FIN 430 - Chapter 46 Market Efficiency

List some implications of the efficient market hypothesis

* Securities markets are weak-form efficient, and therefore, investors cannot earn abnormal returns by trading on the basis of past trends in price. * Securities markets are semi-strong efficient, and therefore, analysts who collect and analyze information must consider whether that information is already reflected in security prices and how any new information affects a security's value.21 * Securities markets are not strong-form efficient because securities laws are intended to prevent exploitation of private information.

What are the two major categories of Time-series anomalies?

1) calendar anomalies and 2) momentum and overreaction anomalies.

What is contrary to market efficiency?

A finding that investors can consistently earn abnormal returns by trading on the basis of information

With respect to efficient market theory, when a market allows short selling, the efficiency of the market is most likely to: A increase. B decrease. C remain the same

A is correct. According to theory, reducing the restrictions on trading will allow for more arbitrage trading, thereby promoting more efficient pricing. Although regulators argue that short selling exaggerates downward price movements, empirical research indicates that short selling is helpful in price discovery

If a researcher conducting empirical tests of a trading strategy using time series of returns finds statistically significant abnormal returns, then the researcher has most likely found: A a market anomaly. B evidence of market inefficiency. C a strategy to produce future abnormal returns.

A is correct. Finding significant abnormal returns does not necessarily indicate that markets are inefficient or that abnormal returns can be realized by applying the strategy to future time periods. Abnormal returns are considered market anomalies because they may be the result of the model used to estimate the expected returns or may be the result of underestimating transaction costs or other expenses associated with implementing the strategy, rather than because of market inefficiency

Researchers have found that value stocks have consistently outperformed growth stocks. An investor wishing to exploit the value effect should purchase the stock of companies with above-average: A dividend yields. B market-to-book ratios. C price-to-earnings ratios

A is correct. Higher than average dividend yield is a characteristic of a value stock, along with low price-to-earnings and low market-to-book ratios. Growth stocks are characterized by low dividend yields and high price-to-earnings and high market-to-book ratios

An increase in the time between when an order to trade a security is placed and when the order is executed most likely indicates that market efficiency has: A decreased. B remained the same C increased

A is correct. Operating inefficiencies reduce market efficiency

Regulation that restricts some investors from participating in a market will most likely: A impede market efficiency. B not affect market efficiency. C contribute to market efficiency

A is correct. Reducing the number of market participants can accentuate market imperfections and impede market efficiency (e.g., restrictions on foreign investor trading)

Which of the following market regulations will most likely impede market efficiency? A Restricting traders' ability to short sell. B Allowing unrestricted foreign investor trading. C Penalizing investors who trade with nonpublic information

A is correct. Restricting short selling will reduce arbitrage trading, which pro-motes market efficiency. Permitting foreign investor trading increases market participation, which makes markets more efficient. Penalizing insider trading encourages greater market participation, which increases market efficiency

With respect to rational and irrational investment decisions, the efficient market hypothesis requires: A only that the market is rational. B that all investors make rational decisions. C that some investors make irrational decisions

A is correct. The efficient market hypothesis and asset-pricing models only require that the market is rational. Behavioral finance is used to explain some of the market anomalies as irrational decisions

With respect to the efficient market hypothesis, if security prices reflect only past prices and trading volume information, then the market is: A weak-form efficient B strong-form efficient. C semi-strong-form efficient.

A is correct. The weak-form efficient market hypothesis is defined as a market where security prices fully reflect all market data, which refers to all past price and trading volume information

A Classic B Modern Return = Risk assumed (All costs are already captured in the price)

A. Classic

Research suggests that short selling is (A. helpful or B. harmful) in price discovery

A. Helpful

Can researchers look back on data and find a trading strategy that would have yielded abnormal returns?

Absolutely. Enough data snooping often can detect a trading strategy that would have worked in the past by chance alone. But in an efficient market, such a strategy is unlikely to generate abnormal returns on a consistent basis in the future

IF all pricing is efficient, why is technical analysis (looking at patterns of trading prices and volumes) not useful?

Although some price patterns persist, exploiting these patterns may be too costly and, hence, would not produce abnormal returns. Consider a situation in which a pattern of prices exists. With so many investors examining prices, this pattern will be detected. If profitable, exploiting this pattern will eventually affect prices such that this pattern will no longer exist; it will be arbitraged away. In other words, by detecting and exploiting patterns in prices, technical analysts assist markets in maintaining weak-form efficiency

A market in which assets' market values are, on average, equal to or nearly equal to intrinsic values is best described as a market that is attractive for: A active investment. B passive investment. C both active and passive investment.

