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FINC3017 - IPM FINAL > TOPIC 8 - MARKET EFFICIENCY > Flashcards

TOPIC 8 - MARKET EFFICIENCY Flashcards

1
Q

What did Kendall (1953) find regarding stock price changes?

A

no predictable pattern –> prices as likely to go up down on any day –> random

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2
Q

what are the 2 predictions of the efficient market hypothesis?

A

1) security prices reflect whatever info is available to investors
2) active traders will find it difficult to outperform passive strategies like market indices (Investors buying securities in an efficient market should expect to obtain an equilibrium rate of return)

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3
Q

under behavioural finance are investors assumed to be rational?

A

no!

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4
Q

CAPM assumes only one thing when it comes to determining why dif securities offer dif expected rates of return

A

beta ( a measure of how an individual asset moves (on average) when the overall stock market increases or decreases.)

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5
Q

why is it nearly impossible to conduct a definitive test of CAPM?

A

bc it relies on an unobservable market portfolio

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6
Q

recent research suggests what about the return relationship

A

Risk-return relationship might entail multiple sources of systematic risk

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7
Q

under the EMH, stock prices should follow

A

a random walk

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8
Q

in terms of the EMH, what are random walks a consequence of?

A

intelligent investors competing to discover relevant information on which to buy or sell stocks before the rest of the market becomes aware of that information

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9
Q

higher investment returns motivates what?

A

information gathering (info the most precious financial commodity!)

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10
Q

weak form version of EMH

A

stock prices already reflect all info contianed in teh history of past prices

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11
Q

semi-strong form version of EMH

A

stock prirces already reflect all publicly available info

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12
Q

strong form version of EMH

A

stock prices reflect all relevant info, including insider info

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13
Q

technical analysis

A

Research to identify mispriced securities that focuses on recurrent and predictable stock price patterns and on proxies for buy or sell pressure in the market

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14
Q

Key to success from technical analysis

A

is a sluggish response of stock prices to fundamental supply-and-demand factors

EMH implies technical analysis should be fruitless

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15
Q

fundamental analysis

A

Assessment of firm value that focuses on such determinants as earnings and dividends prospects, expectations for future interest rates, and risk evaluation

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16
Q

fundamental analysis seeks to

A

find firms that are mispriced

EMH predicts that most fundamental analysis is dommed to failure

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17
Q

active vs passive management

A

• Active Management
An expensive strategy
Suitable for very large portfolios

•	Passive Management
No attempt to outsmart the market
Accept EMH
Index Funds and ETFs
Low cost strategy
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18
Q

even if markets are efficient what’s the role of portfolio management?

A

a) diversification
b) tax considerations
c) risk profile of investor

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19
Q

3 issues affecting markets and their efficiency

A

1) magnitude issue

2) selection bias issue
(only unsuccessful/partially successful investment schemes made public)
3) lucky event issue (for every winner there are big losers, we just don’t hear it as not publicised much)

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20
Q

1) magnitude issue

A

(only large portfolio managers can earn enough trading profit to exploit minor mispricing)

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21
Q

2) selection bias issue

A

(only unsuccessful/partially successful investment schemes made public)

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22
Q

3) lucky event issue

A

(for every winner there are big losers, we just don’t hear it as not publicised much)

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23
Q

acute market inefficiencies like a temporary drop in a stock price due to a large sale is more or less easily exploited than chronic inefficiencies

A

more easily exploited!

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24
Q

for weak form EMH what are returns like over short term?

A

tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods (moment effect)

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25
Q

for weak form EMH what are returns like over long-term?

A

reversal effect is the tendency of poorly performing stocks and well performing stocks in 1 period to experience reversals in following periods

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26
Q

Fama and French say what about returns on the stock market and dividends

A

return on stock market tends to be higher when dividend yields are higher

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27
Q

Campbell and Shiller say what about predicting stock market returns

A

earnings yield can predict market returns

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28
Q

Keim and Stambaugh say what about bond spreads and the market

A

bond spreads can help predict broad market returns

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29
Q

price drift and post earnings announcements in sem-strong markets

A

there’s a sluggish response of stock prices to firms’ earnings announcements –> market adjusts earnings info gradually –> results in sustained periods of abnormal returns

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30
Q

semi-strong tests

A

1) post earnings-announcement price drift
2) P/E effect
3) Neglected firm effect
4) liquidity effect

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31
Q

semi-strong test - P/E effect

A

portfolios of low P/E ratio stocks have provided higher returns that high P/E portfolios

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32
Q

semi-strong test - neglected firm effect

A

investments in stocks of less well known firms have generated abnormal returns

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33
Q

semi-strong test - illiquid effect

A

illiquid stocks have strong tendency to exhibit abnormally high returns

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34
Q

interpreting market anomalies - what do Fama and French say?

