Financial Economics Lectures Flashcards
(158 cards)
1
Q
Market Efficiency Concepts: Allocatively Efficiency?
A
Allocate scarce resources to most productive use.
2
Q
Market Efficiency Concepts: Operationally Efficiency?
A
Transaction costs are determined competitively. Therefore no frictions.
3
Q
Market Efficiency Concepts: Informationally Efficient?
A
Current prices fully reflect all available information.
4
Q
What do perfectly efficient markets satisfy?
A
Allocative, operationally and informational efficiency.
5
Q
What efficiencies do we assume Security Markets to have?
A
Allocative and Operational Efficiency.
6
Q
Efficient Market Hypothesis?
A
Market prices instantaneously and fully reflect all relevant available information. So, if efficient, market price (Pt) = fundamental price (Pf,t). If prices are unpredictable then market price wonβt equal fair price, but given the transaction cost, this isnβt possible to exploit.
7
Q
Fundamental price?
A
The fair price (PV).
8
Q
Unpredictable?
A
Unforeseen change within a company which investors did not know of when investing.
9
Q
When do we have a βfair game modelβ and what is this model used for in our course?
A
If there is no systematic difference between the actual and expected return before the game is played. EMH can be explained using a fair game model.
10
Q
In the fair game model, a security market is said to be efficient when the error value is what?
A
The error has to be a non-systematic error. Expected and actual return on the security before the game is played.
11
Q
When is the error consistent?
A
If, on average the error = 0. So there is no difference between actual and expected.
12
Q
Fair game model: When is the error independent?
A
If it is uncorrelated with the expected return. So there is no relationship between the error and expected return.. If there was a relationship, we would not be using all of the information.
13
Q
Fair game model: When is an error term efficient?
A
If it is contemporaneously and serially uncorrelated.
14
Q
Fair game model: Contemporaneously and serially uncorrelated?
A
covariance of errors = 0.
15
Q
Stochastic?
A
Having a random probability distribution or pattern that may be analysed statistically but may not be predicted precisely.
16
Q
If EMH holds, what is the result on the securities market?
A
The securities market will be in a continuously stochastic equilibrium and either:
a) market price = fundamental price at all times
b) Fair prices are only affected by unpredictable information which cannot be exploited to make a predicted profit.
17
Q
Weak-Form Information Set?
A
Contains past prices
18
Q
Semi-Strong-Form Information Set?
A
Contains all publicly available information
19
Q
Strong-Form Information Set?
A
Contains all known information (public+private)
20
Q
Random Walk?
A
The return on a security tomorrow is equal to the return on a security today plus an amount that depends on the new information generated between today and tomorrow, which is unpredictable given todayβs information set. A Random walk model assumes Weak form EMH.
21
Q
Weak-Form EMH?
A
Current security prices instantaneously and fully reflect all information contained in the past security prices.
22
Q
Semi-Strong-Form EMH?
A
Current security prices instantaneously and fully reflect all publicly available information (price changes are unpredictable). e.g. balance sheets and profit/loss accounts.
23
Q
Strong-Form EMH?
A
Current security prices instantaneously and fully reflect all known information. Trading with inside information is not profitable.
24
Q
How information is reflected in security prices - Strong-Form?
A
Requires that the market is Fully Aggregating Information: security prices reflect information as though is held by all investors
25
How information is reflected in security prices - Semi-Strong-Form?
Requires that the market is Averaging Information (not all investors are the same): response of security prices to new information depends on the balance of
'informed' and 'uninformed' investors. This assumption is more realistic.
26
Informed investors?
Invest in costly superior information to make excess returns and affect security prices.
27
Uninformed investors?
AKA Noise Traders - infer information by observing security prices' fluctuations in response to trades by 'Informed' investors.
28
Net vs Gross?
Net is the total amount minus all the costs. Gross is the total.
29
Information-Efficient Equilibrium?