B Passive Investments (B is correct because an active investment is not expected to earn superior risk-adjusted returns. The additional costs of active investment are not justified in such a market)

Suppose that the future cash flows of an asset are accurately estimated. The asset trades in a market that you believe is highly efficient based on most evidence. But your intrinsic value estimate exceeds market value by a moderate amount. The most likely conclusion is that you have: A overestimated the asset's risk. B underestimated the asset's risk. C identified a market inefficiency.

B is correct (If risk is underestimated, the discount rate being applied to find the present value of the expected cash flows (estimated intrinsic value) will be too low and the intrinsic value estimate will be too high.)

If markets are efficient, the difference between the intrinsic value and market value of a company's security is: A negative. B zero. C positive

B is correct. A security's intrinsic value and market value should be equal when markets are efficient.

Observed overreactions in markets can be explained by an investor's degree of: A risk aversion. B loss aversion. C confidence in the market

B is correct. Behavioral theories of loss aversion can explain observed overreaction in markets, such that investors dislike losses more than comparable gains (i.e., risk is not symmetrical)

If markets are semi-strong-form efficient, then passive portfolio management strategies are most likely to: A earn abnormal returns. B outperform active trading strategies. C underperform active trading strategies

B is correct. Costs associated with active trading strategies would be difficult to recover; thus, such active trading strategies would have difficulty outperforming passive strategies on a consistent after-cost basis

If markets are semi-strong efficient, standard fundamental analysis will yield abnormal trading profits that are: A negative. B equal to zero. C positive.

B is correct. If all public information should already be reflected in the market price, then the abnormal trading profit will be equal to zero when fundamental analysis is used

If a market is semi-strong-form efficient, the risk-adjusted returns of a passively managed portfolio relative to an actively managed portfolio are most likely: A lower. B higher. C the same.

B is correct. In a semi-strong-form efficient market, passive portfolio strategies should outperform active portfolio strategies on a risk-adjusted basis

Which one of the following statements best describes the semi-strong form of market efficiency? A Empirical tests examine the historical patterns in security prices. B Security prices reflect all publicly known and available information. C Semi-strong-form efficient markets are not necessarily weak-form efficient

B is correct. In semi-strong-form efficient markets, security prices reflect all publicly available information.

Technical analysts assume that markets are: A weak-form efficient. B weak-form inefficient. C semi-strong-form efficient

B is correct. Technical analysts use past prices and volume to predict future prices, which is inconsistent with the weakest form of market efficiency (i.e., weak-form market efficiency). Weak-form market efficiency states that investors cannot earn abnormal returns by trading on the basis of past trends in price and volume

Which of the following is least likely to explain the January effect anomaly? A Tax-loss selling. B Release of new information in January. C Window dressing of portfolio holdings

B is correct. The excess returns in January are not attributed to any new information or news; however, research has found that part of the seasonal pattern can be explained by tax-loss selling and portfolio window dressing

The intrinsic value of an undervalued asset is: A less than the asset's market value. B greater than the asset's market value. C the value at which the asset can currently be bought or sold

B is correct. The intrinsic value of an undervalued asset is greater than the market value of the asset, where the market value is the transaction price at which an asset can be currently bought or sold

The market value of an undervalued asset is: A greater than the asset's intrinsic value. B the value at which the asset can currently be bought or sold C equal to the present value of all the asset's expected cash flows

B is correct. The market value is the transaction price at which an asset can be currently bought or sold

If prices reflect all public and private information, the market is best described as: A weak-form efficient. B strong-form efficient. C semi-strong-form efficient

B is correct. The strong-form efficient market hypothesis assumes all information, public or private, has already been reflected in the prices

Which of the following market anomalies is inconsistent with weak-form market efficiency? A Earnings surprise. B Momentum pattern. C Closed-end fund discount.

B is correct. Trading based on historical momentum indicates that price patterns exist and can be exploited by using historical price information. A momentum trading strategy that produces abnormal returns contradicts the weak form of the efficient market hypothesis, which states that investors cannot earn abnormal returns on the basis of past trends in prices.

In a semi-strong market, efforts to analyze publicly available information are (A. useful or B. futile)

B. Futile (all publicly available information is quickly incorporated into prices)

A (A. Classic or B. Modern) perspective calls for the investor to consider transaction costs and information-acquisition costs when evaluating the efficiency of a market. A price discrepancy must be sufficiently large to leave the investor with a profit (adjusted for risk) after taking account of the transaction costs and information-acquisition costs to reach the conclusion that the discrepancy may represent a market inefficiency.

