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Investments > Week 7 > Flashcards

Week 7 Flashcards

1
Q

Efficient Market Hypothesis

A

markets are informationally efficient, meaning:

Security prices should fully reflect all available information; and,

New information should be incorporated into security prices in an instantaneous and unbiased manner

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2
Q

when assessing market efficiency, we should be concerned with both

A

The speed at which new information is incorporated into prices and,

 Whether new information is correctly incorporated into stock prices

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3
Q

An instantaneous price reaction will mean

Imagine a firm whose shares trade every 15 minutes. Further:

Shares in the firm last traded at 10.30am for exactly $1; and,

At 10.38am (ie after the 10.30am trade), information has been released about the firm that should see its value decrease and the share price fall by 40%.

A

information is reflected in the next price established in the market after its release

this will be at 10.45am.

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4
Q

non-instantaneous price reaction

A

delay between the release of information and its reflection in the share price. Here, this will be after the 10.45am trade.

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5
Q

biased price reaction

overreaction

A

an initial response to information and a subsequent revision to it

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6
Q

biased price reaction

underreaction

A
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7
Q

If markets are informationally efficient

A

information which could predict the performance of an instrument should already be impounded into its price.

  • any new information will be instantaneously and unbiasedly impounded into prices;
  • As new information is unpredictable, changes in prices resulting from this information will also be unpredictable; and,
  • therefore, stock price changes should follow a random walk.
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8
Q

three versions of the EMH

weak-form hypothesis

A

argues that prices reflect historical information

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9
Q

three versions of the EMH

semistrong-form hypothesis

A

prices reflect all publicly available information, past and present

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10
Q

three versions of the EMH

strong-form hypothesis

A

prices reflect all publicly and privately available information, past and present

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11
Q

Tests of weak-form efficiency focus on

A

Tests of weak-form efficiency focus on whether trading based on historical price patterns yields abnormal profits.

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12
Q

Tests of weak-form efficiency focus on whether trading based on historical price patterns yields abnormal profits. To do this, they study

A

the relationship between past and present returns over short horizons and long horizons

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13
Q

Tests of weak-form efficiency focus on whether trading based on historical price patterns yields abnormal profits. To do this, they study the relationship between past and present returns over short horizons and long horizons

Short horizons

A

Testing provides some evidence of positive serial correlation, or performance persistence at the portfolio level eg the momentum effect

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14
Q

Tests of weak-form efficiency focus on whether trading based on historical price patterns yields abnormal profits. To do this, they study the relationship between past and present returns over short horizons and long horizons

long horizons

A

There is evidence of negative serial correlation consistent with periods of market overshooting followed by correction.

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15
Q

Many tests of semistrong-form efficiency consider

A

whether publicly available information can be used to predict abnormal risk-adjusted returns.

If the market is indeed semistrong-form efficient, this should not be possible; but

Empirical evidence suggests that a number of publicly available factors can explain returns. Examples of these factors (or anomalies) include size, book-to-market and liquidity.

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16
Q

Other tests of semistrong-form efficiency employ an

A

event study methodology to test whether security prices adjust instantaneously to an event such as a public announcement

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17
Q

Other tests of semistrong-form efficiency employ an event study methodology to test whether security prices adjust instantaneously to an event such as a public announcement:

why?

A

any expected component of the announcement should already be impounded in share prices, we should only observe a reaction to the unexpected component of the announcement; and,

This reaction should be observed as an abnormal return (relative to what was otherwise expected) at the time of the announcement.

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18
Q

If markets are strong-form efficient,

A

insiders including company directors who possess private (inside) information should not be able to make abnormal returns from trading on this information.

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19
Q

If markets are strong-form efficient, insiders including company directors who possess private (inside) information should not be able to make abnormal returns from trading on this information. Importantly:

A

We do not expect markets to be strong-form efficient given regulations prevent / limit trades based on inside information;

Insiders must report their trades with regulators within designated timeframes for publication. At this point, information becomes public;

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20
Q

strong-form efficiency

If markets are efficient,

A

information contained in the reports will be instantaneously and unbiasedly incorporated into share prices, meaning investors should not be able to profit from following insider trades; and,

Consistent with this, evidence suggests any abnormal returns earned by following insider trades are less than the transaction costs incurred in executing them.

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21
Q

what do the anomalies mean in terms of market efficiency

A

Some argue they are evidence of market inefficiency (see, for example, Lakonishok et al, 1995);

Others argue they are simply risk premiums and indicate the need to augment the CAPM to include other sources of risk (see, for example, Fama and French, 1993); and,

 Others still argue they are the result of data mining.