Requires a balance between informed and uninformed investors in order to make net return = 0 and both have the same gross return.
30
Weak-Form EMH evidence?
Alexander (1961). k% filter trading rule should generate excess returns as prices up overtime. Buy when the security price is up (down) k% above (below) its previous low (high). If there are systematic patterns over time in security prices. them a filter rule should earn excess returns over a bit and hold strategy.. The k will depend on the success of the strategy, if to low, to many transactions will be made, and the transaction costs will eat into returns. If to high, many opportunities will be missed.
Conclusion: Whatever the size of k, no filter rule can systematically generate excess returns (after transaction costs) over a bu-and-hold strategy. It provided strong evidence that markets are weak for efficient: security prices incorporate any information embodies in past prices far too rapidly for there to be a profitable trading rule based on the movement of past prices.
31
Serial Correlation?
What is 'Serial Correlation'
Serial correlation is the relationship between a given variable and itself over various time intervals. Serial correlations are often found in repeating patterns, when the level of a variable effects its future level.
Also referred to as 'autocorrelation' or 'lagged correlation'.
32
Contemporaneous Correlation?
Correlation between the realizations of two time series variables in the same time period.
33
Semi-Strong-Form EMH Evidence and findings i) (Ball and Brown)?
Ball and Brown (1968) examine whether information contained in company reports/ announcements affect security prices. 90% of price adjustments occur on average 12 months before public announcements made, with 10% being made in the in the subsequent 6 months. It would be to late for an investor to wait until the announcement is reported in the financial press the following day.
No trading rule based on exploiting public earnings announcements
generates excess returns over buy-and-hold strategy if semi-strong form EMH is true.
34
Semi-Strong-Form EMH Evidence and findings ii) (Kraus and Stoll)?
Kraus and Stoll (1972) examine whether information involved in 'block trades' can be exploited. If an individual with insider information sold a large number of shares, others may follow expecting an announcement of bad news, resulting in the lowering of the share price, but markets may overreact. As such, an investor could make excess returns, adjusting for risk and TCs, though buying after a block trade and then selling once the slightly higher equilibrium price is reached.
On average, prices fell by 1.1% as a result of the sale and then rose by
0.7% just fifteen minutes after the sale.
No excess returns are available more than a few minutes after news of the block sale becomes publicly available. The evidence shows that markets tend to be semi-strong-form efficient as no excess returns are to be made just a few minutes after the block trade.
35
Semi-Strong-Form EMH Evidence and findings iii) and iv)?
Announced changes in the BoE's base rate do not generate excess returns. Most changes in price occur due to anticipation of a rate change. No evidence that securities consistently lead or lag the business cycle.
Therefore this is evidence that the markets are not only weak form efficient but also semi-strong for efficient.
36
Strong-Form EMH (legal information) Evidence i)? 1968
Jenson shows that unit trusts only just generate excess returns when adjusted for risk and costs over a buy and hold strategy with the use of legal informed information. We conclude that on average, unit trusts make the same return, adjusted for risk and costs, as a buy-and hold strategy
37
Strong-Form EMH evidence contributors and the year of contribution?
Meiselman (1962)
Modigliani & Sutch (1966)
Malkiel (1966)
Jensen (1968)
38
Strong-Form EMH evidence from bond market? (1962)
1962 - Meiselman shows that revisions to one-year implied forward rates (1rf2) were highly correlated with forecasting errors in models used to predict future interest rates. Remember formula used. Further evidence of strong form emh. Check sheets.
39
Strong-Form EMH evidence from bond market? 1966
1966 - Modigliani and Sutch confirmed the Expectations Hypothesis.
Also 1966 - Malkiel found that changes in relative supplies of bonds at different maturities had no effect on interest rate differentials at these maturities. This indicated that bonds at different maturities were perfect substitutes for each other, so that the supply of a bond of a particular maturity could be increased without changing its relative price vis-a-vis other bonds.
40
Evidence against Weak-Form EMHi)?
