BKM Chapter 11 – Efficient Market Hypothesis – Flashcards
Unlock all answers in this set
Unlock answersquestion
Assume a computer model was able to determine with 100% confidence that a stock price would increase from $90 to $100 over the course of the day. What would happen to the price of the stock?
answer
(Assuming all investors could see the results of this model) The price of the stock would immediately jump to $100 without any trades. Investors would but in orders to buy the stock at $90 dollars, but no one would agree to sell their shares until the price increased to $100.
question
Assume a computer model was able to determine with 100% confidence that a stock price would increase from $90 to $100 over the course of the day. What would happen to the market if only a few investors were able to see the results of this market?
answer
This investors would quickly take advantage of mispricing in the market and gobble up all available mispricing until the entire market was fairly priced.
question
Define the Efficient Market Hypothesis.
answer
The prices of securities fully reflect available information. Investors buying securities in an efficient market should expect to obtain an equilibrium rate of return.
question
Define random walk.
answer
Describes the notion that stock price changes are random and unpredictable.
question
How was the random movement in market prices misinterpreted?
answer
Initially, people that that the randomness of stock price indicated that the market was irrational. However, instead it should be interpreted as the market reflecting all available current information, such that only new, random news impacts price fluctuations.
question
How does competition impact the overall efficiency of the market?
answer
The level of efficiency depends upon the level of competition in the market. A market like U.S. large caps is thoroughly covered by analyst and therefore very efficient, while international markets may be less so.
question
Is there still room for active investors in a very efficient market?
answer
Even if a market is very efficient there still may be value unlocked by uncovering new information. The incremental value of this information may be very small, but for very large firms even small incremental increases in performance can mean very large dollars. Therefore even in efficient markets investors may still try to seek to uncover new information.
question
What are the three versions of the Efficient Market Hypothesis?
answer
1. weak-form 2. semi-strong form 3. strong form
question
Describe the weak-form of the Efficient Market Hypothesis?
answer
All market trading information (such as trading volume and short interest) is already incorporated into current market prices.
question
Define the semi-strong version of the Efficient Market Hypothesis
answer
This assumes that all public information is already reflected in current market prices.
question
Define the strong form version of the Efficient Market Hypothesis.
answer
All information (including private information) is incorporated into current market prices.
question
Does the Efficient Market Hypothesis imply that all assets are accurately priced?
answer
It does not imply that all assets are ultimately priced correctly. Just that securities are fairly priced given current information, and that we do not know if actual prices will turn out to be higher or lower.
question
What is technical analysis?
answer
It is the search for reoccurring and predictable patterns in stock prices.
question
What is the true test of a technical trading rule?
answer
If it continues to hold once it has been discovered.
question
What is fundamental analysis?
answer
The determination of a securities price based on an analysis of expected future cash flows discounted to the present value.
question
Why does the Efficient Market Hypothesis predict that most fundamental analysis is doomed to fail?
answer
If an analyst relies on publicly available data, his or her evaluation is not likely to be significantly more accurate or different from his competition. Therefore only analysts with a truly unique insight will profit.
question
What is a passive investment strategy?
answer
A investment strategy that seeks only to establish a large, well-diversified portfolio without any attempts to find over or under valued stocks.
question
How does the Efficient Market Hypothesis support a passive investment strategy?
answer
Efficient Markets are difficult for individual investors to can valuable additional insight that reveals mispricing because security analysis is already very competitive. However relying on a professional investors may also be a poor idea because fees may overcome the benefit associated with the excess return. Therefore the optimal risky portfolio for an investor may well be a passive portfolio.
question
What role does portfolio management have even in a strong form Efficient Market?
answer
1. Diversification still needs to be achieved. 2. Tax considerations still need to be taken into consideration. 3. An investor must still decided their optimal portfolio given their utility.
question
What is an event study?
answer
Research methodology designed to measure the impact of an event of interest on stock returns.
question
What is an abnormal event in an event study?
answer
The estimated difference between the stock's actual return and the return which would have occurred despite the occurrence of the event trying to be quantified.
question
What is the market model for valuing abnormal returns?
answer
It is a single factor index model. In which the firm-specific risk is interpreted as the abnormal return.
question
What complication arises in using the market model for abnormal returns?
answer
When fitting the regression equation one must be carefully when fitting the alpha and beta parameters. These factors should be estimated in such a way that they are not impacted by the event being measured.
question
What is the magnitude issue with regard market efficiency?
answer
Some investors which large economies of scale may be able to make money with security analysis, but the improvement in return is probably so small that it is hidden by the volatility of market returns. Therefore it may be difficult to measure if active portfolio managers are actually finding excess returns.
question
How does selection bias relate to the Efficient Market Hypothesis?
answer
Only trading techniques that do not work will be revealed. Individuals that do know of market mispricing will silently continue to take advantage of them. Opponents of EMH argue that this is one reason we cannot fairly evaluate whether EHM is true or not.
question
How does the luck make testing the Efficient Market Hypothesis difficult?
answer
We want to see if individual's performing security analysis can consistently earn excess returns, which would be at odds with the EMH. However an examination of historical returns along is difficult because of market volatility which will make result in a large range of actual returns. Therefore it is difficult to determine if excess returns were anything more than luck.
question
Where researchers able to find short term stock returns that conflicted with the EMH?
answer
They were able to find that there was a week correlation between weekly stock returns. But not enough to conflict with the EHM.
question
Where researches able to find medium term stock returns that conflict with the EHM?
answer
They were able to find a medium term momentum effect, which suggests information is not incorporated into market prices as quickly as EHM would suggest.
question
What is the momentum effect?
answer
The tendency of poorly performing stocks and well performing stocks in one period to continue that abnormal performance in the following periods.
question
What correlations have been observed in prices over the short term?
answer
Negative correlation has been observed. Indicating that there may be overreaction to information in shorter time periods, which then gets corrected in market prices later on.
question
Define the reversal effect?
answer
The tendency of poorly performing stocks and well-performing stocks in on period to experience reversals in the following periods.
question
Fama-French found that aggregate stock market returns tend to be higher when the dividend to price ratio is high. Does this contradict the EHM?
answer
Probably not. The thought is that changes in this variable is really just serving as a proxy for changes in the market risk premium.
question
List a number of market anamolies which seem contradictory to the Efficient Market Hypothesis?
answer
1. P/E Effect 2. Small-Firm (In January) Effect 3. Book to Market Effect 4, Post Earnings Announcement Drift 5. Neglected Firm Effect
question
What is an explanation for the P/E Effect?
answer
Risk adjusted returns on not being calculated correctly to truly adjust for the risk differences.
question
What is an explanation of the Small Firm Effect?
answer
Small firms do not have as much analyst scrutiny. This means there is less public information and therefore small firms are in fact more risky investments. Therefore a higher return is demanded on a risk adjusted basis.
