Michaelmas Term - Lecture 4

Question 1

What does the Efficient Market Hypothesis state?

Answer 1

All stocks are fairly valued at all times based on all currently available information

Question 2

What are the characteristics of the Efficient Market Hypothesis

Answer 2

1) Prices reflect all available information
2) The market responds only to new information
3) It is not possible to forecast price changes

Question 3

What are the 3 forms of market efficiency?

Answer 3

1) Weak-form efficiency: History of prices and returns
2) Semi-strong efficiency: Public information
3) Strong-form efficiency: Public and private information

Question 4

What is autocorrelation?

Answer 4

This is the correlation between past and current values and how they move in relation with one another

Question 5

What do we see in terms of returns for medium and long horizons?

Answer 5

Medium horizons: Momentum

Long horizons: Reversals

Question 6

What is technical analysis and what is the problem with it?

Answer 6

This is a collection of strategies that are based on the belief that regularities can be profitably exploited to forecast future price movements. The problem with these strategies is that they often have high transaction costs.

Question 7

What are ‘filter rules’?

Answer 7

If price goes down by x% then sell, if it goes up by y% then buy. This is a violation of the EMH

Question 8

What is fundamental analysis?

Answer 8

This is the process of using earnings, dividends and other financial information to forecast future returns of the stock

Question 9

What are event studies?

Answer 9

This is looking at a particular event to see if it has an effect on returns:

1) Identify the event that is to be measured
2) Estimate the expected return model
3) Measure abnormal returns
4) Compute cumulative abnormal returns
5) Aggregate abnormal returns across individual firms
6) Test to see if the event has price impact (essentially testing to see if CAR = 0)

Question 10

What is joint hypothesis?

Answer 10

This is the theory that every test of efficiency is a test of the market and the asset pricing model used to calculate expected returns

Question 11

What would happen to market efficiency if all investors attempted to follow a passive strategy?

Answer 11

If everyone follows a passive strategy, sooner or later prices will fail to reflect new information. At this point there are profit opportunities for active investors who
uncover mispriced securities. As they buy and sell these assets, prices again will be driven to fair levels.