B. Modern

In a highly efficient market, active investors seek to own assets selling ________ perceived intrinsic value in the marketplace and to sell or sell short assets selling _________ perceived intrinsic value

Below & Above

Like traditional finance models, the behavioral theory of loss aversion assumes that investors dislike risk; however, the dislike of risk in behavioral theory is assumed to be: A leptokurtic. B symmetrical. C asymmetrical

C is correct. Behavioral theories of loss aversion allow for the possibility that the dislike for risk is not symmetrical, which allows for loss aversion to explain observed overreaction in markets such that investors dislike losses more than they like comparable gains

Fundamental analysts assume that markets are: A weak-form inefficient. B semi-strong-form efficient. C semi-strong-form inefficient

C is correct. Fundamental analysts use publicly available information to estimate a security's intrinsic value to determine if the security is mispriced, which is inconsistent with the semi-strong form of market efficiency. Semi-strong-form market efficiency states that investors cannot earn abnormal returns by trading based on publicly available information.

With respect to efficient markets, a company whose share price reacts gradually to the public release of its annual report most likely indicates that the market where the company trades is: A semi-strong-form efficient. B subject to behavioral biases. C receiving additional information about the company

C is correct. If markets are efficient, the information from the annual report is reflected in the stock prices; therefore, the gradual changes must be from the release of additional information

If a market is weak-form efficient but semi-strong-form inefficient, then which of the following types of portfolio management is most likely to produce abnormal returns? A Passive portfolio management. B Active portfolio management based on technical analysis. C Active portfolio management based on fundamental analysis

C is correct. If markets are not semi-strong-form efficient, then fundamental analysts are able to use publicly available information to estimate a security's intrinsic value and identify misvalued securities. Technical analysis is not able to earn abnormal returns if markets are weak-form efficient. Passive portfolio managers outperform fundamental analysis if markets are semi-strong-form efficient

Which of the following regulations will most likely contribute to market efficiency? Regulatory restrictions on: A short selling. B foreign traders. C insiders trading with nonpublic information

C is correct. Regulation to restrict unfair use of nonpublic information encourages greater participation in the market, which increases market efficiency. Regulators (e.g., US SEC) discourage illegal insider trading by issuing penalties to violators of their insider trading rules

In an efficient market, the change in a company's share price is most likely the result of: A insiders' private information. B the previous day's change in stock price. C new information coming into the market

C is correct. Today's price change is independent of the one from yesterday, and in an efficient market, investors will react to new, independent information as it is made public

An analyst estimates that a security's intrinsic value is lower than its market value. The security appears to be: A undervalued. B fairly valued. C overvalued.

C. Overvalued (The market is valuing the asset at more than its true worth.)

What is the basis for profitable investing?

Discrepancies between market value and intrinsic values

What do informative prices promote?

Economic Growth

True or False: Researchers have observed that mutual funds, on average, outperform the market on a risk-adjusted basis

False

True or False: In the case of a strong-form efficient market, insiders would be able to earn abnormal returns from trading on the basis of private information.

False

True or False: Emerging markets that sometimes lack available information will be highly efficient

False

True or False: Limits on short selling encourage arbitrage trading

False

True or False: Window Dressing and Tax-loss selling account for the entire explanation of this anomaly

False. Account for some, but not all of the explanation

True or False: Financial markets are classified as either completely inefficient or completely efficient

False. Financial Markets are generally not classified at the two extremes as either completely inefficient or completely efficient but, rather, as exhibiting various degrees of efficiency

True or False: Technicians often argue that simple statistical tests of trading rules are conclusive because they are applied to the more sophisticated trading strategies that can be used and that the research excludes the technician's subjective judgment.

False. NOT conclusive and are NOT applied

True or False: In a semi-strong market, only a select few can gain an advantage in predicting future prices and gain abnormal returns using public information

False. No investors gain an advantage. Only those with private info can

Most asset-pricing models assume that markets are irrational and that the intrinsic value of a security reflects this irrationality.

False. Rational & Rationality

True or False: Most of the pricing anomalies are still fairly common occurrences

False. They have mostly been eliminated. One view is that the anomalies have been exploited such that the effect has been arbitraged away. Another view, however, is that increasingly sophisticated statistical methodologies fail to detect pricing inefficiencies.

True or False: Strong-form where prices reflect all private information (which means that prices reflect everything that the management of a company knows about the financial condition of the company that has not been publicly released) is likely

False. this is not likely because of the strong prohibitions against insider trading that are found in most countries.