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22
Q

Interpreting the Evidence

The best test of market efficiency is

A

whether skilled investors can consistently earn abnormal trading profits. They should not be able to do this if markets are efficient; and,

We will look evidence in this regard for two groups of professional investors, namely analysts and mutual fund managers

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23
Q

Mutual Funds Performance

Testing of mutual funds’ ability:

A

 Involve examining risk-adjusted mutual fund performance, that is, returns adjusted for exposure to systematic risk factors. Risk adjustment is typically made using Cahart’s Four-Factor Model;

 Suggests that, while some managers can outperform some of the time, most managers don’t seem to be able to consistently outperform (ie earn abnormal returns) after fees; but,

 There are some notable exceptions.

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24
Q

Analyst Performance

Studies of analyst performance:

A
  • Look at the relationship between levels of (changes in) analyst recommendations and stock price movements following release of these recommendations (changes);
  • Suggest firms with better recommendations (positive changes in recommendations) outperform those with lesser recommendations (negative changes in recommendations);
  • Do not conclude whether these returns are the result of analysts providing new information or changes in demand and supply following releases of analyst recommendations / changes therein; and,
  • Does not resolve whether any returns would be greater than the transaction costs incurred in earning them.
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25
Q

Are Markets Efficient?

A

The performance of professional managers is broadly consistent with market efficiency;

Most managers do not do better than the passive strategy; but,

 There is sufficient empirical evidence of anomalies to justify the ongoing search for underpriced securities.

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26
Q

Behavioural Finance

A

argues that the anomalies are consistent with irrationalities observed in individuals when making complex decisions

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27
Q

Behavioural finance argues that the anomalies are consistent with irrationalities observed in individuals when making complex decisions. In particular:

A

Investors don’t always process information correctly and therefore don’t infer incorrect probability distributions about future rates of return; and,

 Even if they infer correct probability distributions, they often make inconsistent or systematically suboptimal decisions.

28
Q

Behavioural Finance

Information Processing

Important biases include:

A
  • Forecasting errors: People give too much weight to recent experiences;

 Overconfidence: People are unjustifiably confident in the forecasts they make;

Conservatism: Investors are slow to update their beliefs when new information becomes available; and,

 Sample size neglect and representativeness: Investors generalise patterns observed in small samples to the population in general.

29
Q

Behavioural Finance

Information Processing

Behavioural biases include:

A

Framing: Framed can significantly impact how investors choose between investment choices. A type of framing, where people segregate particular decisions, is known as mental accounting;

Regret avoidance: Investors are more regretful of decisions with bad outcomes when they are unconventional and, therefore, tend to avoid them; and,

 Prospect theory: Conventional finance theory argues utility depends on the level of an investors’ wealth. Under prospect theory, it depends on changes in wealth from current levels.

30
Q

Limits to Arbitrage

The ability to profit from any mispricing is limited as a result of:

A

 Fundamental Risk: Investors worry about the risk of investing in stocks that are underpriced given the potential for the underpricing to get worse;

ImplementationCosts: Tradingisnotcostless. Indeed, transaction costs may make mispricing not worth exploiting; and,

Model Risk: Investors may be concerned that the valuation model is faulty and the stock might not really be mispriced.

31
Q

Technical analysts aim to

A

take advantage of recurring and predictable patterns in stock prices.

32
Q

Technical analysts aim to take advantage of recurring and predictable patterns in stock prices. They believe

A

 Recurring patterns are observable in stock prices;

 While useful, information on the firm’s expected future performance isn’t necessary to formulate profitable trading strategies; and,

 Whatever the fundamental reason for stock price changes, if price adjustments are slow, trends can be identified and taken advantage of. This is at odds with the idea that markets are informationally efficient.

33
Q

Technical Analysis

One of the first theories of technical analysis was Dow theory, which argues

A

that stock price movements can be broken down into:

 A primary trend, or long-term movement in prices;
 Secondary or intermediate trends, or short-term

deviations from the primary trend; and,

 Tertiary or minor trends, which are very short-term fluctuations.

