Midterms

Question 1

a theory in finance that suggests that financial markets are “informationally efficient,” meaning that asset prices always reflect all available information. This implies that it is impossible to consistently achieve higher returns than the market average because prices adjust quickly when new information becomes available

Answer 1

Efficient Market Hypothesis

Question 2

suggests that stock prices always reflect all available information, making it impossible for investors to consistently outperform the market through stock picking or market timing. According to this, stocks are always priced fairly, meaning that it’s not possible to buy undervalued stocks or sell overvalued ones. The only way to achieve higher returns is by taking on more risk.

Answer 2

Efficient Market Hypothesis

Question 3

Key Principles of EMH

Answer 3

1. Information is Quickly Reflected
2. Stock Prices Follow a Random Walk
3. No Free Lunch

Question 4

o Any new information (such as earnings reports, economic data, or company announcements) is almost instantly incorporated into stock prices.
o This means that prices adjust rapidly, making it difficult to “beat the market.”

Answer 4

Information is Quickly Reflected

Question 5

o According to EMH, price movements are unpredictable because they are based on newly available information, which is random.
o If prices followed a predictable pattern, investors would exploit it, and the opportunity would disappear quickly.

Answer 5

Stock Prices Follow a Random Walk

Question 6

o Since stock prices already reflect all known information, there are no “undervalued” or “overvalued” stocks that can be easily exploited for profit. o The only way to earn higher returns is by taking higher risks.

Answer 6

No Free Lunch

Question 7

Real-Life Examples of EMH in Action

Answer 7

1. Earnings Reports and Stock Prices
2. Stock Market Reactions to News

Question 8

o If a company announces higher-than-expected profits, the stock price will increase almost immediately.
o If profits are lower than expected, the stock price will drop. o Since this adjustment happens quickly, it is nearly impossible for investors to act on the news before the price changes.

Answer 8

Earnings Reports and Stock Prices

Question 9

o If an economic crisis is announced, stock prices might fall right away as investors react.
o If a company is rumored to be acquired, its stock price might rise instantly. o Because prices react so fast, most investors cannot profit from public news.

Answer 9

Stock Market Reactions to News

Question 10

His strategy of buying undervalued stocks has been very successful, leading some to argue that EMH doesn’t always apply.

Answer 10

Warren Buffett’s

Question 11

Reasons the Market is Efficient

Answer 11

✅ Stock prices update fast
✅ Many smart investors
✅ Hard to beat the market

Question 12

New information spreads quickly, and prices adjust almost instantly.

Answer 12

Stock prices update fast

Question 13

Many smart investors

Answer 13

Thousands of professionals analyze stocks, making it hard to find “hidden” opportunities.

Question 14

Studies show that most investors, even professionals, fail to earn better returns than the overall market

Answer 14

Hard to beat the market

Question 15

Reasons the Market Might NOT Be Efficient

Answer 15

❌ People make emotional decisions
❌ Market bubbles and crashes ❌ Some investors beat the market
❌ Information Asymmetry

Question 16

Main Theoretical Foundations

Answer 16

1. Rational Expectations Theory
2. Random Walk Theory
3. The Law of One Price & Arbitrage
4. Capital Asset Pricing Model (CAPM)
5. Rational Expectations & Information Theory
6. Behavioral Finance Challenges (Opposing Viewpoint)

Question 17

 EMH assumes that investors use all available information rationally to form expectations about future prices.
 While individual investors may make mistakes, their errors are assumed to be random and cancel each other out, leading to an overall efficient market.

Answer 17

Rational Expectations Theory

Question 18

 This theory, proposed by Paul Samuelson, suggests that stock prices follow a “random walk,” meaning future prices cannot be predicted based on past prices.
 Since all information is immediately reflected in prices, price changes occur randomly in response to new information.

Answer 18

Random Walk Theory

Question 19

 The principle of arbitrage states that identical assets should have the same price across markets.
 If mispricing occurs, traders will quickly exploit it, driving prices back to their correct levels.
 This mechanism contributes to market efficiency.

Answer 19

The Law of One Price & Arbitrage

Question 20

 The CAPM, developed by Sharpe, Lintner, and Mossin, explains the relationship between risk and expected return.
 EMH aligns with CAPM by suggesting that only systematic risk is rewarded in the market, while diversifiable risk is not.

Answer 20

Capital Asset Pricing Model (CAPM)

Question 21

 Investors form their expectations based on publicly available and private information.
 The market aggregates all this information efficiently, leading to fair asset prices.

Answer 21

Rational Expectations & Information Theory

Question 22

 Critics argue that cognitive biases, irrational behavior, and market anomalies challenge the EMH.
 Concepts like herd behavior, overconfidence, and momentum trading suggest that markets may not always be perfectly efficient.

Answer 22

Behavioral Finance Challenges (Opposing Viewpoint)

Question 23

The Three Forms of EMH (Levels of Market Efficiency)

Answer 23

1. Weak Form Efficiency
2. Semi-Strong Form Efficiency
   Strong Form Efficiency

Question 24

o Stock prices reflect all past trading data (such as price history and trading volume).
o Technical analysis (predicting prices based on past trends) does not work because past price patterns do not predict future prices.
o Example: If a stock has been rising for 10 days in a row, there’s no guarantee it will continue to rise on the 11th day.

Answer 24

Weak Form Efficiency

Question 25

oStock prices reflect all publicly available information, including news, earnings reports, and financial statements. o Fundamental analysis (evaluating company financials to find mispriced stocks) does not work because this information is already factored into stock prices. o Example: If a company releases an earnings report, its stock price will already incorporate this information within seconds or minutes.

