Michaelmas Term - Lecture 5 Flashcards
What are ‘reversals’?
This is a strategy where investors take advantage of the fact that ‘losers become winners’ and ‘winners become losers’ in the long term (typically 3-5 years)
What is ‘momentum strategy’?
1) Rank stocks on their returns for the past 3-12 months
2) Form a hedge portfolio of winners and loser for zero investment
3) Hold the hedge portfolio for 3-12 months
4) Earn abnormal returns
What possible explanations are there for momentum?
1) The market fails to incorporate information in prices quickly enough. The adjustment is gradual so prices drift.
2) Prior returns may have incorporated other information that is not related to returns and so again it takes time for prices to adjust
What is the earnings announcement puzzle and why does it violate the EMH?
The earnings announcement puzzle is that firms announce earnings and their abnormal returns drift for a period of time afterwards. This is an example of under/overreaction. this violates the EMH because prices should reflect new information quickly.
What is the Twin Stocks Puzzle?
Royal Dutch and Shell merged. Royal Dutch got 60% while Shell got 40%. Royal Dutch’s stock price should have been 3/2 times the prices of Shell’s due to arbitrage pricing but this was not the case. This is a violation of the EMH.
What is a bubble?
This is where the price of an asset rises above its intrinsic value. An example of this is the Dot Com Bubble of the late 90s.
What are closed end funds and why do they violate the EMH?
A closed end fund is a form of mutual fund that typically holds shares like other funds. The difference is that a closed end fund issues a fixed number of shares on an exchange. To get out of the fund investors must sell their shares to other investors. These shares do not typically sell at prices equal to their value (discounts of 10%-20% aren’t uncommon). This breaks the law of one price and violates the EMH.
What is the general result of the time-series predictability of returns?
The stock market risk premium is countercyclical. It is high in bad times and low in good times.
What explains the time-series predictability of returns?
Rational: In bad times there is more uncertainty and investors are more risk-averse so they require a high return
Irrational: In good times investors may be over-optimistic and buy stocks despite their high prices. This means they require a lower expected return
What are the 2 explanations for the difference in B/M ratio-related stocks and their returns?
1) High B/M firms have higher returns because they are riskier and require a greater premium
2) High B/M firms are underpriced because some investors overreact about stocks that have done very badly, seel them and these value stocks become underpriced.
What is an equity carve-out?
This is where a parent company sells a portion of a subsidiary but retains control
What are some calendar anomalies?
January effect - Most of the premium for small cap and high B/M portfolios comes in January
Monday effect - Returns on Monday are lower than the rest of the week
Turn of the Month effect - Stocks show higher returns on the last and first day of the month
What is behavioral finance?
Identifying scenarios in which markets are not perfectly efficient and providing explanations for why the market may not be efficient.
What can psychological biases, heuristics and other forms of irrational behaviour cause?
Violations of the EMH:
- Momentum and reversal
- Under-diversification
- Excessive trading
Name some psychological biases?
1) Conservatism
2) Representativeness
3) Over-confidence
4) Biased self-attribution
5) Under and overreaction
6) Limited attribution