34
Q

Other techniques used by technical analysts to uncover trends include, but are not limited to:

 Moving averages

A

average prices calculated over moving windows of pre-determined length. These averages are compared with market prices to generate buy and sell signals

35
Q

Other techniques used by technical analysts to uncover trends include, but are not limited to:

Relative strength measures

A

compare a stock’s performance of over a period with that of the market / the firm’s industry to determine whether to buy or sell it

36
Q

Other techniques used by technical analysts to uncover trends include, but are not limited to:

Breadth measures

A

measure differences between the number of stocks rising and falling in price, and are used to gauge broad trends

37
Q

Technical analysts also use a number of sentiment measures including

A
  • Trin Statistic, or the ratio of the average volume in declining issues to the average volume in advancing issues;

 Confidence Index, or the ratio of the yield on top- rated corporate bonds to that on intermediate- grade corporate bonds; and,

Put/Call Ratio, or the ratio of outstanding put options to outstanding call options.

38
Q

Technical analysis problems

A

If markets are weak-form efficient, it should not be possible to make superior profits from trading based on patterns in stock prices as:

 Past price data is publicly available;
 Any information that results from examining these series should already be impounded in stock prices; and,

 On the rare occasion it is not, if markets are efficient, the ability to make abnormal profits from it should be quickly removed as large numbers of traders attempt to take advantage of it.

39
Q

Technical analysis also suffers from the problem of data mining:

A

If you test enough rules, some will have worked historically;

You should consider whether rules would seem reasonable before you looked at the data; and,

 The fact these rules would have worked previously does not mean they will work in the future.

40
Q

Fundamental analysis involves:

A

Forecasting fundamental determinants of a given firm’s value including earnings, dividend prospects, firm risk and interest rates;

 Using these forecasts to estimate the present value of cash flows shareholders will receive by investing in the firm’s shares; and,

 Making trading decisions based on these calculations relative to the current stock price.

41
Q

Importantly:

 Fundamental analysis involves the

A

Fundamental analysis involves the search for stocks that are going to perform better than the market expects them to; but,

 As such analysis uses publicly available information, if markets are semistrong-form efficient, it should generally not yield trading strategies capable of generating superior profits.

42
Q

implications of the EMH for investors

A

Even if markets are efficient, randomly choosing stocks to include in an investment portfolio is not a reasonable approach given:

It may yield a portfolio with risk characteristics not consistent with the risk preferences of the investor;

 It may not result in a diversified portfolio; and,

It may not provide a portfolio that is suitable for an investor from a tax perspective.

43
Q

implications of the EMH for investors

in terms of whether investors can “beat the market”, supporters of EMH argue

A

Active portfolio management is both expensive and a waste of time;

Investors should simply buy and hold a well-diversified portfolio; and,

 Examples of passive management strategies include holding index funds and ETFs.

44
Q

Microsoft’s continuing profitability imply that stock market investors who purchased Microsoft shares after its success was already evident would have earned an exceptionally high return on their investments?

A

No

means that Microsoft has made risky investments over the years that have paid off in the form of increased cash flows and profitability. Microsoft shareholders have benefited from the risk-expected return tradeoff, which is consistent with the EMH.

45
Q

Multiple studies suggest that “value” stocks

A

Multiple studies suggest that “value” stocks (measured often by low P/E multiples) earn higher returns over time than “growth” stocks (high P/E multiples). This could suggest a strategy for earning higher returns over time.

However, another rational argument may be that traditional forms of CAPM (such as Sharpe’s model) do not fully account for all risk factors that affect a firm’s price level. A firm viewed as riskier may have a lower price and thus P/E multiple.

46
Q

Multiple studies suggest that “value” stocks

A

Multiple studies suggest that “value” stocks (measured often by low P/E multiples) earn higher returns over time than “growth” stocks (high P/E multiples). This could suggest a strategy for earning higher returns over time.

However, another rational argument may be that traditional forms of CAPM (such as Sharpe’s model) do not fully account for all risk factors that affect a firm’s price level. A firm viewed as riskier may have a lower price and thus P/E multiple.

47
Q

The book-to-market effect suggests

A

an investor can earn excess returns by investing in companies with high book value (the value of a firm’s assets minus its liabilities divided by the number of shares outstanding) to market value

48
Q

A study by Fama and French1 suggests that book-to-market value reflects

A

a risk factor that is not accounted for by traditional one variable CAPM. For example, companies experiencing financial distress see the ratio of book to market value increase. Thus a more complex CAPM that includes book-to-market value as an explanatory variable should be used to test market anomalies.

49
Q

Stock price momentum can be

A

positively correlated with past performance (short to intermediate horizon) or negatively correlated (long horizon).