1992 - Brock shows that Double Moving Average Rule generated excess returns over 1897-1986 of on average 17% per annum.
He also showed that the Channel Rule (trading range breakout rule) generated excess returns.
41
How did Brock Double Moving Average Rule work? (when to buy or sell security)
Using a short (10-day) and a long (60 day) moving average MA of security prices. Short MA > Long MA (purchase). Short MA < Long MA (purchase security).
42
How would you operate the Channel Rule?
Buy when closing price is greater than the highest price over the last 100 days, as long as the previous days closing price was below the highest price. This rule generated excess returns of 18% on average.
43
What do unit funds (mutual funds) do?
Heavily invest in company research to generate information (private).
44
Evidence against Semi-strong form EMH (3)? (Excess returns can be made)
1. Calendar effects (excess returns can be made after announcements such as Black Friday and Christmas announcement in January)
2. Effects related to a firms' characteristics; size, market-to-book ratio, earnings-price ratio (trading on the basis of these characteristics can generate excess returns)
3. Volatility tests.
45
Perfect foresight price of as share?
Discounted value of all future dividends of a share (assuming all dividends are known).
46
What does covariance show and how does it differ from correlation?
The direction of a relationship. Correlation deals with the strength of a relationship. It is the expected product of the deviations of two return from their means/
47
The perfect foresight price (P0*)of a share?
When all future dividends are down with certainty.
48
Cov(X,X)?
Var(X) = π^2(X).
49
Covariance formula (π)?
[(Cov(Ri,Rj)] / [SD(Ri)SD(Rj)]
R values are in percentages.
50
In a fair game, what are the three properties of the error term?
1. Consistency: On average the prediction error is 0.
2. Independence: uncorrelated from expected return,
3. Efficient: contemporaneously and serially uncorrelated.
51
What do the two volatility bounds Shiller found state?
With regards to the share price relationship with all future dividends being known; Shiller showed that if semi-strong EMH holds, then the volatility of the perfect foresight share price should exceed the volatility of the actual share price.
With the dividend alternative form of the variance bounds, he showed that if the semi-strong form EMH holds, the volatility of dividends (divided by the square root of twice the firms cost of capital, which chiller assumed to be constant_ should exceed the volatility of share price changes.
52
Who showed the upper volatility (variance) bound and what was the final formula?
Where did the original evidence of this come from? What was the outcome of this with regards to the real world data?
Shiller:
π(P*o) Greater than or equal to π(Po).
Where P*o is the fundamental price.
From the equity markets.
He showed that both variance bounds were violated, with both bounds being exceeded by a factor of 6, showing excess volatility. He concluded that this was inconsistent with market efficiency and even suggested that it was inconsistent with the rational behaviour of investors.
53
What does π equal in the alternative upper variance bound and what is the relationship with Po if EMH holds?
π = P1 + d + Po(1+r).
The error in predicting P1 at t=0(due to the errors in predicting P1, e1 and e0).
If EMH holds, π will be uncorrelated with Po.
54
Further Evidence against semi strong form in equity markets, not Shiller, iv)?
DeBont and Thaler (1985) showed that security markets overreact; shares whose price falls for 3 years would show excess returns of 6.1% per year for the subsequent 3 years.
55
Evidence against the Semi-Strong Form EMH from the Bond market (Shiller)?
Shiller (1979) found that long-term interest rates were excessively volatile in comparison to short-term interest rates. He showed that π(rh) is less than or equal to π(r) / ((2r)^1/2. Recite rest of this from sheet. rh is the holding period and r is the short term interest rate. There was excess volatility while, although less than with shares, being only 1.14x.
56
What does the evidence indicate about securities markets from the 1960s?
The market is both weak-form and semi-strong-form dependent. Not possible to generate excess returns in for risk and transaction costs with information on lagged security prices are currently available public information.
