Lecture 8

Question 1

Abnormal return

Answer 1

An abnormal return is a term used to describe the returns generated by a given security or portfolio over a period of time that is different from the expected rate of return. The expected rate of return is the estimated return based on an asset pricing model, using a long run historical average or multiple valuation.

Question 2

Market efficiency

Answer 2

a market is said to be efficient if one cannot achieve significant abnormal returns.

Market efficiency was developed in 1970 by economist Eugene Fama, whose theory of efficient market hypothesis (EMH) stated it is not possible for an investor to outperform the market because all available information is already built into all stock prices. Investors who agree with this statement tend to buy index funds that track overall market performance and are proponents of passive portfolio management.

Question 3

Three forms of market efficiency, depending on information set:

Answer 3

• Weak form
• Semi-strong form
• Strong form

Question 4

The weak form of market efficiency

Answer 4

Weak form efficiency, also known as the random walk theory, states that future securities’ prices are random and not influenced by past events. Advocates of weak form efficiency believe all current information is reflected in stock prices and past information has no relationship with current market prices.

A market is weak-form efficient if we cannot achieve abnormal returns by using information contained in past prices/returns.

Question 5

The semi-strong form of market efficiency

Answer 5

Semi-strong form efficiency is a class of EMH (Efficient Market Hypothesis) that implies all public information is calculated into a stock’s current share price, meaning neither fundamental nor technical analysis can be used to achieve superior gains. This class of EMH suggests only information not publicly available can benefit investors seeking to earn abnormal returnson investments. All other information is accounted for in the stock’s price and no amount of fundamental or technical analysis achieves superior returns.

Question 6

The strong form of market efficiency

Answer 6

Practitioners of strong form efficiency believe that not even insider information can give an investor an advantage. This degree of market efficiency implies that profits exceeding normal returns cannot be made, regardless of the amount of research or information investors have access to.

Question 7

Behavioral finance

Answer 7

A field of finance that proposes psychology-based theories to explain stock market anomalies such as severe rises or falls in stock price. Within behavioral finance, it is assumed the information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes.

Question 8

Limits of arbitrage

Answer 8

• Arbitrage strategies can be (very) risky.
• Sophisticated investors may face constraints (e.g., capital constraints, short sale constraints) that prevent them to completely eliminate abnormal returns.
• Calling a bubble too early may result in losses and fund outflows — better ride the bubble with others than be contrarian alone.

Question 9

Fuller and Thaler Asset Management — how they use behavioral finance

Answer 9

“Investors make mental mistakes. F&T’s objective is to exploit them. Our investment approach applies insights from some of the foremost scholars in behavioral finance to identify these opportunities and gain a competitive edge over the market.”

Question 10

Tests of the weak form

Answer 10

• Serial correlations.
• Momentum and Reversal

Question 11

Tests of the semi-strong form

Answer 11

• Event studies: Price reactions to company announcements.
• The Value Premium.
• Performance of mutual funds.

Question 12

Serial correlations and weak form:

Answer 12

One particular test of the weak form is to check whether returns exhibit serial correlation (or “auto-correlation”). If they do, then price changes can be predicted using past prices.

Question 13

Momentum investing

Answer 13

Momentum investing is an investment strategy that aims to capitalize on the continuance of existing trends in the market. To participate in momentum investing, a trader takes a long position in an asset that has shown an upward trending price, or the trader short-sells a security that has been in a downtrend. The basic idea is that once a trend is established, it is more likely to continue in that direction than to move against the trend.

Question 14

Contrarian investing

Answer 14

Question 15

Post-earnings-announcement drift

Answer 15

the tendency for a stock’s cumulative abnormal returns to drift in the direction of an earnings surprise for several weeks (even several months) following an earnings announcement.

Question 16

Value premium

Answer 16

refers to the greater risk-adjusted return of value stocks over growth stocks. Yet value stocks typically have lower beta. Hence, a long-short zero-cost strategy consisting in buying value stocks and selling growth stocks delivers profits that cannot be explained by CAPM.

Question 17

Value stock definition

Answer 17

A value stock is a stock that tends to trade at a lower price relative to its fundamentals (e.g., dividends, earnings and sales) and thus considered undervalued by a value investor. Common characteristics of such stocks include a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio. An easy way to attempt to find value stocks is to use the “Dogs of the Dow” investing strategy by purchasing the 10 highest dividend-yielding stocks on the Dow Jones at the beginning of each year and adjusting the portfolio every year thereafter.

Question 18

Growth stock definition

Answer 18

A growth stock is a share in a company whose earnings are expected to grow at an above-average rate relative to the market.

A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects. Growth investors choose stocks based on the potential for capital gains, not dividend income, so they can be risky.

Question 19

Mutual funds

Answer 19

• Mutual funds are sophisticated investors, who have access to publicly available information.
• A simple test of the semi-strong form is whether mutual funds can achieve abnormal returns.
• The evidence suggests that they don’t.

Question 20

Summary of statistical evidence regarding weak- and semi-strong forms

Answer 20

Question 21

When assessing a trading strategy, one needs to bear in mind two important issues:

Answer 21

• Data mining/Hindsight bias: Does the trading strategy work only for the data base on which it was constructed?
• Transaction costs: Are the abnormal returns adjusted for transaction costs?

Question 22

Backtesting

Answer 22

the process of testing a trading strategy on relevant historical data to ensure its viability before the trader risks any actual capital. A trader can simulate the trading of a strategy over an appropriate period of time and analyze the results for the levels of profitability and risk.

Question 23

Transaction costs

Answer 23

In a financial sense, transaction costs include brokers’ commissions and spreads, which are the differences between the price the dealer paid for a security and the price the buyer pays.