Week 10: EMH Flashcards
(22 cards)
What is the random walk in the Efficient Market Hypothesis (EMH)?
A random walk suggests that stock price movements are unpredictable. Since future movements cannot be predicted based on current information, it implies that stock prices follow a random path.
What is the Efficient Market Hypothesis (EMH)?
EMH, originating from Samuelson (1965) and coined by Roberts (1967), states that in an efficient market, prices fully reflect all available information. Price changes are random and unpredictable, as market news is announced randomly and quickly reflected in prices.
What are the forms of the Efficient Market Hypothesis (EMH)?
EMH has three forms:
1) Weak form - Prices reflect all past trading information.
2) Semi-strong form - Prices reflect all publicly available information.
3) Strong form - Prices reflect all public and private information.
What is the weak-form efficiency in the Efficient Market Hypothesis (EMH)?
The weak-form efficiency asserts that stock prices reflect all past information, such as past prices, trading volume, and short interest. This implies that trend and technical analysis are ineffective, as any signals would have already been exploited by investors, making them lose value once widely known.
What is the semi-strong-form efficiency in the Efficient Market Hypothesis (EMH)?
The semi-strong-form efficiency asserts that all publicly available information about a firm, such as financials, product lines, and management quality, is reflected in its stock price.
This means fundamental analysis cannot determine if a stock is undervalued or overvalued. Stock prices adjust rapidly to new public information.
What is the strong-form efficiency in the Efficient Market Hypothesis (EMH)?
The strong-form efficiency states that stock prices reflect all information, including insider information. This means even company insiders cannot earn excess profits from non-public information. Since insider information is unobservable, this form is nearly impossible to test empirically.
What defines an efficient market?
In an efficient market, stock prices and returns are determined by supply and demand in a competitive market with rational traders. Traders adjust prices instantly based on new information, making it impossible to generate profits greater than the market once risk and transaction costs are considered.
What is the passive strategy in EMH?
The passive strategy, endorsed by EMH, advocates a buy-and-hold approach with a diversified portfolio, avoiding attempts to outsmart the market.
How are abnormal returns calculated in event studies?
Abnormal returns are calculated as the difference between the stock’s actual return and its expected return based on risk (e.g., using the Market Model approach). The formula is:
rt = α + β rmt + et
Where the abnormal return (AR) is:
ARt = rt - (α + β rmt)
What are the investigation issues in EMH testing?
The key investigation issues in EMH testing are:
Magnitude Issue
Selection Bias Issue
Lucky Event Issue
What are strong-form tests in EMH?
Strong-form tests focus on insider trading.
What is the Magnitude Issue in EMH testing?
The Magnitude Issue suggests that only managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort.
What is the Selection Bias Issue in EMH testing?
The Selection Bias Issue states that only unsuccessful investment schemes are made public, while successful schemes remain private.
What is the Lucky Event Issue in EMH testing?
The Lucky Event Issue highlights that for every big winner, there are many big losers. However, only the winners make it to the public eye, like in The Wall Street Journal, and then profit from publishing newsletters.
what are the two tests for weak form?
the two tests:
Momentum Effect: Good or bad recent performance continues over short to intermediate time horizons
Return Reversal: Losers rebound and winners fade back over the long term, suggesting the stock market overreacts to relevant news
What are the three tests for the Semi-strong-form of EMH?
the three tests for the Semi-strong-form of EMH:
1) The size effect (or the Size Anomaly): Small stocks earn higher returns
2) The value effect (the “book-to-market” anomaly): Value stocks (high book-to-market ratios) earn higher returns
3) Post–Earnings-Announcement Price Drift: According to EMH any new information ought to be reflected in stock prices very rapidly
How is the Strong-Form Efficiency tested?
The strong-form efficiency is tested by checking if insiders can trade profitably. Studies show stock prices rise after insiders buy and fall after they sell, rejecting the strong-form efficiency.
What are asset pricing anomalies?
Asset pricing anomalies are patterns that defy standard theories, suggesting inefficiencies or flaws in pricing models, with profit opportunities that can persist despite the EMH.
What are three well-known stock anomalies?
Size Effect: Small stocks tend to have higher average returns than large stocks.
Momentum: Stocks with high recent returns continue to perform well over the next 3-12 months.
Contrarian Effect: Past losers (low returns over 3-5 years) tend to outperform past winners (high returns over 3-5 years).
What is technical analysis?
Technical analysis forecasts future prices by identifying patterns in past prices. Key methods include the moving average rule (buy/sell signals based on past returns) and the filter rule (trailing stops to capture trends).
What is the core idea of behavioral finance?
Behavioral finance argues that conventional finance ignores how real people make decisions, leading to anomalies due to irrationalities. Individuals are affected by cognitive biases (predictable mistakes) and heuristics (rules of thumb based on experience).
What are five types of cognitive biases in behavioral finance?
five types of cognitive biases in behavioral finance:
1) Overconfidence: Overestimating beliefs or abilities.
2) Extrapolation: Relying too much on recent experiences for forecasts.
3) Anchoring Bias: Relying too heavily on early information.
4) Information Processing: Errors in assessing event probabilities.
5) Limited Attention: Human attention span is constrained.