Degree of underpricing

For IPO's, the percentage difference between the issue price and the closing price at the end of the first day of trading. (the initial selling price is set too low and that the price increases dramatically on the first trading day)

Technical or Fundamental? Data is gathered from financial statements to help find the intrinsic value

Fundamental

Technical or Fundamental? Used for an investor with a long term approach

Fundamental

In general, abnormal returns are returns _________ than those expected given a security's risk and the market's return. In other words, abnormal return equals actual return less expected return.

Greater

Herding

Group think. Decisions based on other people's decisions. Sometimes based on info sometimes not. (Ex: People do what Warren Buffet does)

Growth or Value Stock? Low dividend yields, high price-to-earnings, and high market-to-book ratios

Growth Stock

Information Cascades

Have less information than those in herding. Transmission of information from those participants who act first and whose decisions influence the decisions of others

What is a "fragile" cascade?

If a cascade is leading toward an incorrect value, this cascade will be corrected because investors will ultimately give more weight to public information or the trading of a recognized informed trader

Behavioral Finance sees humans as.....

Imperfect

Is a market with a low amount of participants efficient or inefficient?

Inefficient

What do efficient markets imply?

Informative Prices

the value that would be placed on it by investors if they had a complete understanding of the asset's investment characteristics (the personal valuation). Can be estimated but never certain

Intrinsic Value

The more complex an asset's future cash flows, the more difficult it is to estimate its _____________

Intrinsic value

Overreaction Anomalies

Investors hear information and act on it before they realize the information will not impact the stock as much as they thought (ex: Tesla)

What does a lack of information available lead to? (Beside an inefficient market)

Leads people to question what information is actually quality information

the price at which an asset can currently be bought or sold

Market Value

Describe some negatives of mutual funds when they are placed against the market

Mutual funds perform, on average, similar to the market before considering fees and expenses and perform worse than the market, on average, once fees and expenses are considered. Even if a mutual fund is not actively managed, there are costs to managing these funds, which reduces net returns

Yes or No: Do market efficiency and asset-pricing models require that each individual is rational?

No —rather, only require that the market is rational. If individuals deviate from rationality, other individuals are assumed to observe this deviation and respond accordingly. These responses move the market toward efficiency. If this does not occur in practice, it may be possible to explain some market anomalies referencing observed behaviors and behavioral biases.

Is it possible to consistently get abnormal returns from pricing inefficiencies patterns in technical analysis?

No, because the actions of market participants will arbitrage this opportunity quickly, and the inefficiency will no longer exist.

Can these Closed-End Investment Fund discounts be exploited to earn abnormal returns if transaction costs are taken into account?

No. First, the transaction costs involved in exploiting the discount buying all the shares and liquidating the fund would eliminate any profit.39 Second, these discounts tend to revert to zero over time. Hence, a strategy to trade on the basis of these discounts would not likely be profitable

Consistent, superior, risk-adjusted returns (net of all expenses) are ______________ in an efficient market

Not achievable

In an efficient market, prices should be expected to react only to the information releases that are.....

Not fully anticipated by investors

Why does recent evidence suggest the January Effect is not persistent and does not produce abnormal returns?

Once an appropriate adjustment for risk is made, the January "effect" does not produce abnormal returns

Can technical analysts profit from trading on past trends?

Overall, the evidence indicates that investors cannot consistently earn abnormal profits using past prices or other technical analysis strategies in developed markets

the IPO underpricing and the subsequent poor performance suggests that the markets are __________________________

Overly optimistic initially

Market Value > Intrinsic Value

Overvalued

In a highly efficient market, is a passive or active investment strategy preferred?

Passive (because of lower cost). Although, in an inefficient market, opportunities may exist that make active investment strategies preferable

Tests of whether securities markets are weak-form efficient require looking at

Patterns of Prices

Overconfidence

People are too confident on their ability to analyze a stock and misinterpret information. IF enough people do this, the stock will be wrongfully prices.

Many technical analysts, also referred to as "technicians," argue that many movements in stock prices are based, in large part, on __________

Psychology

Classic View: Active investors incur acquisition costs but that money is wasted because prices already reflect all ___________ _______________

Relevant information

Holiday effect

Returns on stocks in the day prior to market holidays tend to be higher than other days.

Weekend effect

Returns on weekends tend to be lower than returns on weekdays.

Turn-of-the-month effect

Returns tend to be higher on the last trading day of the month and the first three trading days of the next month.

What market form? Prices reflect all publicly known and available information. Publicly available information includes financial statement data (such as earnings, dividends, corporate investments, changes in management, etc.) and financial market data (such as closing prices, shares traded, etc.).