They appear to be strong form efficient on the basis of using privately generated information, but inefficient when it came to illegally obtained insider information
57
Lecture 2 Start
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58
What assumptions do we hold when testing whether Capital markets benefit society?
- All outcomes from Investment (I) are known with certainty
- No transaction costs/taxes
- Two periods economy, t = {0; 1}
59
Production possibility schedule (PPS) and what is its implications?
A schedule of productive investment opportunities that each agent has, arranged from the highest rate of return to the lowest. Each individual has a productive opportunities schedule. There will be demising returns on investment, as the more an individual invests, the less the rate of return on the marginal investment.
60
Marginal Rate of Transformation (MRT)?
The slope of the Production Possibility Schedule (The rate at which Β£1 of consumption today forgone is transformed by the productive investment into consumption tomorrow.
61
When does an individual 'I' maximise U)C*o*,C*1*)?
When MRT = MRSi. The individual will invest in productive opportunities that have rates of rerun higher than his or her subjective rate of time preference.
62
What do Capital Markets facilitate?
The inter temporal exchange of consumption bundles between borrowers and lenders at a market-determined rate of interest, r. Without them, two individuals with the same investment opportunities and same endowment may choose completely different levels of consumption due to their preferences.
63
Capital Market Line?
Represents the borrowing and lending opportunities, with initial endowment (y0,y1), agents can reach any point along CML by borrowing or lending at r.
64
If |MRS| < 1+r, What are agents likely to do?
Agents desire to lend. (think about this as there intersection point and the slopes from there. We want MRS = CML slope (1+r)
65
What will the decision process be with production opportunities and CM?
1. Optimal production decision: invest in projects until MRT = 1 + r
2. Optimal consumption decision: Borrow/lend along CML until 1 + r = MRSi.
66
Fisher separation theorem and explanation why?
When CMs are perfect, production and consumption decisions can be separated. The production decisions are governed by profit maximisation without regard to individuals' consumption preferences. The investment decisions can be delegated to managers.
67
What will the equilibrium of the Fisher Separation Theorem be?
MRSi = MRSj = (1 + r) = MRT
68
With regards to the Fisher Separation Theorem, what to CMs allow the lenders/ investors to do?
CMs allow the efficient transfer of funds between lenders (with few productive opportunities) to borrowers (with many productive opportunities).
69
What would invalidate the Fisher Separation Theorem?
CM frictions, as individuals with different consumption preferences will choose different levels of investment
70
Agency Problem?
Managers (agents) may not always act in the best interest of shareholders (principles). Principles insure costs to align managers' incentives through monitoring and compensation.
71
Capital Budgeting Techniques and assumption?
Managers' investment rules to maximise shareholders' wealth. We assume that the stream of a projects cash flows and cost of capital are known, CMs are perfect.
72
When using capital budget techniques, what are the 3 properties that should be satisfied?
1) all cash flows should be considered and discounted at the opportunity cost of funds.
2) Select a project that maximises shareholders' wealth from a set of mutually exclusive projects (vs. independent, contingent)
3) Value-additivity principle: Mangers should consider one project
independently from all others
73
Payback method?
Selects the project with the shortest payback period (number of years it takes to revere the initial cash outlay).
74
What are the negatives of the payback method and why does it fail as a capital budgeting technique?
Does not consider all cash flows and fails to discount them. As a result it violates property 1 of the capital budgeting technique.
75
ARR meaning and formula?
Accounting Rate of Return.
| ARR = (Average after-tax accounting profit) / (initial outlay)
76
Does the ARR method have negatives and why does it fail as a capital budgeting technique?
Method considers accounting profits rather than cash flows and fails to discount them. Therefore it fails under 1 of the capital budgeting technique.
77
Net present value?
Accepts projects that have the greatest NPV (>0) where NPV is computed by discounting the cash flows (CF) at the firm's opportunity cost of capital (k). It satisfies 1. and is the correct decision rule for Capital budgeting purposed.
78
IRR?
