Topic 12 Asset Market Efficiency and Behavioural Finance Flashcards

Question

What is a test of weak form efficiency?

Answer 1

Generally speaking, academic research finds that it is not possible to make systematic profits from trading rules relying on price patterns in Australia, implying that the ASX is weak form efficient. More recent studies in other markets have reported that no useful information can be obtained from past prices (Asian markets, China, and other emerging markets).

Answer 2

The most common test of semi strong form efficiency is an event study which examines the behaviour of prices around information events or announcements * The purpose of these studies are to analyse how quickly new information is reflected in share prices and the returns possible for an investor * A large number of academic studies find that the equity market in the United States is semi strong form efficient  public reacts strongly to public news

Answer 3

ARt = rt - E(rt) ARt = abnormal return in the time interval t rt = actual return in the time interval t E(rt) = expected return in the time interval t

Answer 4

A research methodology designed to measure the impact of an event of interest on stock prices after the event date

Answer 5

a. Define as day ‘zero’ the day the information is released (event day) b. Define abnormal return as the difference ARit = Rit – E(Rit) c. Calculate ARit T days around ‘zero’: t = -T, -(T-1),…, -1, 0, 1,…., T-1, T d. Calculate average abnormal returns (AAR) over all N events in the sample for all references days between [-T, T] e. Calculate the cumulative average abnormal returns (CAAR)

Answer 6

This methodology is easy to apply, and has been used to study a large number of events a. Dividend changes b. Earnings c. Mergers d. Capital expenditures e. New issue of stock, or new issues of debt f. Changes in stock exchange listing g. Stock buybacks Almost all the evidence indicates that the market is semi-strong form efficient.

Answer 7

If a market is strong form efficient all available information is fully reflected in current prices. Therefore, it should not be possible to profit from “insider trading” If a market is strong form efficient it is impossible to consistently outperform the market due to the fact that all information is already reflected in current asset prices and, therefore, it is impossible to earn long term abnormal returns.

Answer 8

EMH supports the passive investing approach: investors should hold a well diversified market portfolio based on the portfolio and CAPM theory

Answer 9

Index funds are passively managed funds that track and invest in a particular benchmark index.

Answer 10

* Some people might think inefficient is better as people can get information and use that to get abnormal profits * In an inefficient market however you cannot determine if a price is fair * Benefit of efficient market is that you do not need to perform a lot of research to determine if a price is fair, just making sure you diversify your portfolio and buying a few index funds

Answer 11

a. Market anomalies b. Behavioural Finance

Answer 12

A market anomaly is a price action that contradicts the expected behaviour of the stock market.

Answer 13

* The existence of these anomalies is contrary to the Efficient Markets Hypothesis. These studies are based on repeated patterns or behaviour in stock price movements. * Anomalies allow the prediction of future returns using these known patterns * Prices may not reflect value

Answer 14

1. Day of the week effect 2. January effect 3. Size effect 4. Book to market effect 5. Momentum effect

Answer 15

returns on Mondays are often lower than other days of the same week

Answer 16

higher stock prices in January than other months of the year

Answer 17

buy small stocks and sell large stocks

Answer 18

Buy stocks with small B/M ratio and sell stocks with large B/M ratio Compares the book value of the company to the price of the stock. Less than 1 implies that a company can be bought for less than the value of its assets. A higher figure of around 3 would suggest that investing in a company would be expensive

Answer 19

Buy ‘winner’ stocks and sell ‘loser’ stocks of the previous period can generate trading profit * Tendency of stocks that performed well in the past to continue to do well in the following period and vice versa for stocks with a poor performance * Both over and underreaction to news may explain the momentum effect

Answer 20

Investors do not always process information correctly or may make inconsistent or sub optimal decisions This results in market prices that differ from fundamental values

Answer 21

1. Overconfidence bias 2. Herding tendency

Answer 22

Overconfidence bias: overconfident investors may overestimate their abilities to identify successful investments and tend to underperform in trading

Answer 23

* Herding tendency that investors like to follow others resulting in market bubbles eg. tech bubble and housing bubble

Answer 24

1. Markets and investors are perfectly rational 2. Investors always seek to maximize their utility 3. Investors have perfect self control 4. Investors are never confused in their decision taking by cognitive errors

Answer 25

1. Markets and investors are normal, not rational 2. Investors are risk-averse 3. Investors have limits to their self-control due to individual biases 4. Investors often experience cognitive errors which may contribute to wrong decisions