Lesson 6

Question 1

6.1.1 Explain the premise of EMH

Answer 1

Efficient market hypothesis is an investment theory that states it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.

Believers argue it is pointless to search for undervalued stocks or try to predict trends in the market through either fundamental or technical analysis

Question 2

6.1.2 Describe the assumption about available information that underpins EMH

Answer 2

EMH assumes that the market is efficient with respect to some information, if that information is not useful in earning a positive access return.

The emphasis is on with respect to some particular information. The question of whether in market is efficient with meaning for only relative to some type of information.

Three types of information sets are of interest in the context of market efficiency and they are nested. That is the information in the strong information set includes the information in the semi strong information set which in turn includes the information in the weak information set.

Question 3

6.1.3.a Discuss the weak form of EMH in terms of information sets

Answer 3

The weak form of EMH asserts that the stock prices already affect all information that could be driving by examining market trading data, such as the history of past prices and trading volume. Past stock price data are publicly available and virtually cost us to obtain.

The week form hypothesis hold that if such data ever conveyed reliable signals about future performance, all investors would have learned already to exploit the signals. Ultimately the signals lose their value as they become widely known

Question 4

6.1.3.b Discuss the semistrong form of EMH in terms of information sets

Answer 4

The semi strong form of EMH asserts that all publicly available information regarding the prospects of a company must be reflected already in the stock price.

Such information includes, in addition to past price history, fundamental data on the company’s product, quality of management, balance sheet composition, earnings forecasts and accounting practices.

The premise is the same as that for the weak form if any investor has access to such information from publicly available sources one would expect it to be reflected in stock prices

Question 5

6.1.3.c Discuss the strong form of EMH in terms of information sets

Answer 5

The strong form of EMH asserts that stock prices reflect all information relevant to the company, including information available only to company insiders.

This version of the hypothesis is quite extreme. If you would argue the notion that corporate officers have access to pertinent information long enough before public release to enable them to profit from trading on that information.

These insiders, their relatives and any associates a trade on information supplied by insiders are considered in violation of the law. However defining insider trading is not always easy and stock analysts are in the business of uncovering information not already widely known to market participants

Question 6

6.1.4 Describe the two key implications of EMH for investors

Answer 6

1. It implies that security prices properly reflect whatever information is available to investors. The driving force behind market efficiency are simply competition and profit
2. The second is implication is that active traders will find it difficult to outperform passive strategies.

Out performance of passive strategies requires differential or divergent insight by traders which is very hard to come by in a highly competitive financial market. Investors constantly try to identify superior performing investments this constant appraisal and subsequent trading activity asked to ensure the prices never differ much from their efficient market price.

Question 7

6.1.5 Describe the essence of the conflict between EMH and technical analysis

Answer 7

The essence of the conflict between EMH a technical analysis lies in both the weak form and semi strong forms of EMH.

EMH follows from the idea that rational, profit seeking investors will act on new information so quickly that prices will nearly always reflect on publicly available information.

Technical analysis, on the other hand asserts the existence of long lived trends that play out slowly and predictably. Such patterns if they exist would violate the EMH notion of essentially unpredictable stock price changes

Question 8

6.2.1 Explain the significance of financial market anomalies for investors

Answer 8

Financial market anomalies are patterns of security returns that seem to contradict EMH; they are types of predictable continuing trends and security returns that ought to be impossible in an efficient market.

Several explanations have been offered but many anomalies have no conclusive explanations. Some occur once and then disappear while others are consistently observed.

An anomalies are generally small and that they do not involve many dollars relative the size of the market and they tend to disappear when discovered. Anomalies are not easily used as a basis for trading strategy

Question 9

6.2.2.a Describe the market anomaly known as the P/E effect

Answer 9

The price to earnings ratio is widely followed by investors and used in stock a valuations. Because it is publicly available information according to EMH it should already be reflected in stock price.

However purchasing stocks with relatively low price to earnings ratio’s appears to be potentially profitable as an investment strategy. Researchers have found that on average returns of stocks with low price to earning ratios are higher than stocks with high priced earning ratios even after adjusting for risk

Question 10

6.2.2.b Describe the market anomaly known as the size or small firm effect

Answer 10

This effect is measured using annual historical performance of 10 portfolios that are created by dividing the New York Stock Exchange stocks into 10 portfolios according to market capitalization

Researchers have found that average annual returns are consistently higher on small market capitalization firms. The small firm fact is logical in the sense that affirms economic growth is ultimately the driving force behind the stocks performance the premise is that smaller firms of higher rate of growth opportunities than larger companies

Question 11

6.2.2.c Describe the market anomaly known as the neglected firm effect

Answer 11

This effect explains the tenancy for certain lesser known companies to perform better known companies.