Internal Rate of Return. Accepts projects that have the greatest IRR (>k)(return should be greater than the market rate): the rate that equates the present value of the cash inflows and outflows such the NPV(IRR) = 0. Therefore the highest IRR will be the project that can have the highest rate of interest and still be profitable.
79
IRR rule?
Discount the cash flows at the IRR rate, rather than the market rate (k).
80
Reinvestment rate assumption?
Reinvestment rate is the same as the opportunity cost of capital k.
NPV assumes that shareholders can reinvest their funds at the k.
IRR assumes that shareholders can reinvest their funds at the IRR for each project - incorrect though as all projects are assumed to have the same risk.
81
Does IRR fulfil the capital budgeting technique rules?
Rule 1 fails as IRR does not discount cash flows at k (but at IRR).
Can violate the value-additivity principle.
82
Value additivity principle?
Managers should consider projects independent of each other.
83
Multiple rates of return?
The IRR can result in MRR if the stream of estimated cash flows changes sign more than once. It results in multiple roots.
84
How do we solve the multiple rates of return problem with the case of IRR?
The firm appears to finance the problem multiple times. We work out the value of the original investment and then recalculate with the new value. Look at sheet.
85
Problems with IRR?
Assumes funds invested in projects have opportunity cost = IRR of the project, meaning cash flows are not discounted at k.
Does not obey the Value-Additivity Principle (managers cannot consider projects independently of each other).
Can lead to multiple IRR whenever the sign of cash flows changes more than once.
86
What is better for managers, IRR or NPV?
NPV rule as it avoided all problems associated with the IRR and maximises shareholders' wealth.
87
Lecture 3
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88
What are the 5 axioms of cardinal utility?
1. Comparability (or Completeness)
2. Transitivity (or Consistency)
3. Strong Independence
4. Measurability
5. Ranking
89
Markowitz Risk Premium (π*M*)?
The maximum amount of wealth an individual is willing to give up in order to avoid the gamble (Insurance).
π*M* = E(W) + W'
Risk Premium = Expected W + Certainty Equivalent Wealth.
90
Certainty Equivalent Wealth (W')?
The level of wealth that an individual would accept with certainty if the gamble is removed.
91
Cost of gamble (c)?
The amount an individual is willing to pay (+) or get payed (-) to take a gamble.
c = W - W'
Costs of Gamble = Current wealth - Certainty equivalent wealth.
92
RRA in terms of ARA?
Relative risk aversion = W(ARA)
ARA(absolute risk aversion)
93
What does Arrow-Pratt measure?
Measure of a local risk premium π*A*
94
ARA?
Absolute Risk Aversion.
| (-) [U''(W)] / [U'(W)]
95
RRA
Relative Risk Aversion.
| (-)W[-U''(W)] / [U'(W)]
96
Is there a difference between ranking investments by their value and ranking by fluctuations? What is the interpretation?
They are the same. Riskier investments have higher expected return. Investors are averse to fluctuations in the value of their investments and demand a risk premium. Risky investments are more likely to be liquidated
97
When the return on an investment is unknown, how do we resolve this?
We assign a probability 'p*i*' to each possible Ri and create a probability distribution of R.
98
Semi-interquartile range?
(Upper quartile value - lower quartile value) / 2
99
What does semi-variance do?
Captures the upside or downside of risk.
100
Independent risk?
Theft insurance has almost no risk as the number of claims each year is predictable. The incidence have no correlation are are independent across policy takers.
101
Common Risk?
Such as earthquake insurance. When one person claims, everyone in an area will claim. Therefore, portfolio risk is high with such policies. Common risks are perfectly correlated risks
102
Diversification?
The averaging out of independent risks in a large portfolio.
103
How does the Arrow Pratt definition of risk aversion differ from the Morkowitz concept?
It assumes that risks are small and actuarially neutral. Therefore it is more restrictive than the Markowitz concept.
