UoL questions

Question 1

Excess return

Answer 1

equal to the difference between actual return and the equilibrium expected return. In a forward-looking perspective could be replaced by the optimal forecast return.

If the market is informationally efficient, then you can not have consistent excess returns.
But you may make occasional excess returns (fair game - guessing)

Question 2

Joint hypothesis problem

Answer 2

the model used to determine the expected return in calculation of excess return may be incorrect
=> measure of excess return would be incorrect
=> problem to test whether excess returns exist and are consistent:
1. The equilibrium expected return is accurately specified
2. The market is efficient
Rejection may occur if first is violated while the second is correct

Question 3

Reaction to new information (impilcations)

Answer 3

Underreaction to new information implies that a momentum strategy could be profitable.
=> against semistrong form of ME

Weak form: evidence, as well. buying past winners, selling past losers - violation of weak form

Question 4

Financial bubbles => efficiency

Answer 4

Financial bubble is an irrationality in financial decision-making by borrowers and banks
information efficiency is not necessarily violated. as long as traders use all information in forming expectations then markets are informationally efficient. but they can still deviate from the true value (violation of valuation efficiency)

Question 5

Capital budgeting, Asset Pricing why important ME?

Answer 5

Capital budgeting: the purpose is to maximize shareholders wealth => increase the value of stocks. So, it is important that financial markets value the stocks correctly. That is, the signal given by the market through the price to the shareholders has to reflect the firm’s investment decisions in the correct way.

What is more, in capital budgeting discount rate is used. If the markets are inefficient, then it is impossible for managers to take rational capital investment decisions since they can not determine the opportunity cost of capital

One main assumption in the portfolio theory is that markets are reasonably efficient. Equilibrium return (by CAPM or APT) loses credibility, otherwise

Question 6

Forms of market efficiency

Answer 6

weak form - prices fully reflect all historical info
semistrong - prices reflect all available public info
strong - prices reflect all public and private info

nests

weak form => cannot use models, technical analysis based on past data to predict future prices

semistrong - can’t use fundamental analysis to try to pick undervalued securities