It is measured by looking at the annual performance of portfolios created by dividing companies into three portfolios [highly researched, moderately researched and neglected] based on the number of large institutions holding the stock.

Because small companies tend to be neglected by investors information about such companies is less available which makes them risk your investments that command higher returns and presumably investors do not purchase generic stocks without the prospect of greater returns.

Question 12

6.2.2.d Describe the market anomaly known as the liquidity effect

Answer 12

Because small and less analyzed stocks are as a rule less liquid the liquidity effect might be a partial explanation of the abnormal returns since investors will demand a premium to invest in less liquid stocks.

These stocks may also have higher trading costs so exploring the liquidity affect can be more difficult than it would appear because trading cost on small stocks can easily offset any appeared abnormal profit opportunity

Question 13

6.2.3.a Describe the market anomaly known as the low price book ratio

Answer 13

The low price book ratio. Research shows that part a powerful predictor of returns is the ratio of market value of a stock with book value.

Stocks with below average price book ratios tend to out perform the market. Numerous test portfolios have shown that buying a collection of stocks with low price book ratios can deliver market meeting performance.

This is normally makes sense to a point, and that you unusually cheap stocks should attract buyers attention and as they are purchased the price would adjust

Question 14

6.2.3.b Describe the market anomaly known as the post earnings announcement price drift

Answer 14

The post earnings announcement price drift is the tendency for stocks cumulative abnormal returns to drift for several weeks following a positive earnings announcement.

Well EMH suggests the stock prices should respond very quickly to unanticipated news or earning surprises research shows that it take a days or longer for the market price to just fully resulting in a sustained period of abnormal returns.

Research shows that buying stocks after a positive earning surprise is a profitable investment strategy

Question 15

6.2.3.c Describe the market anomaly known as the January effect

Answer 15

The premise of the January effect is that stocks that under performed in the fourth quarter of the previous year tend to outperform the markets in January.

This is normally is perhaps the most rational as investors tend to sell under performing stocks just before year end to use their losses to offset capital gains taxes. This separates the motivation to sell from the fundamentals of the stock about you.

Intern investors with Levi under performing stocks in the fourth quarter waiting until January to get avoid getting caught up in this tax driven selling behaviour this leads to access the link of pressure before January 1 and access buying pressure after January 1

Question 16

6.2.3.d Describe the market anomaly known as the reverse effect

Answer 16

Some research suggests that stocks at either end of the performance spectrum over periods of time (a year) do tend to reverse course in the following period

Stocks that tend to do very well will reverse and under perform the market for as long as a year. By the same token stocks that were under performing become outperforming for an extended period of time

This reversal occurs whether or not company financial statements justify the price movements. This is normally is logical and maybe due in part to invest your psychology driving behavior. Investors expect high performers to fall in neglected stocks to get discovered and rise, if investors habitually buy and sell in this pattern, it becomes a self-fulfilling anomaly

Question 17

6.3.1 Explain the connection between the premise under pinning behavioral finance and findings in the anomalies literature. Give two broad categories for irrationalities

Answer 17

Well conventional financial theories presume that investors are rational, behavioral finance presumed they are not. Behavioral finance focusses on systemic irrationality is that characterize investor decision making.

A number of economist interpret findings of anomalies literature as consistent with several irrationality’s or behavioral shortcomings. These rationality’s fall into two broad categories

1. Investors do not always process information correctly and therefore infer incorrect probability distribution’s about future rates of return
2. Even given a probability distribution of returns investors often make inconsistent or systemically sub optimal decisions

Question 18

6.3.2.a Explain how forecasting error/memory bias can lead investors to misestimate the true probabilities of possible events or associated rates of returns

Answer 18

Research suggests that people give too much weight to recent experience as a post to prior experience with making forecast tending to make forecast that are too extreme

Question 19

6.3.2.b Explain how overconfidence biased can lead investors to misestimate the true probabilities of possible events or associated rates of return

Answer 19

Overconfidence bias means that people tend to over estimate their abilities and the position of their beliefs or forecast.