104
Firm Specic News?
news about the company that affect Rt are Independent Risks (Firm-Specic, Idiosyncratic, Diversiable risk)
105
Market Wide News?
news about the economy that affect Rt are Common Risks (Market, Systematic, Undiversiable risk)
106
Lecture 5
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107
Portfolio weights?
A way of describing a portfolio. The fraction of the Toal investment in the portfolio held in each individual investment in the portfolio.
xi = (Value of investment)/(Total value of portfolio)
Result is in percentage.
108
What does a portfolios volatility depend on?
Whether the stocks returns move in the same or opposite directions.
109
Covariance with relation to a multiple stock portfolio?
Measures the expected product of deviations of two returns from their means; so the direction of movement.
110
Covariance between Ri and Rj?
E [ ( Ri - E[Ri] ) ( Rj - E[Rj] ) ]
111
Intuition of covariance with two assets?
If they move in the same direction, covariance well be positive (even if both go down), whereas if they move in opposite directions, covariance will be negative.
112
Why is the magnitude not easy to interpret?
It will be LARGER if the stocks are more volatile, (meaning a larger deviation from expected returns), and will be LARGER the more closely the stocks move in relation to each other.
113
Correlation formula?
The covariance of the returns divided by the SD of each return (multiplied together).
Corr between stocks has the same sign as Cov and the overall value will be between -1 and +1 due to division by volatilities.
114
Correlation use with returns??
Measures the strength of the relationship between the returns of two stocks. It is a barometer of the degree to which the returns share common risk and tend to move together. The more correlated, the more the returns tend to move together as a result of common risk.
115
Why is diversification necessary and what number of stocks needed to be invested in to achieve diversification?
As n increases, The Variance of the portfolio almost equals the average Covariance. Portfolio volatility down as n increases. Achieved by about 20 stocks.
116
When a portfolio has arbitrary weights, How is Var(Rp) expressed?
In terms of Cor(Ri,Rj).
| SD(Rp) = Sum of (xi x SD(Ri) x Corr(Ri,Rj).
117
Efficient portfolio?
When the portfolio chosen is better than all others in terms of both expected return and volatility. In terms of a diagram, this will be a portfolio that has none the the NW of it (up and left). They offer the highest rate of returns for a given level of risk. Ranking depends on investors preferences.
118
When will efficient portfolios lie on a straight line?
When correlation = 1 or -1. With negative one, we represent this line by reflecting off the y-axis.
119
What happens of the correlation of two assets is less than 1?
Efficient portfolios curve bends to the left.
120
What effect does correlation have on expected return?
None, with the level of volatility will only change with correlation.
121
What happens when we have perfect correlation of two stocks and what if it is less than one?
We identity the portfolios by the straight line between them. The volatility of the portfolio is equal to the weighted average volatility of the two stock - there is no diversification. When correlation is less than one, diversification reduces volatility, with the curve being to the left.
122
What is noteworthy about when correlation between two assets in a portfolio is -1?
It is possible to achieve absolutely no risk, enabling investors to construct a perfect hedge.
123
MVOS?
Minimum variance opportunity set. It is the locus of risked return combinations offered by portfolios or risky assets (n>2) that yield the minimum variance for a given rate of return.
124
Locus?
A particular position or place where something technical is located.
125
Indifference curves of risk-avers investor?
Increasing and convey in mean-volatility space
126
Efficient set?
The set of mean volatility choices from MCOS where for a given Var(Rp) no other investment opportunity offers a higher E(Rp).
127
What will the efficient set be like if two assets are perfectly correlated?
The efficient set is linear.
128
Long position with respect to investments?
Positive investment, so x>0.
129
Short position with respect to investments?
Negative investment, so x<0
130
When is short selling profitable and how does it effect volatility (S.D)?
If investors expect stock price to fall and the proceeds are invested in a stock with a higher return. The Volatility will increase with short selling
131
How does short selling impact our graph?
