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Flashcards in BKM Chapter 11 Deck (52)
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Efficient market hypothesis (EMH)

(BKM - 11)

stock prices reflect all available information at a given point in time


Cause of stock price changes under EMH

(BKM - 11)

release of new information


Main consequence of EMH

(BKM - 11)

stock prices should follow a random walk (e.g. random & unpredictable)


Support for EMH

(BKM - 11)

competition b/w investment firms (to identify & exploit mispricing) leads to investors immediately bidding up or forcing down prices

>> suggests stock prices reflect nearly all available information


Difference between an efficient market and an efficient portfolio

(BKM - 11)

efficient market = information rapidly reflected in stock prices

efficient portfolio = highest expected return for a given level of risk


Forms of the EMH (3)

(BKM - 11)

1. weak-form

2. semistrong-form

3. strong-form


Difference between forms of the EMH

(BKM - 11)

meaning of "all available information"


Weak-form EMH

(BKM - 11)

stock prices reflect all information that can be derived from historical data


Implication of the weak-form EMH

(BKM - 11)

trend analysis is not worthwhile


Types of data considered in weak-form EMH (3)

(BKM - 11)

1. past stock prices

2. trade volume

3. short interest


Semistrong-form EMH

(BKM - 11)

stock prices reflect all publicly available information related to a firm's prospects

*implies weak-form EMH


Types of data considered in semistrong-form EMH (6)

(BKM - 11)

1. product lines
2. quality of management
3. balance sheet composition
4. patents held
5. earnings forecasts
6. accounting practices


Strong-form EMH

(BKM - 11)

stock prices reflect all information relevant to a firm, including information only available to company insiders

*implies semistrong- and weak-form EMH


Common aspect of all forms of EMH

(BKM - 11)

prices should reflect available information


Technical analysis

(BKM - 11)

search for recurrent and predictable patterns in stock prices

*only works if stock prices are slow to respond to market forces of supply and demand


Technical analysis & efficient markets

(BKM - 11)

if markets are truly efficient, technical analysis will not work (b/c stock prices already reflect all available information)


Resistance levels in technical analysis

(BKM - 11)

values at which it is difficult for stock prices to rise above/fall below (driven by market psychology)


Self-destructing nature of price patterns

(BKM - 11)

once a useful price pattern is discovered, it is soon invalidated once it is exploited by many traders


Fundamental analysis

(BKM - 11)

using a firm's earnings and dividend prospects + expectations of future interest rates to determine stock prices


Buy decisions in fundamental analysis

(BKM - 11)

if PV(future payments) > current stock price, then buy


Fundamental analysis & efficient markets

(BKM - 11)

under EMH, fundamental analysis will not work since it relies on publicly available information and it is unlikely for evaluations to be significantly different b/w competing firms


Critical element of success in fundamental analysis

(BKM - 11)

superior firm analysis relative to other firms (e.g. more accurate projections)


Are small investors better off using active or passive portfolio management?

(BKM - 11)

passive strategy


Advantage of using index funds in a passive strategy

(BKM - 11)

minimizes trading costs/management fees


Reasons portfolio management is still necessary in an efficient market (3)

(BKM - 11)

1. portfolio must be well-diversified to eliminate firm-specific risk (select stocks that provide strong diversification)

2. optimal securities depend on the tax bracket of the investor (preferences for low-yield, tax-exempt bonds to minimize taxes)

3. must consider the risk profile of the individual investor (e.g. age or other sources of income)


Event study

(BKM - 11)

method to measure the impact of an event/release of new information on stock prices


Steps in an event study (2)

(BKM - 11)

1. find a benchmark return to represent what the stock price would have been in the absence of the event

2. calculate the abnormal return due to the event


Possible benchmark returns for an event study (3)

(BKM - 11)

1. broad market index (e.g. S&P 500)

2. narrow broad index down to firms of similar size, beta, etc.

3. use an asset pricing model to estimate an expected ROR (e.g. CAPM)


Estimating alpha and beta with event studies

(BKM - 11)

should be estimated using data sufficiently separated in time from the event so they are not impacted by event-period abnormal performance


Impact of information leakage on an event study

(BKM - 11)

flawed event stud because it does not recognize the change in prices ahead of the event caused by leakage