as much as new information warrants. You conserve your prior beliefs
What is CONFIRMATION BIAS under the 10 psychological factors, judgement & cognitive errors all investors make
-An investor’s beliefs become more extreme over time
-Info that confirms the investors position is given more credence, contradictory info is not payed attention to.
What is ANCHORING under the 10 psychological factors, judgement & cognitive errors all investors make
-An individual inability to sway from initial estimates, forecasts, opinion, personal bias
-Investor picks his position and stays with it no matter what
-Anchoring is the biggest factor that leads to investment losses
What is OPTIMISM/OVERCONFIDENCE under the 10 psychological factors, judgement & cognitive errors all investors make
Investors are generally overconfident about the quality and precision of their knowledge
What is CRIME OF SMALL NUMBERS under the 10 psychological factors, judgement & cognitive errors all investors make
Using too small of a sample size to draw a conclusion resulting in two judgment errors
What is Gambler’s fallacy
occurrence of a positive streak does not alter the probability of the next event (ex: coin toss)
What is Clustering illusion
Misperception of order, when the outcomes are truly random, a few events in an ordinary streak in a random walk get interpreted from trend change
What is IMITATIVE BEHAVIOUR/HERDING under the 10 psychological factors, judgement & cognitive errors all investors make
-Looking at behaviour of others for cues and try to imitate their actions
What is information cascades
chain of imitative behaviour initiated by the (random) action of a few
How can feedback play a role in price systems
-Positive and negative feedback can have an impact on price
What is positive feedback
System output multiplied by a +ve number. This amplifies, snowballs, a system’s behaviour
-Positive stock gains lead to more positive gains as positive news feeds on itself (same can be said for price declines)
What is negative feedback
systmen output multiplies by a -ve number. This has a dampening effect it drives output back to equilibrium.
What is MENTAL ACCOUNTING under the 10 psychological factors, judgement & cognitive errors all investors make
-contributes to positive feedback
-thinking of money as if it belonged in separate accounts - which should be treated differently
What is PONZI SCHEMES/BUBBLES under the 10 psychological factors, judgement & cognitive errors all investors make
-Bubbles are naturally occurring Ponzi schemes, and also the stock market is naturally occurring Ponzi (fraud) scheme
What is SELF ATTRIBUTION under the 10 psychological factors, judgement & cognitive errors all investors make
-Attributing successful results to our own ability (we take credit for positive outcomes) unsuccessful results attributed to “bad luck” or blaming other stuff
What is PROSPECT THEORY under the 10 psychological factors, judgement & cognitive errors all investors make
-How investors value gains and losses differently.
-Not the same as anchoring
-Having two stocks deciding to sell the higher one thinking the lower one will go up
What is the conclusion of behavioural finance contentions?
EMH predicts that systematic price motion should not be observed, behavioural finance hypotheses do predict the occurrence of systematic price motion and tries to offer an explanation why
what are some (3) reasons as to why systematic price motion co-exist with efficiency?
1) possibility of price prediction does not necessarily imply that markets are inefficient
2) predictability is motivational
3) Different risk tolerances exist because participants are compensated with risk premium
What are the 4 types of risk premium in which investors are compensated with
1) equity risk premium: Returns above the risk free rate
2) hedge risk transfer premium premium: compensation of speculators versus commercial hedger for price risk
3) liquidity premium: higher returns for holding illiquid securities or providing liquidity
4) Information or price discovery premium: compensates investors for making buy and sell decisions that move prices to rational level
What is the MAIN POINT in systematic price motion co-existing with efficiency?
-TA signals may generate profit because they assume risk premiums that other investors wish to shed. Systematic price movements can be explained as a risk premium that can be exploited by TA
-Markets can be at times efficient and prices random and at other times be inefficient with predictable prices dependent on investors behaviour and cognitive errors
What are the 2 market micro structure stock exchanges in Canada
1) equity exchanges which are called “auction markets”
2) stock exchanges in canada called “TMX group”
What are auction markets
-Provide an organized and regulated environment for participants to trade securities
-this includes both traditional floor trading and electronic trading
-all trading activity is overseen by IIROC (industry regulators)
What is TMX groups
-Toronto stock exchange (TSX)
-Venture exchange (TSXV)
-Montreal exchange (MX)
What does an auction show?
it shows the “best price avaliable” at any given time
What is a BID price
the highest price people are willing to pay
What is a ASK price
the lowest someone is willing to sell at
What can the National Best Bid and Offer (NBBO) show
It shows the highest BID and lowest (ASK) for a security among all exchanges and market makers
What is a flaw of the NBBO
The data isn’t always up to date so investors may not get the prices they were anticipating upon trade execution, a concern for high-frequency investors
What is “market size”
indicates how many shares are available at the BID and ASK price
What is “market depth” or level 2 quote
indicates how many shares are available at each and every price hat is inferior to the BID and superior to the ASK
What are the 5 main types of orders
1) market order
2) limit order
3) stop selling order with stop limit
4) stop buy orders with stop limit
5) trailing stop order
What is market order
An order for immediate execution at the best available price. No price is specified. (ex: I want to buy tesla shares at the best price available)
What is limit order
-an order to buy or sell a security at a specified price. A better price may be obtained than the limit specified
What is stop sell (stop loss) order with stop limit
-an order to sell which becomes effective as a market order when the price trades at or below the “trigger” or stop loss price
-stop loss orders must be set a stop price BELOW the current market price
-a stop limit MUST now be used to set a LOWER boundary
What is stop buy (buy stop) order with stop limit
-an order to buy which becomes effective as a market order when the price trades at or above the “trigger” or stop buy price
-stop buy orders must always be above the current market price
-a stop limit MUST now be used to set the UPPER boundary max price
What is trailing stop order
-an order that adjusts and follows a stock price by a fixed dollar or percentage amount
What is the 4 special term orders
1) day order
2) good till cancelled
3) all or none
4) market on close (MOC)
What is a day order
-an order that is valid for that day only
What is good till cancelled
-an order that is valid until a pre-specified date
What is all or none
-an order that can be filled for the specific number of shares at a specific price. No partial fills
What is market on close (MOC)
-an order entered before the close of the exchange to trade at the closing price. This order becomes unmodifiable after this time