It enables the full range of risk and return possibilities to be exploited, so shade the area to the right of the MVOS in as all these can now be attained.
132
How does n effect our E(Rp) and s.d(Rp) graph?
It improves the efficient frontier.
133
What are two ways that can reduce volatility?
Diversification or investing in a risk free asset such as treasury bills.
134
Efficient Frontier?
Those offering the highest rate of return for a given level of volatility.
135
What is the benefit of adding assets that offer an inferior risk to return than previous assets and what can we conclude from this?
They add additional diversification, moving the efficient frontier more to the NW, thereby improving it. As such, to arrive at theist possible set of risk and return opportunities, we should keep adding stocks until all investment opportunities are represented.
136
Extra from lecture 1
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137
Calendar effects?
Evidence against weak-form emh. significant excess returns associated with specific times of the day, days of the week, or months of the year.
1. The January Effect
2. The turn-of-the-month Effect
3. The Monday (or weekend) Effect
4. Day-end Effect
5. The Holiday Effect.
a) Rozeff and Kinney showed that between 1904 and 1974, the average return on shares in January exceeded that average return on shares for the other eleven months by 3.06 per cent.
b) Ariel found that returns during the first half of the month were much higher than the retunrs furing the second half of the month
c) Lakonishok and Smidt found that the run-of-the-month effect was actually concentrated in the first three trading days of the month.
d) French and Gibbons found that the average return on shares was negative on Mondays whereas it was positive for the other dats of the week, with Wednesdays and Fridays being increases of 0.1% and 0.09% respectively, the largest in the week on average. Harris found that it was the first hour of trading on Monday that caused this negative return, then the rest of the day behaved as normal.
e) Ariel found that returns on the two trading days prior to national holidats in the US were between 9 and 14 times higher than the average daily returns for the rest of the uear
138
Examples of firms characteristics and there result on returns. EMH implications?
** Banz, Small Firm Effect: The positive excess returns that could be generated by investing in small companies with low stock market capitalizations (small cap stocks). Major excess returns over the largest companies in the New York Stock Exchange. Keim found that the excess return generated by small cap shares over large cap shares was concentrated in the first five trading days of January. 26.3% of the excess return was generated in those five days.
Fama and French examined the relationship between the return on securities and market to book ratios, earnings price ratios and firm size. Growth shares have high market to book ratios and value shares have low market to book ratios. They found a strong negative relationship between returns and market to book ratios, therefore meaning one should invest in value companies. Value shares tend to outperform growth shares.
Fama and French also found that firms with the highest 1/12th earning-price ratio had higher average returns than firms with the lowest earnings-price ratio. As value shares often have higher earning-price ratios, this is further evidence that value shares outperform growth shares.
De Bont and Thalor showed that the share market appears to overreact: they found that shares whose price has fallen dramatically over a three-year period would hsow excess returns of 6.1% per year over the subsequent three years.
139
What is testing for semi-strong-form EMH equivalent to testing (assumptions)?
If investors are risk neutral, so indifferent between investments with the same expected return but different levels of risk. So spot and forward markets deliver the same return on average but with different levels of risk.
1. The forward exchange rate (Ft) is an unbiased predictor of the future sport exchange rate (S*t+1*). SO Ft = E(S*t+1*| πt).
140
Who provided the first evidence against Semi-strong form EMH in bond markets?
Bond (1981) by showing that a β 0, and b < 1.
141
What would be the alternative hypothesis with regards to semi-strong form EMH in bond FX markets?
That individuals are actually risk averse rather than risk neutral, so they need to be compensated for the risk they take. The joint hypothesis of risk neutrality and semi-strong makers efficiency is rejected by the data.
142
Covered Interest Parity Hypothesis? Who used this and what did they use it for?
Provided better support for semi-strong form efficiency. Frenkel and Levich (1977) found that the CIP provides support for the Semi-Strong-Form EMH as deviations from the CIP were not profitable by estimating... look on sheet.