Overconfidence biased may be responsible for the prevalence of active management which is itself a new normally do proponents of EMH. The dominance of active management, despite research that suggest under performance of active management strategies, is consistent with a tendency to estimate ability to highly

Question 20

6.3.2.c Explain how conservatism bias can lead investors to misestimate the true probabilities of possible events or associated rates of return

Answer 20

I conservatism bias means that people are too slow, too conservative, in updating their beliefs in response to the new information. For example investors might initially under react to use a better company with the result being that prices will fully reflect new information only gradually

Question 21

6.3.2.d Explain how representativeness error/sample size neglect would processing information can lead investors to miss estimate the true probabilities of a possible event or associated rates of return

Answer 21

Representativeness errors occur if people do not account for the size of the sample when inferring patterns assuming a small sample is just as representative of a population of the large sample.

This can result in incorrect patterns being inferred in trend six populated too far in the future. For example a short run earnings report maybe take him to be representative of long-term performance

Question 22

6.3.3 Explain how the behavioral tendency called the framing effect influences how investors evaluate risk versus return. Provide an example

Answer 22

How investment choices are presented, the number and type of options listed, is an example of framing.

Research suggests that it investors are presented with a list of options of which the majority is equity funds, they will allocate a higher percentage of their portfolio to equity then if presented with a list with her if you were equity funds.

Question 23

6.3.4 Explain how the behavioural tendency of mental accounting affects how investors evaluate risk versus return. Provide an example

Answer 23

Mental accounting is a specific form of framing. It contains that rather than rationally viewing every current and future dollar as identical, individuals divide the current and future funds into separate, non-transferable categories and then assign different levels futility to each category of funds which affects decision-making behaviour around each category.

For example when an investor takes considerable risk with his or her retirement savings but takes a risk averse position with a out that is dedicated to their child’s education.

Research suggests that mental accounting is consistent with some investors Irrational preference for stocks with high cash dividends, they do not consider the dividend income is dipping into capital since it comes in cash

Question 24

6.3.5 Explain how regret avoidance affects how investors evaluate risk versus return provide an example

Answer 24

Psychologist have found that individuals who make decisions that turn out badly have more regret when their decision was more unconventional.

For example the loss experienced on a stock of an unknown start up company triggers more regret than the same loss experienced on the blue chip stock.

Regret avoidance may cause investors to become more risk averse a bit less conventional investments

Question 25

6.3.6 Explain how prospect theory affects how investors evaluate risk versus return

Answer 25

Also known as loss aversion theory, prospect theory is a behavioural economic theory that describes the way people choose probabilistic alternatives that involve risk.

It assumes that losses and gains are valued differently and investors make decisions based on perceived games instead of perceived losses.

If two choices are presented both equal, with one presented in terms of potential gains and the other in terms of possible losses the former option will be chosen

Question 26

6.4.1 Explain the concept of arbitrage provide an example

Answer 26

Arbitrage is the simultaneous purchase and sale of an asset to profit from the difference in the price. It is a trade that profits bikes floating the price differences of identical or similar financial instruments on different markets or different forms. Arbitrage exist because of market inefficiencies

Rubber trashcan exist when the law of one price is not that or where to assets with identical cash flow do not trade at the same price. Advances in computer is trading we could increasingly difficult to profit from pricing errors in the market

Question 27

6.4.2 List three factors that advocates of behavioural of finance argue limit the ability to profit from mispricing

Answer 27

1. Fundamental risk occur incurred in exploring the apparent profit opportunity. For example will price eventually should converge to intrinsic value this may not happen until after the investors time horizon
2. Implementation cost of the investment transaction
3. Risk that the motto being used to price the investment is it so faulty and the price is actually correct

Question 28

6.4.3 Explain the law of one price

Answer 28

The law of one price states that if two assets are equivalent in all economically relevant respects they should have the same price.

The assumption is that market price as well move to rule out arbitrage opportunities which is perhaps the most fundamental concepts in capital market theory

Question 29

6.5.1.a describe the basic premise of fundamental analysis

Answer 29

Fundamental analysis maintains that markets may incorrectly price of security in the short run but that the correct price will be eventually reached. Profits can be made by purchasing the incorrectly press security and waiting for the market to recognize it’s a mistake.

