Market Efficiency Quiz Prep

Question 1

What are the assumptions behind the efficient market hypothesis?

Answer 1

1. ) A large number of profit-maximizing participants analyze and value securities
2. )New information regarding securities comes to the market in a random fashion
3. )The buy and sell decisions of all those profit-maximizing investors who adjust security prices rapidly reflect the effect of new information.

Question 2

What are the three sub-hypothesis that Fama created about the EMH?

Answer 2

1. ) The weak form EMH
2. ) The semi-strong-form EMH
3. ) The strong-form EMH

Question 3

What is the weak form EMH and what is the result of it in terms of trading?

Answer 3

• Current prices reflect all security-market historical information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information
• In short, prices reflect all historical information and technicians cannot beat the market.

Question 4

What is the semi strong form EMH and what is the result of it in terms of trading?

Answer 4

• Current security prices reflect all public information, including market and non-market information
• In short, prices reflect all public information and all historical information and fundamental analysts cannot beat the market

Question 5

What is the strong form EMH and what is the result of it in terms of trading?

Answer 5

• Stock prices fully reflect all information from public and private sources
• This assumes perfect markets in which all information is cost-free and available to everyone at the same time
  In short, prices reflect all public and private information and all historical information and nobody can beat the market.

Question 6

According to the efficient market hypothesis, how do prices adjust to news?

Answer 6

Security prices adjust so rapidly to new information, that the current prices of securities reflect all information about the security.

Question 7

If an investor has superior returns for a certain time, in what sense does it or not contradict the efficient market hypothesis?

Answer 7

Argues for EMH because it is such a complex system that is too unpredictable to identify any pattern for superior results.

Question 8

What is the concept of “random walk”?

Answer 8

it states that changes in stock prices occur randomly and are unpredictable.

Question 9

Does the concept of efficient market hypothesis exclude the possibility of boom and bust?

Answer 9

Proponents argue that mispricing can create booms, but it is impossible to detect them ex ante (meaning in advance)

Question 10

What are some of the biases that affect the performance of investment or trading according to behavioral finance?

Answer 10

1. ) Propensity of investors to hold on to a looser too long and sell winners too soon.
2. ) Belief perseverance: once an individual has formed an opinion, he clings to it too tightly and for too long.
3. ) Anchoring: when an individual estimates something, he starts with an initial arbitrary value and adjusts away from it.

Question 11

What is the idea behind behavioral finance?

Answer 11

To oppose EMH. it is the study of effects of psychological, social and cognitive factors on markets.

Question 12

Does behavioral finance may be considered as a total opposition to efficient market hypothesis?

Answer 12

Yes. it is the study of effects of psychological, social and cognitive factors on markets.

Question 13

What are the fundamental elements behind complex systems?

Answer 13

1. ) We start with the idea that systems are composed of different or heterogeneous agents that make autonomous decisions. Because of their diversity, they react differently to events.
2. ) Those agents are not only connected, but they are also interdependent in the sense they influence each other. It is a crucial element because it is the source of evolution of those systems.
3. ) Finally, those agents have the capability to learn. Thus, not only the system evolve according to the reinforcing interaction among agents, but also the same agents learn and adapt their behavior.

Question 14

What are the characteristics of complex systems?

Answer 14

1. ) Emergent properties: specific combination of agents and relationships provoke the creation of systems. However, it is extremely difficult to model those emergence, and practically impossible to predict. It may be consistent with the efficient market hypothesis result that it is impossible to beat the market.
2. ) This unpredictability may also apply to the development and end of those systems.
3. ) Those system may be open, in the sense that they can expand and cover different “territories”. However, it may also evolve in an environment of pattern stability, so it may not be incompatible with disequilibrium theory with pattern recognition.
4. ) It may have memory
5. ) It may be nested: components of a complex system may be complex themselves

Question 15

Does the complex systems theory refute the efficient market hypothesis?

Answer 15

Some argue that they are too unpredictable and some that they have patterns.

Question 16

How would you describe the difference between the efficient market hypothesis and the disequilibrium theory?

Answer 16

The notion of disequilibrium implies that current prices are away from an equilibrium price, even if we can recognize that it could be a theoretical price out of reach because it changes constantly. Whereas under the EMH, the price fits perfectly as a result of all the current information.

Question 17

What do you think the assumptions behind the disequilibrium are?

Answer 17

1. ) A SMALL number of profit-maximizing participants analyze and value securities
2. )New information regarding securities comes to the market in a PREDICTABLE fashion
3. )The buy and sell decisions of all those profit-maximizing investors who adjust security prices rapidly DO NOT reflect the effect of new information.

Question 18

How can the concept of knowledge can be used to develop a disequilibrium theory?

Answer 18

To develop a disequilibrium theory with pattern recognition, we need in addition an understanding of mass human psychology and mainly the concept of herd mentality in social learning.

Question 19

What is the herd theory?

Answer 19

Herd effects (probabilities) can be observed and determined and give opportunities for investors to make abnormal profits, but it is not easy.