143
L.2 extra. When will a consumer maximise utility?
By moving along the market line to the point where their subjective time preference equals the market interest rate, using their endowment..
144
Comparisons between NPV and IRR - 1?
Reinvestment rate assumption: The reinvestment rate is the same as the opportunity cost of capital k.
NPV assumes that shareholders can reinvest their funds at the market determined rate of capital, k, which is correct. All projects have the same risk so they are all discounted by k.
Irr assumes that shareholder can reinvest their funds at the IRR for each project, which is different depending on the project, which is incorrect as all projects are assumed to have the same risk. The IRR fails to discount cash flows at the opportunity cost of capital.
145
Comparisons between NPV and IRR - 2?
Value Additivity Principle: The 3rd desirable properties of capital budgeting requires that we can consider one project independently of all others, aka the value additivity principle. Say we have two mutually exclusive project and one independent project. Say we would prefer project 1 using IRR over project 2. It would be possible that when chiming 1 and 3 or 2 and 3 that by IRR, we would prefer the combination of 2 and 3, despite 1 being chosen without the use of three. The implication for management would be that they would have to consider all possible combinations of projects and choose the combination that has the greatest IRR, which increases exponentially with the number of projects. The NPV rule always obeys the additivity principle. The combination of projects are simply the sum of the individual projects at the given %.
146
Comparisons between NPV and IRR - 3?
Multiple Rates of Return: A problem that arises with IRR if the stream of estimated cash flows changes sign more hate once.
With a change in sign, there will be two potential IRR values, We solve the quadratic problem using the quadratic formula by attain two roots. The reason for the two roots is that we think of the project as an investment, with the firm putting money more than once (depending on how many negatives). Look at sheet for actual example of this (or Phone picture from 05/06/18.THeree is a way to solve this problem, by assuming that all cash flows are loaned to the firm by the project at the market opportunity cost, and that the rate of return on cash lows invested in the project is the IRR.
147
L3 Continued: Comparability symbols and understanding?
FOr an entire set of uncertain alternatives, an individuals can ether: x>y, x ~ y or x < y
148
Transitivity symbols and understanding?
If x > y and y > z, x > z.
149
Strong Independence symbols and understanding?
```
If x ~ y, G(x,z : a) ~ G(y,z : a)
Where G(x,z : a) a gamble that yields x with probability a and z with probability (1 - a) (outcomes are mutually exclusive).
```
150
Measurability symbols and understanding:
If x β» y < z or x < y β» z ) there exists a unique a; such that y ~ G(x; z : a)
151
What do the five axioms of cardinal utility do?
They provided a minimum set of conditions for consistent and rational behaviour.
152
What are the two properties utility functions must hold?
1. Order Preserving
| 2. Ranking of risky alternatives.
153
What axioms are required for Order Preserving?
Axiom 4: Measurability
Axiom 5: Ranking
See sheet.
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What axioms are required to enable the ranking of risky alternatives?
Axioms 3: Strong Independence
Axiom 4: Measurabliity
Axiom 5: Ranking
see sheet.
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What conclusion does the correct ranking of risky alternatives lead us to?
The correct ranking function for risky alternatives is expected utility. We can see that the utility of z is equal to the probably of x multiplied by its utility + the probability of y multiplied by its utility. This is an expected utility that represents the linear combination of the utility outcomes.
156
When is a person Risk Averse, Risk neutral or a risk lover?
```
Risk-Averse:
U[E(W)] > E[U(W)
Risk-Neutral:
U[E(W)] = E[U(W)
Risk- Lover:
U[E(W)] < E[U(W)
```
157
What part of a utility diagram will be the expected utility of W?
The straight line.
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Definition of risk averse?
When you receive more from the the actuarial value of the gamble (the expected value) or from the gamble itself. So the utility of the expected wealth (the wealth we can guarantee) is greater than the expected utility of wealth. The utility function will be strictly concave.