The goal is not to identify companies that are good but identify companies that have higher value than other analyst perceive them to have. Investors using fundamental analysis can use either a top down or bottom up approach

Question 30

6.5.1.b Describe three tools that fundamental analysis uses to estimate the present discounted value of all the payments a shareholder route receive from each of the stock

Answer 30

1. Economic analysis [expectations of future interest rates]
2. Industry analysis [prospects for the industry as a whole]
3. Company analysis [financial statement analysis that includes financial ratios, earnings and evident prospects, the quality of the management and the company standing within its industry]

Question 31

6.5.1.c In regards to fundamental analysis Define top down approach and bottom up approach

Answer 31

The top down investor starts the analysis with global economics, including both international and national economic indicators. These may include the GDP, gross rates, inflation, interest rates, exchange rates, productivity and energy prices. The search is subsequently narrowed to regionals/industry analysis of total sales, price levels, the effects of competing products, foreign competition, and entry or exit from the industry. Only then is the search narrowed to the best business in the area being studied

The bottom up investor starts with the specific business regardless of the region/industry and proceeds in the reverse of the top down approach

Question 32

6.5.2 Explain how EMH proponents view fundamental analysis

Answer 32

EMH asserts that most fundamental analysis as little value in analyzing securities.

If analyst rely and publicly available earnings and industry formulation one analyst evaluation of the companies prospects is not likely to be significantly more accurate than another. Only analyst with unique insights will be rewarded

Question 33

6.5.3 Explain how technical analysts view the value a fundamental information

Answer 33

Technical analyst assume that a securities price already reflects all publicly available information. They do not deny the value of fundamental information however they believe that stock prices eventually close in on their fundamental values.

Technical analyst believe that shifts in market fundamentals can be discerned it before the impact of those shifts is fully reflected in prices.

Whatever the reason for a change in stock price, if the stock price responds slowly enough, technical analyst will be able to identify a trend that can be exploited during the adjustment period

Question 34

6.5.3.b Define technical analysis

Answer 34

Technical analysis is an attempt to exploit recurring and predictable pattern in stock prices to generate abnormal trading profits

Question 35

6.5.4 Define momentum and explain the significance to technical analysis

Answer 35

Much of technical analysis exists to uncover trends in market prices. This is in effect a search for a momentum, the tendency for price to move in the direction of the trend.

Momentum can be absolute, in which case one searches for upward priced trends, or relative, in which case the analyst looks to invest in one sector over another

Question 36

6.5.5.a Explain the significance of primary, intermediate, and minor trends on stock prices according to Dow theory

Answer 36

The main movement or primary trend lasting from several months to several years can be publish or bearish market. Within these broader primary trends markets me experience medium swings, or secondary trends, which may last from three weeks to three months and often work against the primary trend.

The short swing or minor trend varies from hours to month or more the three movements may be simultaneous, four instance a daily minor movement in a bearish secondary reaction in a bullish primary movement.

The premise is that his primary, intermediate, and minor trends in stock prices can be identified on a chart and acted on by an analyst before the trans fully dissipate

Question 37

6.5.5.b Define the Dow theory on stock price movement

Answer 37

The Dow theory on stock price movement is a form of technical analysis used to forecast stock market direction

Question 38

6.5.6 Explain the implications of data mining as it relates to using charting as a tool for predicting stock market patterns

Answer 38

A problem related to the tendency to perceive patterns for they don’t exist is data mining, sorting through large amounts of historical data to uncover systemic patterns that can be exploited to make future returns.

After the fact, patterns and trading rules that if applied, would have generated enormous profits can always be found. If enough rules are tested some would have worked.

However a rule or a theory that would’ve worked after the fact carries no guarantees a future success

Question 39

6.5.7 Describe how moving averages are used to predict market movements

Answer 39

Two examples of measures used our 50 day and 100 day moving average is

When the stock price moves from one side of a moving averages and closes on the other side, a price crossover, it can signal the beginning of a price trend.

Price crossovers are used to identify shifts in momentum and can be used as a basic market entry or exit strategy.

Question 40

6.5.7 what signals does a moving average crossing a stock price send (from each direction, above to below and below to above)

Answer 40

When the market price crosses from below the moving average line to above it it is taken as a bullish signal.

When the market price crosses from above the moving average to below it it is considered time to sell

Question 41

6.5.9 Explain the concept of self-destructing patterns

Answer 41

Self-destructing pattern suggested a technical rule used by technical out us to identify patterns of security returns it seem to contradict EMH may not continue to work in the future wants to rule becomes widely recognized by other investors

Technical and analysis is a continual search for profit will technical rules for trading followed by the distraction by overuse of those rules found to be successful followed by yet more search for undiscovered rules

Question 42

6.6.1.a List three kinds of technical indicators

Answer 42

1. Sentiment indicators
2. Flow of funds indicators
3. Market structure indicators

Question 43

6.6.1.b Define sentiment indicators in relation to technical analysis

Answer 43

Sentiment indicators measure how various groups of investors feel about what is going on in the environment and how that will influence their future behaviour.