Answer 25

Semi-Strong Form Efficiency

Question 26

o Stock prices reflect all information, including both public and private (insider) information. o Even company executives with insider knowledge cannot consistently profit from trading stocks. o Example: If an executive knows their company will be acquired and buys stock in advance, EMH suggests that this won’t help because the stock price already reflects this possibility.

Answer 26

Strong Form Efficiency

Question 27

is an idealized decision-maker who makes choices to maximize personal benefit based on all available information. This concept is central to many economic theories, including EMH

Answer 27

Rational investor

Question 28

According to this theory, people make rational decisions with complete, accurate information, aiming to maximize their utility.

Answer 28

Rational Actor Theory (RAT)

Question 29

are individuals who make investment decisions based on emotions, biases, or misconceptions rather than logical analysis and sound financial principles. Instead of relying on data and careful study, they often react to fear, excitement, or herd mentality, leading to suboptimal financial choices.

Answer 29

Irrational investors

Question 30

Examples of Irrational Investor Behavior:

Answer 30

 Buying high and selling low  Following the crowd  Holding onto losing stocks  Overconfidence  Fear of missing out (FOMO) – Rushing into inv

Question 31

Sources of Irrational Investment Behavior

Answer 31

1. Overconfidence 2. Pride and Regret 3. Risk Perception 4. Framing 5. Mental accounting 6. Heuristic Simplification 7. Short-term focus 8. Emotional influence

Question 32

causes investors to overestimate their ability to predict market movements. Two key aspects include:  Miscalibration – Underestimating the range of possible outcomes.  Better-than-average effect – Believing oneself to be more skilled than the average investor, leading to excessive risk-taking.

Answer 32

Overconfidence

Question 33

Investors tend to repeat actions that bring pride and avoid those that create regret. This leads to the disposition effect, where investors sell winning stocks too early and hold onto losing stocks too long. The perception of success or failure is influenced by their reference point rather than actual gains and losses.

Answer 33

Pride and Regret

Question 34

Investors’ risk tolerance fluctuates based on their experiences:  House-money effect – After making gains, they take greater risks.  Snakebite effect – After losses, they become overly cautious.  Trying-to-break-even effect – Seeking high-risk investments to recover losses quickly.  Endowment effect – Valuing assets they own more highly than identical assets they do not own.  Status quo bias – Avoiding action when overwhelmed by investment choices.

Answer 34

Risk Perception

Question 35

How an investment is presented affects decision-making. Many investors focus on whether an investment seems “good” or “bad” rather than considering risk-adjusted returns.

Answer 35

Framing

Question 37

Investors often separate their finances into different “mental accounts,” which leads to suboptimal decisions, such as failing to diversify properly. Behavioral Portfolio Theory (BPT) suggests that investors create portfolios in layers based on specific goals, rather than optimizing for overall returns and risk.

Answer 37

Mental accounting

Question 38

To simplify complex financial decisions, investors use mental shortcuts (heuristics), which can lead to errors:  Representativeness bias – Assuming good companies are always good investments.  Familiarity bias – Preferring known investments over unfamiliar ones, leading to poor diversification.

Answer 38

Heuristic Simplification

Question 39

The constant flood of financial news and market updates can cause investors to react impulsively, prioritizing short-term gains over long-term stability.

Answer 39

Short-term focus

Question 40

Market bubbles and crashes are often fueled by greed and fear, leading to irrational buying and selling behaviors.

Answer 40

Emotional influence

Question 41

THEORETICAL AND EMPIRICAL CHALLENGES TO THE EMH

Answer 41

1. Different Investor Perspectives ­ 2. Unequal Profitability ­ 3. Market Outperformance 4. Time Lag in Price Adjustments 5. Random Events and Market Anomalies

Question 42

­ EMH assumes that all investors interpret available information in the same way. However, investors use different strategies--some focus on undervalued stocks, while others prioritize growth potential. Since perspectives vary, determining a stock's "true" value is subjective and contradicts the EMH.

Answer 42

Different Investor Perspectives

Question 43

EMH claims that no single investor can consistently outperform others with the same resources since they all have access to the same information. However, real-world data shows a wide range of investment returns. If the hypothesis were true, every investor would achieve the same outcome, which is not the case.

Answer 43

Unequal Profitability

Question 44

According to EMH, no investor should be able to beat the market over time. If true, the best strategy would be to invest in index funds that mirror overall market performance. Yet, many investors, such as Warren Buffett, have consistently outperformed market averages, contradicting EMH.

Answer 44

Market Outperformance

Question 45

The hypothesis does not specify how quickly stock prices adjust to new information. In reality, markets take time to incorporate new data, allowing inefficiencies to persist longer than EMH suggests.

Answer 45

Time Lag in Price Adjustments

Question 46

EMH acknowledges random price fluctuations but assumes they eventually correct themselves. However, market anomalies and speculative bubbles indicate that inefficiencies exist and persist over time, challenging the idea of absolute efficiency

Answer 46

Random Events and Market Anomalies

Question 47

It happens when someone buys or sells stocks based on important company information that is not available to the public. This can include company employees, managers, or even outside investors who somehow gain access to private details.

Answer 47

Insider trading

Question 48

is the attempt to determine the future price of stocks or other financial assets. If someone can accurately predict prices, they can make a profit. However, predicting stock prices is difficult because markets react to new information. Some experts believe stock prices follow a "random walk," meaning they move unpredictably, while others believe certain methods can help forecast future movements.

Answer 48

Stock market prediction

Question 49

is the actual worth of a company, determined through fundamental analysis. It considers both tangible and intangible factors, like company earnings, market position, and potential growth.

Answer 49

Intrinsic value

Question 50

Stock Market Prediction Methods

Answer 50

1. Fundamental Analysis 2. Technical Analysis (Charting) 3. Technological Methods