A

these effects can be explained by risks premiums

35
Q

Feature that small firms, low market-to-book firms, and recent “losers” seem to have in common is

A

a stock price that has fallen considerably in recent months/years

36
Q

interpreting market anomalies - what do Lakonishok, Shleifer, and Vishny say?

A

argue that these effects are evidence of inefficient markets

37
Q

performance on factor portfolios are shown to correlate with

A

state of the business cycle (previous years economic growth) suggests these factors (style and size factors) from Fama and French are capturing a source of systematic risk –> market wide influence

38
Q

in well functioning markets, over time anomalies should

A

self-destruct over time

39
Q

liquidity and low trading costs facilitate

A

efficient price deiscovery

40
Q

when do bubbles occur?

A

when a rapid run-up in prices creates a widespread expectation that they will continue to rise

41
Q

what do stock market analysts have a tendency to do?

A

be overwhelmingly positive in the assessment of the prospects of firms

42
Q

mutual fund performance

A

Some active managers outperform, some underperform but on average level of outperform not that dif from 0

43
Q

what does conventional finance say?

A

prices are correct and = to intrinsic value, resources allocated efficiently

44
Q

behavioural finance

A

investors may not be rational –> arbitragerus are limited and thus insufficient to force prices to match intrinsic value

45
Q

2 aspects of the behavioural critique

A
  1. Investors don’t always process info correctly and thus infer incorrect probability distributions of future returns
  2. Even when given a probability distribution of returns, investors may make inconsistent or suboptimal decisions
46
Q

4 types of behavioural biases

A

1) framing
2) mental accounting
3) regret avoidance
4) affect and feelings

47
Q

framing - behavioural bias

A

Decisions affected by how choices are described, such as whether uncertainty is posed as potential gains from a low baseline level, or as losses from a higher baseline value

48
Q

mental accounting - behavioural bias

A

Specific form of framing in which people segregate certain decisions

humans place different values on money, which leads to irrational decision making.

when people put their money into separate mental categories, separating them into different mental accounts, based on, say, the source of the money, or the intent of the account.

49
Q

regret avoidance - behavioural bias

A

Individuals who make decisions that turn out badly have more regret when that decision was more unconventional

50
Q

affect and feelings - behavioural bias

A

Investors tend to choose stocks with high affect, driving up prices while simultaneously driving down returns

51
Q

behavioural view prospect theory vs conventional view

A

behavioural view: utility depends on changes in wealth from current levels, not the level of wealth

conventional view: higher wealth provides higher utility but at a diminishing rate

52
Q

behavioural view prospect theory (which is consistent with risk averse behaviour)

A

people think in terms of expected utility relative to a reference point (e.g. current wealth) rather than absolute outcomes.

53
Q

3 things that limit arbitrage

A

1) fundamental risk - intrinsic value and market value may take too long to converge
2) implementation costs - transaction costs can take too long and restrictions on short selling, limiting arbitrage activity
3) model risk- ur model could just be shit and market value actually correct

54
Q

dividend discount model

A

=expected dividend /(cost of equity - growth rate)

provides a rational explanation for stock market bubble using this model

55
Q

market bubbles are inconsistent with

A

rational pricing, intrinsic value in the securities, and market efficiency

56
Q

expected return beta relationship

A

E(ri) = rf + B[E(rm)-rf)

B= Cov(ri,rm)/Vm

57
Q

what is the security characteristic line

A

is a regression line​, plotting performance of a particular security or portfolio against that of the market​

58
Q

first pass regression and the SCL for tests of the E(r) beta relationship

A

time series regression to estimate betas of securities/portfolios

59
Q

second pass regression and the SCL for tests of the E(r) beta relationship

A

cross-sectional regression of portfolio excess returns on betas, where estimated slope is the measurement of the reward for bearing systematic risk during the period

60
Q

If beta is measured with error and appears as a right-hand-side variable in the second-pass regression:
Slope coefficient of the regression equation will be

A

biased downward Intercept biased upward

61
Q

In terms of CAPM tests Fama and MacBeth verify the following:

A

1) Observed relationship between average excess returns and beta is indeed linear
2) Non-systematic risk does not explain average excess returns

62
Q

• Liquidity involves the following 5 things

A

1) Trading costs
2) Ease of sale
3) Necessary price concessions to effect a quick transaction
4) Market depth
5) Price predictability

63
Q

what does technical analysis focus on?

