LM 3: Market Efficiency

Question 1

What is an informationally efficient market?

Answer 1

market were prices reflect all past & present information

Question 2

What are 4 things affecting market efficiency? MILT

Answer 2

1. market participants
2. information availability & financial disclosure
3. limits to trading
4. transaction costs & information acquisition costs

Question 3

What is the performance difference between an efficient market and an inefficient market?

Answer 3

efficient market cannot get consistent, superiors risk adjusted returns

inefficient market can outperform on a risk adjusted basis

Question 4

What kind of information should efficient markets react too?

Answer 4

efficient markets should only react to unexpected information, expected news is already built into prices

Question 5

What are the 3 degrees of market efficiency?

Answer 5

1. weak
2. semi-strong
3. strong

Question 6

What information is reflected in prices in a weak form market efficiency?

Answer 6

past market data (price and trading volume)

Question 7

What information is reflected in prices in a semi-strong market efficiency?

Answer 7

public information & past market data (past price and trading volume information)

Question 8

What information is reflected in prices in a strong market efficiency?

Answer 8

private information, public information, and past market data

Question 9

Using technical analysis shows what kind of market efficiency?

Answer 9

weak form

Question 10

What kind of market efficiency does fundamental analysis support?

Answer 10

semi-strong form

Question 11

What kind of market efficient do portfolio managers benefit from?

Answer 11

none, studies show active portfolio managers do not beat the market on average. however, good to create an investment strategy based on ones objectives and constraints

Question 12

What is a market anomaly?

Answer 12

change in a security’s price that cannot be attributed to new information.

Question 13

What are 2 types of time series anomalies?

Answer 13

1. calendar anomalies
2. momentum & overreaction anomalies

Question 14

What are calendar anomalies?

Answer 14

Anomalies that are linked to a particular time (eg. January effect)

Question 15

What is momentum & overreaction anomalies?

Answer 15

momentum anomaly: observed tendency for rising asset prices to rise further and falling prices to keep falling.

overreaction anomaly: securities become excessively overbought or oversold due to psychological reasons rather than fundamentals.

Question 16

What are 2 types of cross sectional anomalies, describe them?

Answer 16

1. size effect (small cap outperformed big cap on risk adjusted basis)
2. value effect (the observation that stocks with attractive valuations tend to outperform the market in the long term)

Question 17

What are 4 other market anomalies besides time series & cross sectional? CEIP

Answer 17

1. closed end investment fund discounts
2. earnings surprise
3. IPO
4. predictability of returns based on prior information

Question 18

What is closed end investment fund discounts anomaly?

Answer 18

Shares of closed-end funds trade on stock markets like other equity securities, but at a discount to their net asset value (NAV)

Question 19

What is earnings surprise anomaly?

Answer 19

companies with positive surprise earnings announcements experience a prolonged period of abnormal positive security returns

Question 20

What is initial public offerings anomaly?

Answer 20

companies that issue IPOs tend to set low offering prices so earn excess returns by purchasing IPO at offering price

Question 21

What is Predictability of Returns Based on Prior Information anomaly?

Answer 21

equity returns are linked to factors including interest rates, inflation rates, volatility, and dividend yields.

Question 22

What is one implication you must consider with market anomalies?

Answer 22

trading costs

Question 23

What is behavioral finance?

Answer 23

Behavioral finance: area of study that proposes psychology-based theories to explain market outcomes and anomalies.

Question 24

What are 8 behavioral finance biases that can cause or explain anomalies? LHOIRMCN

Answer 24

1. loss aversion
2. herding
3. overconfidence
4. information cascades
5. representativeness
6. mental accounting
7. conservatism
8. narrow framing

Question 25

What is loss aversion and herding?

Answer 25

loss aversion: phenomenon where a real or potential loss is perceived by individuals as psychologically or emotionally more severe than an equivalent gain.

herding: investors take the same side as the market even if this is inconsistent with their own private information.

Question 26

What is overconfidence & information cascades?

Answer 26

overconfidence: Investors are often overconfident in their own abilities

information cascades: when market participants influence decision of others by acting first

Question 27

What is representativeness and mental accounting bias ?

Answer 27

Representativeness: assessing likelihood of event based on past event (police who are looking for a suspect in a crime might focus disproportionately on Black people in their search, because the representativeness heuristic (and the stereotypes that they are drawing on) causes them to assume that a Black person is more likely to be a criminal than somebody from another group.)

mental accounting: tendency to mentally sort our funds into separate “accounts,” which affects the way we think about our spending

Question 28

What is conservatism and narrow framing bias?

Answer 28

Conservatism: Failing to incorporate new information in a timely manner

Narrow framing: when you focus on the details at the expense of the big picture.

Question 29

What is portfolio window dressing?

Answer 29

when portfolio managers try to boost reported performance before publishing required reports

Question 30

What is the characteristic of value stocks in terms of dividend yield, price to earnings, and market to book ratios?

Answer 30

Higher than average dividend yield

Low price to earnings

Low market to book ratios

Question 31

What is the characteristic of growth stocks in terms of dividend yield, price to earnings, and market to book ratios?

Answer 31

low dividend yields

High price to earnings

High market to book ratios

Question 32

What is data mining?

Answer 32

Data mining: when analysts run test or market data until a statistically significant relationship can be found and used to formulate a hypothesis.

Question 33

What is the difference between market value and intrinsic value?

Answer 33

market value determined by market quotes and transactions

intrinsic value objective true value investors would get if they had all relevant quantitative and qualitative information

Question 34

What is the degree of underpricing for IPO’s?

Answer 34

Difference between a stock at the end of its first day trading on a secondary market after an IPO and its issue price.

Question 35

With respect to rational and irrational investment decisions, the efficient market hypothesis requires:

A. only market is rational
B. that all investors make rational decisions
C. that some investors make irrational decisions

Answer 35

A. only market is rational

Question 36

What is weak form inefficient?

Answer 36

when investors earn abnormal returns by trading on the basis of past trends in price and volume.

Question 37

What is semi-strong inefficient?

Answer 37

producing abnormal returns by active portfolio management of fundamental analysis