Lecture 5&6

Question 1

What drives stock price?

Answer 1

• Finance and market-based accounting says only information should drive the share price
• However, non-information (sentiment) can also drive prices

Question 2

Why do we do fundamental analysis?

Answer 2

To identify misvalued securities for investment purposes. Difference between intrinsic value and current price

Question 3

Efficient Market Hypothesis (EMH)

Answer 3

• In an EM prices reflect all available information
• Price = Fundamental value of the firm
• No profitable investment opportunities from superior analysis
• No difference in performance between knowledge investors (professionals) and picking stocks randomly

Question 4

Speed of adjustment

Answer 4

Time it takes the market to fully incorporate the effect of new information

Question 5

When is a market efficient?

Answer 5

• When prices of securities traded in the market act as though they fully reflect all available information
• When prices react instantaneously in an unbiased fashion to new information

Question 6

Weak-form market efficiency

Answer 6

• Prices reflect the information contained in past stock prices
• There are no predictable patterns in (abnormal) returns

Question 7

Semi-strong market efficiency

Answer 7

• Prices reflect all publicly available information

Question 8

Strong form market efficiency

Answer 8

• Prices reflect all information both publicly and privately
• Insider trading is illegal

Question 9

Efficient Capital Markets

Answer 9

Precondition for security prices to reflect all information fully is that information and trading costs always equal zero

Question 10

Joint-hypothesis problem

Answer 10

• Market efficiency per se is not testable
• It must be tested with an “equilibrium” asset pricing model
• Anomalous evidence on market returns may reflect market inefficiency or a bad model (or both)

Question 11

Test of market efficiency

Answer 11

• Tests of return predictability
• Event studies
• Tests for private information

Question 12

Maximally rational market

Answer 12

All investors are rational

Question 13

Rational market

Answer 13

Investors may not be rational, but markets are rational

Question 14

Minimally rational markets

Answer 14

• Even if markets aren’t rational, no abnormal profit opportunities exist even for rational investors
• The vital importance of trading costs

Question 15

Rubinstein’s “Prime Directive” (Rubinstein, 2001)

Answer 15

“Explain asset prices by rational models. Only if all attempts fail, resort to irrational investor behaviour”

Question 16

Information Asymmetry

Answer 16

Different market participants have different information about the firm/product/service
- Leads to an inefficient market, market timing and wealth expropriation

Question 17

Signalling

Answer 17

A mechanism to reduce the effects of adverse selection
- Something to show that your product is high quality

Question 18

Adverse Selection

Answer 18

A market mechanism that leads to market collapse

Question 19

Market for lemons

Answer 19

When customers don’t know the true value of products and will happily pay an average price, the higher quality, more expensive products will not be bought causing those sellers to opt out of the market. This decreases the average willingness to pay resulting in lower quality products in the market

Question 20

A Signal and its Credibility

Answer 20

The more expensive a signal, the more credible
E.g.
- Dividend increase
- Credit ratings
- R&D expense

Question 21

Stock Market Anomalies

Answer 21

Trading strategies that violate the EMH
- Ability to earn positive abnormal returns systematically
Anomalies based on market under/overreaction to firm news
- Short-window and long-horizon event studies
Anomalies based on observable firm characteristics

Question 22

Some traditional Anomalies

Answer 22

• The size (small firm) effect
• The P/E anomaly
• The value (book/market) anomaly
• Price momentum (continuation of prior returns)
• Earnings momentum
• The accruals anomaly

Question 23

Key issues in fundamental analysis and stock market anomalies (Richardson, 2010)

Answer 23

• Need for credible alternative hypothesis
• Sound treatment of risk? The standard joint hypothesis criticism
• Transaction costs issues? Trading costs and other market frictions usually ignored
• Additivity issues. How does this new anomaly differ from existing one?

Question 24

A Caveat (Richardson, 2010)

Answer 24

When forecasting future stock returns it’s difficult to explain why stock prices in a highly competitive capital market are not efficient and why a given accounting attribute seems to be ignored by many individuals who have strong financial incentives to exploit any and all useful forecasting “information”

Question 25

Testing market efficiency - Event studies

Answer 25

• Identify the event of interest and the timing of the event - what’s the actual event date?
• Specify a benchmark or expected return for comparative non-event (normal) stock return behaviour
• Calculate abnormal returns around event date

Question 26

Benchmark Event studies models

Answer 26

1. The (single factor) market model
2. The cumulative abnormal return (CAR) Metric
3. The buy-and-hold abnormal return (BHAR) metric
4. Market adjusted return model
5. CAPM model

Question 27

Fama, 1970

Answer 27

Weak-form, semi-strong form and strong form market efficiency

Question 28

Fama, 1965

Answer 28

“In an efficient market, on the average, competition (among rational, profit-maximising participants) will cause the full effects of new information on intrinsic value to be reflected instantaneously in actual prices.”

Question 29

Fama, 1991

Answer 29

Efficient Capital Markets, The Joint-hypothesis problem, tests of market efficiency

Question 30

RAST, 2013

Answer 30

Report 333 publicly identified “anomalies” (“return predictive signals”) 1970 – 2010
- Many correlated