A

stock price patterns and on proxies for buy or sell pressure in the market.

64
Q

fundamental analysis looks at

A

the determinants of the underlying value of the firm, ie, current profitability and growth prospects

65
Q

Empirical studies of technical analysis don’t generally support the hypothesis that

A

such analysis can generate superior trading profits. One notable exception to this conclusion is the apparent success of momentum based strategies over intermediate term horizons

66
Q

what does behavioural finance focus on?

A

systematic irrationalities that characterise investor decision making. These “behavioural shortcomings” may be consistent with several efficient market anomalies.

67
Q

Limits to arbitrage activity impede the ability of rational investors

A

to exploit pricing errors induced by behavioural investors.

68
Q

Technical analysis is the search for

technical analysis is based on

A

recurring and predictable patterns in stock prices. It is based on the premise that prices only gradually close in on intrinsic value. As fundamental shifts, astute traders can exploit the adjustment to a new equilibrium.

69
Q

what indicators does fundamental analysis use?

A

volume data and sentiment indicators,

70
Q

Early tests of the single-factor CAPM rejected

A

the SML finding that non-systematic risk was related to average security returns.

71
Q

Later tests of the single-factor CPAM controlling for the measurement error in beta found that non-systematic risk

A

doesn’t explain the portfolio returns but also that the estimated SML is too flat compared with what the CAPM would predict.

72
Q

Roll’s critique implies that the usual CAPM test is a test only of

A

the mean-variance efficiency of a prespecified market proxy and thus that tests of the linearity of the expected return-beta relationship do not bear on the validity of the model.

73
Q

Tests of the single-index model that account for human capital and cyclical variations in asset betas are more or less supportive of the single-index CAPM and APT

A

more supportive.

Moreover, anomalies such as the size and book-to-market effects are mitigated once these variables are accounted for.

74
Q

The equity premium puzzle originates from the observation that equity returns exceeded the risk-free rate to an extent that is

A

inconsistent with the covariance of returns with consumption risk and reasonable levels of risk aversion at least when average rates of return are taken to represent expectations.

75
Q

Investors are slow to update their beliefs when given new evidence –> what behavioural effect is this

A

conservatism bias

76
Q

Investors are reluctant to bear losses caused by their

unconventional decisions.

A

Regret avoidance

77
Q

Investors exhibit less risk tolerance in their retirement accounts versus their other stock accounts.

A

mental accounting

78
Q

Investors are reluctant to sell stocks with “paper” losses.

A

Disposition effect

79
Q

investors disregard sample size when forming views about the future from the past.

A

representativeness bias

80
Q

illusion of knowledge in behavioural finance

A

if u believe you’re an expert on and can make accurate forecasts about something based on own research –> might not understand how to analyse the info nor have the ability to apply it to a proposed investment

81
Q

overconfidence in behavioural finance causes us to

A

misinterpret the accuracy of our info and our skill in analysing it. IF u assume info you have is accurate w.o trying to verify it/consult other resources, plus u may assume overconfidence in ability to evaluate/analyse the info

82
Q

reference points in behavioural finance

A

fixation on a reference point and waiting for price of a security to move above that reference point before selling it eg, could prevent investor from undertaking a risk/return-based analysis of portfolio position

83
Q

familiarity in behavioural finance

A

Irrational investors believe an investment in a company with which they are familiar will produce higher returns and have less risk than unfamiliar investments

(where you evaluate holding in a stock based on familiarity with the company rather than sound investment and portfolio principles. Company employees eg could have distorted view of the company)

84
Q

representativeness in behavioural finance

A

confusing company (which may well be a good company) with the company’s stock (which may or may not be an appropriate holding for his portfolio and/or a good investment) and its future performance. This can result in employees overweighting their company stock, thereby holding an under-diversified portfolio.

FINC3017 - IPM FINAL (12 decks)

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