1 Flashcards
(20 cards)
What is an efficient market
Prices fully reflect all available information
What is an inefficient market
Prices reflect only some information but not all
What are the foundations of market efficiency
Rationality
Independent deviations from rationality
Arbitrage
What is rationality in foundations of market efficiency
Assumes all investors are rational therefore, when new information is released in market, they will adjust their estimates of share price in a rational way
What is independent deviations from rationality in foundations of market efficiency
Accepts that some investors do not act fully rationally however, supposes that about as many individuals are irrationally optimistic as irrationally pessimistic therefore, these countervailing irrationalities will move market in a manner consistent with market efficiency
What is arbitrage in foundations of market efficiency
Process through which an investor can buy an asset or combination of assets at one price and concurrently sell at a higher price, thereby earning profits without investing any money or being exposed to any risk
What would the combined actions of many investors engaging in arbitrage result in
Rapid price adjustments that eliminate any arbitrage opportunities
In efficient markets, is it possible to earn abnormal returns
No. Arbitrage activities will quickly eliminate arbitrage opportunities available in market thereby promoting market efficiency
What is abnormal return
Returns that are in excess of return required for risk assumed
What are the 3 forms of efficiency
Weak form – past prices
Semi strong Form – public information
Strong Form – all information
What is the random walk theory
Security prices change randomly with no predictable trends or patterns. Movement of stock prices is random. 
What are technical analyst’s
Investors who attempt to identify undervalued stocks by searching for patterns in past stock prices. Forecast stock prices based on watching fluctuations in historical prices. 
What are fundamental analysts
Investors who attempt to find mispriced securities by analysing fundamental information such as accounting data and business prospects. Research value of stocks using NPV and other measurements of cash flow
What are the common misconceptions of market efficiency
Dart throwing just as effective as stock pricing – wrong. Investors still have to worry about risk and diversification
Price fluctuations are predictable – wrong. Prices are random because new information is released randomly
Markets can’t be efficient because only a subset of shareholders trade – wrong. Only a subset of investors are needed to take advantage of arbitrage opportunities
What is rationality in behavioural challenge of market efficiency
Behavioural view is not that all investors are irrational but that some perhaps many are
What is independent deviations from rationality in behavioural challenge of market efficiency
Deviation from rationality are not random and likely to cancel each other out. In contrary, psychologists argue that individuals deviate from rationality in accordance with a number of basic principles, most relevant to finance representativeness and conservatism
What is arbitrage in behavioural challenge of market efficiency
Arbitrage strategies might involve too much risk to eliminate market efficiencies. An investor buying an under priced asset and selling overpriced one doesn’t have sure thing. Deviation from parity could actually increase in the short run meaning losses for arbitrageur. Therefore, risk consideration might force arbitrageurs to take positions that are too small to move prices back to parity
What are the four important implications for corporate finance
Accounting and financial choices
Timing of debt and equity issues
Speculation
Using information in market prices
What does efficient market hypothesis not say
Prices are uncaused
Investors are foolish and too stupid to be in market

All shares have same expected returns
There is no upward trend in share prices
Investors should throw darts to select shares
What does efficient market hypothesis say
Prices reflect underlying value
Financial managers cannot time equity and bond sales
Managers cannot profitably speculate
Managers cannot boost share prices through creative accounting
