Market Efficiency

Question 1

What is market efficiency?

Answer 1

The extent to which market prices incorporate available information. If market prices do not fully incorporate information, then opportunities may exist to make a profit from the gathering and processing of information.

Question 2

What are active returns?

Answer 2

Returns earned by strategies that do not assume that all information is fully reflected in market prices.

Question 3

What is an informationally efficient market?

Answer 3

A market in which asset prices reflect new information quickly and rationally. An efficient market is thus a market in which asset prices reflect all past and present information.

Question 4

Market inefficiencies mean profitable trading opportunities.

Question 5

What is passive investment?

Answer 5

In an efficient market, a passive investment strategy that does not seek superior risk-adjusted returns can be preferred to an active investment strategy because of lower costs.

Question 6

What is market value versus intrinsic value?

Answer 6

Market price is the price at which an asset can currently be bought or sold. Intrinsic value / fundamental value is the value that would be placed on it by investors if they had a complete understanding of the asset’s investment characteristics.

Question 7

A highly efficient market has market prices that accurately reflect intrinsic values.

Question 8

Discrepancies between market price and intrinsic value are the basis for profitable active investment.

Question 9

What are factors that contribute to and impede the degree of efficiency in a financial market?

Answer 9

Market participants
Information availability
Financial disclosure
Limits to trading
Transaction costs and information-acquisition costs

Question 10

A large number of investors follow the major financial markets closely on a daily basis, and if mispricings exist in these markets, investors will act so that these mispricings disappear quickly.

Question 11

Information availability and financial disclosure should promote market efficiency.

Question 12

Arbitrage trading contributes to market efficiency by benefiting from pricing discrepancies.

Question 13

Some market experts argue that restrictions on short selling limit arbitrage trading, which impedes market efficiency. Others argue that short selling may exaggerate downward market movements.

Question 14

What are transaction costs?

Answer 14

Costs incurred in trading to exploit any perceived market inefficiency. Thus, “efficient” should be viewed as efficient within the bounds of transaction costs.

Question 15

A market is seen to be inefficient if, after deducting transaction and information-acquisition expenses, active investing can still earn superior returns.

Question 16

What are the three forms of market efficiency?

Answer 16

Weak
Semi-strong
Strong

Question 17

What is a weak form of market efficiency?

Answer 17

Only reflects past market data

Question 18

What is a semi-strong form of market efficiency?

Answer 18

Reflects past market data and public information

Question 19

What is a strong form of market efficiency?

Answer 19

Reflects past market data, public information and private information

Question 20

What are abnormal returns?

Answer 20

Returns in excess of those expected given a security’s risk and the market’s return.

Question 21

What are market anomalies?

Answer 21

Market inefficiencies

Question 22

Market anomalies are exceptions to the notion of market efficiency. Researchers conclude that a market anomaly may be present if a change in the price of an asset or security cannot directly be linked to current relevant information known in the market or to the release of new information.

Question 23

What is data mining / snooping?

Answer 23

Data are examined with the intent to develop a hypothesis, instead of developing a hypothesis first.

Question 24

What are calendar anomalies?

Answer 24

Stock market returns in January were significantly higher compared to the rest of the months of the year = January effect / turn-of-the-year effect

Question 25

What is window dressing?

Answer 25

Portfolio managers sell their riskier securities prior to 31 December because the annual reports will look less risky. After 31 December, the manager would simply purchase riskier securities again.

Question 26

Turn-of-the-month effect Day-of-the-week effect = average monday return is negative Weekend effect = lower returns on weekends Holiday effect = returns day prior to holiday is high

Question 27

What is the overreaction anomaly?

Answer 27

Investors tend to overreact to the release of unexpected public information. Therefore, stock prices will be inflated or deflated depending on the news.

Question 28

What are the size and value effects anomalies?

Answer 28

Size effect shows that equities of small-cap companies tend to outperform equities of large-cap companies on a risk-adjusted basis. Value effect shows that value stocks have consistently outperformed growth stocks over long periods of time.

Question 29

What is a pricing anomaly in closed-end investment funds?

Answer 29

The shares traded in the market of a closed-end investment fund should reflect the Net Asset Value per share. However, on average, closed-end funds trade at a discount from NAV.

Question 30

What is an earnings surprise?

Answer 30

The unexpected part of the earnings announcement / the portion of earnings that is unanticipated by investors and, according to the efficient market hypothesis, merits a price adjustment.

Question 31

What is the pricing anomaly of IPOs?

Answer 31

Given the risk that investment bankers face in trying to sell a new issue for which the true price is unknown, it is perhaps not surprising to find that, on average, the initial selling price is too low and that the price increases dramatically on the first trading day. = degree of underpricing.

Question 32

What is herding behavior?

Answer 32

Occurs when investors trade on the same side of the market in securities or when investors ignore their own private information and act as other investors do.

Question 33

What is overconfidence bias?

Answer 33

If investors are overconfident, they overestimate their ability to process and interpret information about a security. Overconfident investors may not process information appropriately, and if there is a sufficient number of these investors, stocks will be mispriced.

Question 34

What is an information cascade?

Answer 34

The transmission of information from those participants who act first and whose decisions influence the decisions of others.

Question 35

What is representativeness?

Answer 35

Investors assess new information and probabilities of outcomes based on similarity to the current state or to a familiar classification.

Question 36

What is mental accounting?

Answer 36

Investors keep track of the gains and losses for different investments in separate mental accounts and treat those accounts differently.

Question 37

What is conservatism?

Answer 37

Investors tend to be slow to react to new information and continue to maintain their prior views or forecasts.

Question 38

What is narrow framing?

Answer 38

Investors focus on issues in isolation and respond to the issues based on how the issues are posed.

Question 39

What is the disposition effect?

Answer 39

It relates to the behavioral bias in which investors tend to avoid realizing losses, but rather, seek to realize gains.