Market Efficiency and Behaviourl Finance

Question 1

Define market efficiency

Answer 1

How efficient the market is in pricing securities so capitalists ( money, no idea) get a fair risk return from investing their money in entrepreneurs

Question 2

Who said “ It is better to be roughly right than precisely wrong”, and what is that critic about?

Answer 2

John Maynard Keynes is a critic of the use of mathematics in finance. He thought that the assumptions made to be able to use the financial formulas ignored some important complexities of the matter.

Question 3

What is the law of numbers and how does that relate to market efficiency

Answer 3

The average total

The meaning average price of a stock is more accurate than any individual valuation an individual can do

Question 4

What is the Random Walk and how does that concept relate to market efficiency

Answer 4

• The random walk refers to the walk of a drunk person, the same way that the individual is equally likely to walk to the right or left when it’s drunk, the stock market is equally likely to go up or down based on news and information.

Question 5

What is the Lucas Critique and how does that concept relate to Market efficiency

Answer 5

• He criticized that as soon as the people being modeled figure out the model, that model does not work anymore.
• So in a way, using arbitrage to get profits from stock trading is only efficient until the point others cannot do it either, as soon as other investors are able to recognize under and over-valued stocks they will stop making the mistake of selling and buying from the wrong price.

Question 6

What are the 4 types of efficiency market types

Answer 6

• weak form: Past and present returns do not predict the stock return
• semi-strong form: future stock returns cannot be predicted with publically available info
• strong form: future stock returns cannot be predicted

Question 7

What is a transcomputational problem

Answer 7

Problems that are solvable in theory ( using formulas ) but not in practice. The amount of work and time needed to find the exact result would take very long so academia summing bounded rationality just created heuristics/rules of thump to make these problems solvable.
In Finance: IRR, NPV and Po

Question 8

what is bounded rationality?

Answer 8

Using rational thinking/logit to get to an approximation of a solution to a problem

Question 9

What is the Zen Equilibrium

Answer 9

if the market becomes too inefficient, arbitragers go in and make it more efficient
if the market becomes too efficient, arbitragers stop trading which makes it more inefficient

Question 10

100% efficient market theory is illogical in economics

Answer 10

economics believes the market is semi-strong ( MC = MR) it is not efficient in terms of information.

Question 11

What are the limits to Arbitrage

Answer 11

• Holding Period: arbitrage is done by making assumptions of future prices if due to some noise, the price does not behave as expected the arbitrage loses money
• Undeversifiable ( Idiosyncratic ) risk: The fact that the risk is undervisiable prevents people from betting their life savings on it
• Contractual Agreement: If the arbitragers are losing money due to the holding period, the contractors force the arbitrators to close the call

Question 12

Pro and Cons to why not use economic supply model to prevent stock price behavior

Answer 12

Pros: Assuming Arbitrage is Incomplete: When a stock is added to the SP500, the demand for that stock increases ( consequently increases the price )
- higher demand - higher price

Cons: Assuming Arbitrage is Complete: if the price of the stock was under or overvalued, arbitragers would sell/buy accordingly and therefore always keep the price in equilibrium

Question 13

What are the three types of stock market participants

Answer 13

1) Arbitragers => push stock prices close to their fundamental value (Deteck mispricing and profit from it)
2) Noise Traders: Lose money so arbitragers stay in business
3) Savers: Responsible for little trading, providing their savings to the company’s to-do NPV > O investments

Question 14

What do the CEF ( Closed-end fund measures ), what does it say about market efficiency?

Answer 14

Close-end funds measure noise trade sentiment.
In theory the PRICE OF cef = Net Asset Value
but P > NAV when market is in bull
P < NAV when market is in bear

Question 15

What do the CEF ( Closed-end fund measures ), what does it say about market efficiency?

Answer 15

Close-end funds measure noise trade sentiment.
In theory the PRICE OF CEF = Net Asset Value
but P > NAV when the market is in bull
P < NAV when the market is in bear therefore it measures the noise trade sentiment

Question 16

What is Stagflation

Answer 16

when higher inflation causes unemployment

Question 17

What are speculative bubbles?

Answer 17

When the price of a good goes up just because others believe it valuable ( Tulipmania )

Question 18

What is the common pattern in all of the market crashes seen in history?

Answer 18

The economy is booming from a recent technology innovation that increases productivity. Therefore investors and entrepreneurs get optimistic, get loans, to invest and profit from that technology (the “next Microsoft”) hoping it will give very high returns.
The company has the capital but has difficulty finding positive NPV projects to invest in the economy. This mass over investment, causes some companies to fail. The market becomes pessimistic and risk-averse, Market crashes.
Stock market crashes are a result of mania and animal spirits

Question 19

What is the Minsky moment

Answer 19

There is a sudden and extreme change in investors’ sensitivity to risk ( not based on any news ).

Question 20

what does the term “door shut panic” illustrates.

Answer 20

stock market bubbles collapse extremely fast due to every individual making a stock market run ( to take their money out ) at the same time.

Question 21

What is a sovereign debt crisis?

Answer 21

When governments default on their T-bills

Question 22

What is the Time Inconsistency problem and what are a couple of examples

Answer 22

1) Bank Bailouts

2) Intelectual/Property rights

Question 23

What is Herding ( Rational or Irrational )

Answer 23

R - making buying and selling decisions based on copying what other people are doing
I - making decisions os stocks to buy due to the positive feedback loop ( prices up, demand up )

Question 24

What is Saliency Bias?

Answer 24

Whatever is at the top of your mind takes priority

Question 25

Status quo bias/Familiriaty/Confirmation

Answer 25

conservative bias

Question 26

If the market is not 100% efficient, but not 0% efficient. How do we measure efficiency?

Answer 26

R^2 of the Asset Pricing model =
(systematic risk) / ( systematic + idiosyncratic risk)

bigger the r^2 = bigger relative percentage of systematic risk = more inefficient the market is.

• The more relative idiosyncratic risk = more efficient the market is

unverifiable/systematic risk => makes stocks move with the market.
idiosyncratic/diversifiable risk => stocks move independently of the market

Question 27

Why do stocks have more systematic risk in more corrupt countries?

Answer 27

• corruption: divert firm-specific profits
• worse corporate governance
• costlier info
• more Herding