Behaviour financed of us considerable attention to market sentiment which may be interpreted as a general level of optimism and pessimism among investors

Technical analyst have devised several measures of sentiment including the trin statistic, odd-lot trading index, confidence index and put call ratio

Question 44

6.6.1.c Define flow of funds indicators in relation to technical analysis

Answer 44

Flow of funds indicators measure the potential for various investor groups to buy or sell stocks and predict the price pressure from these actions.

Examples of the fund indicators are short interest and credit balances in brokerage accounts

Question 45

6.6.1.b Define market structure indicators in relation to technical analysis

Answer 45

Market structure indicators monitor price trends in cycles.

Charting results, breadth and relative strength, are examples of market structure indicators

Question 46

6.6.2 Explain how technical analyst use the Trin statistic to measure market sentiment

Answer 46

Market sentiment may be interpreted as the general level of optimism among investors.

Trading volume can be used to measure the strength of market rise or fall since increased investor participation in a market advance or retreat is viewed as a measure of the significance of the movement.

The higher the volume during the price move the more significant the move.

The Trin Ratio is the ratio of average volume in declining issues to average volume in advancing issues. Ratios above one are considered bearish because declining stocks would have higher average volume than the advancing stocks which indicates net selling pressure.

It can be concluded that ratios below one are considered bullish because falling stocks have to have a higher volume than advancing stocks

Question 47

6.6.3 Explain how technical analyst use the odd lot trading index to measure market sentiment

Answer 47

An odd life is a transaction of fewer than 100 shares and is treated by small individual traders.

The odd lot theory holds that small investors tend to miss key market turning points, typically buying stock after a bull market has run its course and selling too late in a bear market.

The odd lot theory suggests that when odd want to traders are widely buying you should sell and vice versa.

The odd lot trading index can be commute from daily online trading data. A ratio substantially above one is considered bearish because it implies small traders are net buyers

Question 48

6.6.4 Explain how technical analyst use the confidence index to measure market sentiment

Answer 48

The confidence index assumes the actions of bond traders reveal trends that will emerge in the stock market.

It is the ratio of the average yield on 10 top rated corporate bonds divided by the average up on 10 intermediate grade corporate bonds. The ratio will always be below one because higher rated bonds offer lower promise deals to maturity

With the yield spread narrows the confidence index increases since fundraiser optimistic about the economy the signals a bullish market

Question 49

6.6.5 Explain how technical analyst use the put call ratio to measure market sentiment

Answer 49

The ratio of outstanding put options to outstanding, options is the put/call ratio and is typically around 65%

Because put options do well in falling markets and call options do well in rising markets deviations of the ratio from historical norms are a signal of market sentiment

Many technical analyst see an increase in the ratio is bearish since it indicates a growing interest and put options to hedge against decline. However contrarian investors believe that a good time to buy is in the rest of the market is bearish because stock prices are depressed

Question 50

6.6.6 Explain how technical analyst use short interest to measure the potential for investors to buy or sell stocks

Answer 50

Short interest is a flow of funds indicator. It is measured by the total number of shares of stock currently sold in the short market.

Some technical analyst interpret high levels of short interest as bullish want some interpret it as bearish.

The bullish perspective is that because short sales must be covered short interest represents latent future demand for stocks.

The bearish. interpretation of short interest in Sue’s that short sellers tend to be larger more to this dictated investors. Increased short interest reflects bearish. sentiment by larger investors which is a negative signal

Question 51

6.6.7.a Explain how technical analyst assess breadth of the market to monitor price trends and cycles

Answer 51

Breadth is a market structure indicator. Breadth of the market is a measure to the extent to which movement of a market index is reflected widely in the price movements of all the stocks in the market.

The most common measure of breath is the spread between the number of stocks that advance and decline in price.

If advances out number declines by a wide margin then the market is viewed as being stronger because the rally is widespread. Breadth is reported daily

Question 52

6.6.7.b Explain how technical analyst assess relative strength of the market to monitor price trends and cycles

Answer 52

Strength measures the extent to which security has outperform or under performed either the market as a whole or a particular industry.

Relative strength is the ratio of the price of the security to a price index for the industry. For example the relative strength of BP versus the oil and gas industry would be measured by the movements in the ratio of the price of BP divided by the level of an oil and gas industry index.

A rising ratio implies BP has been out performing the rest of the industry. If relative strength can be assumed to purchase cyst overtime, then this would be a signal to buy BP