50
Q

Stock price momentum can be positively correlated with past performance (short to intermediate horizon) or negatively correlated (long horizon). Historical data seem to imply statistical significance to these patterns. Explanations for this include a

A

bandwagon effect or the behaviorists’ explanation that there is a tendency for investors to underreact to new information, thus producing a positive serial correlation.

However, statistical significance does not imply economic significance. Several studies that included transaction costs in the momentum models discovered that momentum traders tended to not outperform the efficient market hypothesis strategy of buy and hold.

51
Q

Market efficiency implies

A

investors cannot earn excess risk-adjusted profits.

If the stock price run-up occurs when only insiders know of the coming dividend increase, then it is a violation of strong-form efficiency. If the public also knows of the increase, then this violates semistrong-form efficiency.

52
Q

While positive beta stocks respond well to favorable new information about the economy’s progress through the business cycle,

A

they should not show abnormal returns around already anticipated events. If a recovery, for example, is already anticipated, the actual recovery is not news. The stock price should already reflect the coming recovery

53
Q

Technical analysis can generally be viewed as

A

a search for trends or patterns in market prices.

Technical analysts tend to view these trends as momentum, or gradual adjustments to ‘correct’ prices, or, alternatively, reversals of trends.

54
Q

Technical analysis can generally be viewed as a search for trends or patterns in market prices. Technical analysts tend to view these trends as momentum, or gradual adjustments to ‘correct’ prices, or, alternatively, reversals of trends.

what contributes to these trends?

A

A number of the behavioral biases might contribute to such trends and patterns. e.g. conservatism bias ight contribute to a trend in prices as investors gradually take new information into account, resulting in gradual adjustment of prices towards their fundamental values

55
Q

Technical analysis can generally be viewed as a search for trends or patterns in market prices. Technical analysts tend to view these trends as momentum, or gradual adjustments to ‘correct’ prices, or, alternatively, reversals of trends.

what contributes to these trends?

apart from conservatism bias

A

concept of representativeness, which leads investors to inappropriately conclude, on the basis of a small sample of data, that a pattern has been established that will continue well into the future. When investors subsequently become aware of the fact that prices have overreacted, corrections reverse the initial erroneous trend

56
Q

Even if many investors exhibit behavioral biases,

A

security prices might still be set efficiently if the actions of arbitrageurs move prices to their intrinsic values.

  • Arbitrageurs who observe mispricing in the securities markets would buy underpriced securities (or possibly sell short overpriced securities) in order to profit from theanticipated subsequent changes as prices move to their intrinsic values.
  • Consequently, securities prices would still exhibit the characteristics of an efficient market.
57
Q

Efficient market advocates believe that publicly available information (and, for advocates of strong-form efficiency, even insider information)

A

is, at any point in time, reflected in securities prices, and that price adjustments to new information occur very quickly.

Consequently, prices are at fair levels so that active management is very unlikely to improve performance above that of a broadly diversified index portfolio.

58
Q

In contrast, advocates of behavioral finance

A

identify a number of investor errors in information processing and decision making that could result in mispricing of securities.

  • However, the behavioral finance literature generally does not provide guidance as to how these investor errors can be exploited to generate excess profits.
  • Therefore, in the absence of any profitable alternatives, even if securities markets are not efficient, the optimal strategy might still be a passive indexing strategy.
59
Q

Mental accounting holds that

A

investors segregate funds into mental accounts (e.g., dividends and capital gains)

  • maintain a set of separate mental accounts
  • and do not combine outcomes
  • a loss in one account is treated separately from a loss in another account
  • Mental accounting leads to an investor preference for dividends over capital gains and to an inability or failure to consider total return
60
Q

mental accounting example

A

Sampson’s requirement that his income needs be met via interest income and stock dividends

61
Q

Overconfident individuals often exhibit

A

risk-seeking behavior. People are also more confident in the validity of their conclusions than is justified by their success rate.

62
Q

Causes of overconfidence include

A

the illusion of control, self-enhancement tendencies, insensitivity to predictive accuracy, and misconceptions of chance processes.

63
Q

overconfidence example

A

Sampson’s desire to select investments that are inconsistent with his overall strategy

64
Q

Reference dependence holds that

A

investment decisions are critically dependent on the decision-maker’s reference point. In this case, the reference point is the original purchase price.

  • Alternatives are evaluated not in terms of final outcomes but rather in terms of gains and losses relative to this reference point. Thus, preferences are susceptible to manipulation simply by changing the reference point.
65
Q

example of reference dependence

A

Sampson’s desire to retain poor-performing investments and to take quick profits on successful investments

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