Week 1

Question 1

Define Behavioural Finance?

Answer 1

Studies how psychological biases affect financial decision-making –> prices deviate from fundamentals due to investors’ systematic mistakes.

Question 2

Define Neoclassical Finance?

Answer 2

1) Assumes investor rationality.
2) Assumes prices accurately reflect fundamentals –> determined using DCF analysis –> prices only move if news about cashflows &/or discount rates.
3) Assumes efficient mkts.
4) Assumes Bayesian Updating –> i.e. new evidence already incorporated into investors’ expectations.
5) Assumes choices made according to EUT –> i.e. discount rate comes from some equilibrium models.

Question 3

What is the Efficient Markets Hypothesis (EMH)?

Answer 3

Mkts are informationally efficient when security prices fully reflect all relevant info re fundamentals –> no investor can consistently, on average, generate excess/abnormal returns on known info.

Question 4

What are the 3 (progressively weaker) conditions of market efficiency?

Answer 4

1) Investor rationality; investors do not make mistakes.
2) Investors can make mistakes –> but uncorrelated & cancel each other out.
3) Investors can make correlated mistakes, but rational investors (arbitrageurs) exploit errors & restore efficiency.

• If any of these 3 conditions met, mkt is efficient.

Question 5

What is the definition of weak form efficiency?

Answer 5

Prices reflect all info contained in historical prices & returns.

Question 6

What is the definition of semi-strong form efficiency?

Answer 6

Prices reflect all publicly available info (including past prices; past financial statements, press info etc.)

Question 7

What is the definition of strong-form efficiency?

Answer 7

Prices reflect ANY info, public or private (e.g. insiders’ info).

Question 8

What do EMH proponents argue about fundamental & technical analysis?

Answer 8

• Technical analysis based on historical data charts & fundamental analysis based on publicly available financial info will not successfully generate excess returns (i.e.. above expected, risk-adjusted return) –> as all relevant info regarding securities’ fundamentals already priced in.

Question 9

Why is stale information not valuable in making profit in efficient markets?

Answer 9

Asset prices have already incorporated all current info so not affected by stale (outdated/irrelevant) info.

Question 10

Do efficient markets rule out profits?

Answer 10

No - but profits must be fair mkt compensations for risk-bearing –> i.e. systematic profits associated w higher risk.

Question 11

Why is active portfolio management not useful in efficient markets?

Answer 11

• On average no abnormal profits –> active trading involves holding non-systematic risk which is not compensated in eq by higher returns.
• If mkts are semi-strong efficient, then info already reflected in stock prices should include all info available to public so mutual fund managers should not consistently outperform mkt by picking undervalued/overvalued stocks.
  -Passive investment strategies ‘tracking’ mkt recommended –> investor avoids holding individual stocks; should invest in index mutual funds or ETFs.

Question 12

How is the EMH affected by the CAPM?

Answer 12

1) alpha = abnormal return over & above systematic risk –> idiosyncratic risk never compensated & hence should be diversified away as info specific to an individual asset is quickly incorporated into its price –> alpha = 0 on avg.
2) εi,t = actual excess returns –> will sometimes be above/below expected eq returns, i.e., may be +ve/-ve.

Question 13

What are the 3 tests for an efficient market according to the EMH?

Answer 13

1) Security prices should not move in absence of news about its fundamental value –> i.e. should not react to changes in demand/supply not caused by news about fundamental value.
2) Security prices react to incorporate news about fundamental value quickly and correctly (do not under-react/overreact).
3) Abnormal return of strategies conditioning on known info should = 0.

Question 14

What are the 3 pieces of empirical evidence supporting the EMH?

Answer 14

1) Random walk of prices (Fama, 1965)
2) Reaction to news (Fama et al., 1969; Keown and Pinkerton, 1981)
3) Ineffectiveness of active portfolio management (Jensen, 1968)

Question 15

How is the random walk of prices evidence for the EMH?

Answer 15

• Supports weak form of EMH.
• Fama (1965) finds best guess for future price is current price, as past price movements provide no useful information for forecasting future price changes: Et(Pt+1) = Pt
• No systematic evidence that technical trading strategies, e.g. buying stocks when their prices increased or selling them when they went down, are profitable.
• Price of a stock on any given day is as likely to rise after a previous day’s increase as after a previous day’s decline.

Question 16

How is reaction to news evidence of the EMH?

Answer 16

• Supports semi-strong form of EMH.
• Fama et al. (1969) conducts event study on stock split event –> company divides existing shares into multiple shares –> no predictable pattern of abnormal returns that can be exploited by investors in months after split, after increased dividends considered –> stock prices adjust rapidly to new info as mkt makes good forecasts of dividend implications of split, & relevant forecasts are fully incorporated into stock price by end of split month.
• Keown & Pinkerton (1981) supports semi-strong form –> examines daly stock price movements prior to public merger announcement –> prices quickly increase on day of public announcement info.

Question 17

How is ineffectiveness of active portfolio management evidence of the EMH?

Answer 17

• Supports semi-strong form of EMH.
• Jensen (1968) examines whether active mutual funds exhibit stock picking skills over time for various funds –> finds on average active funds do not outperform mkt portfolio –> no single fund can consistently beat mkt –> all publicly available info quickly & accurately reflected in security prices, making it challenging for investors to consistently outperform mkt based on publicly available info.