Semi-strong-form efficient market

Two kinds of cross-sectional anomalies

Size effect & Value effect

Momentum Anomalies

Stocks hitting new highs will continue to hit new highs (People keep buying) and vice verse for lows. Contradicts weak-form efficiency

Modern View: views a market as inefficient if, after deducting such costs, active investing can earn _________ returns.

Superior

The market value of an asset represents the intersection of __________ & ____________ (the point that is low enough to induce at least one investor to buy while being high enough to induce at least one investor to sell)

Supply & Demand

If mutual funds are not consistently beating the market, then what purpose do portfolio managers serve?

Te role of a portfolio manager is not necessarily to beat the market but, rather, to establish and manage a portfolio consistent with the portfolio's objectives, with appropriate diversification and asset allocation, while taking into consideration the risk preferences and tax situation of the investor

Technical or Fundamental? Predict future prices based on past performances

Technical

Technical or Fundamental? Used for trading with a short term approach

Technical

Technical or Fundamental? Predict future prices based on charts and indicators

Technical

What type of analysis is better for short term predictions? (Technical or Fundamental)

Technical. (Fundamental is better for long-term predictions)

Day-of-the-week effect

The average Monday return is negative and lower than the average returns for the other four days, which are all positive.

What results have tests on strong-form efficiency yielded?

The results of these tests are consistent with the view that securities markets are not strong-form efficient; many studies have found that abnormal profits can be earned when nonpublic information is used.

Intrinsic value refers to the true value of an asset, whereas market value refers to the price at which an asset can be bought or sold. When markets are efficient, the two should be __________?

The same or very close

How "quickly" do asset prices reflect all current information in an efficient market?

The time frame for an asset's price to incorporate information must be at least as long as the shortest time a trader needs to execute a transaction in the asset. (If the time frame allows many traders to earn profit with low risk, then the market is inefficient)

There are ________ forms of markets

Three (each based on what is considered to be the information used in determining asset prices. In the weak form, asset prices fully reflect all market data, which refers to all past price and trading volume information. In the semi-strong form, asset prices reflect all publicly known and available information. In the strong form, asset prices fully reflect all information, which includes both public and private information)

Practically, ____________ ______ are incurred in trading to exploit any perceived market inefficiency. Thus, "efficient" should be viewed as efficient within the bounds of transaction costs. Arbitrages will not act on price discrepancies if the discrepancies are priced within the bounds of arbitrage (meaning the pricing is efficient)

Transaction Costs

What is critical for the integrity of the market and explains why regulators place such an emphasis on "fair, orderly, and efficient markets"

Treating all market participants fairly

True or False: All investors have bias. For people that recognize this, they may be able to respond and make improved decisions, individually and collectively.

True

True or False: Buy and sell decisions depend on whether the current market price is less than or greater than the estimated intrinsic value.

True

True or False: In most cases, contradictory evidence both supports and refutes the anomaly.

True

True or False: Most empirical evidence supports the idea that securities markets in developed countries are semi-strong-form efficient; however, empirical evidence does not support the strong form of the efficient market hypothesis

True

True or False: Some evidence suggests that there are opportunities to profit on technical analysis in countries with developing markets, including Hungary, Bangladesh, and Turkey, among others

True

True or False: evidence indicates that information cascades are greater for a stock when the information quality regarding the company is poor.

True

True or False: Most research are consistent with the view that developed securities markets might be semi-strong efficient (But some evidence suggests that the markets in developing countries may not be semi-strong efficient)

True

True or False: The finding of excess returns at the time of the announcement does not necessarily indicate market inefficiency. In contrast, the finding of consistent excess returns following the announcement would suggest a trading opportunity. Trading on the basis of the announcement—that is, once the announcement is made—would not, on average, yield abnormal returns.

True

True or False: although identified anomalies may appear to produce excess returns, it is generally difficult to profitably exploit the anomalies after accounting for risk, trading costs, and so on.

True

True or False: the number of financial analysts who follow or analyze a security or asset should be positively related to market efficiency

True

True or False: Information availability (e.g., an active financial news media) and financial disclosure should promote market efficiency

True (Information regarding trading activity and traded companies in such markets as the New York Stock Exchange, the London Stock Exchange, and the Tokyo Stock Exchange is readily available. Many investors and analysts participate in these markets, and analyst coverage of listed companies is typically substantial. As a result, these markets are quite efficient)

True or False: If security issuers provide nonpublic information to some market professionals or investors, they must also disclose this information to the public

True (Required by SEC)

True or False: Semi-strong-form efficient market encompasses weak-form efficiency

True (if a market is semi-strong efficient, then it must also be weak-form efficient)

True or False: finding that equity returns are affected by changes in economic fundamentals is not evidence of market inefficiency and would not result in abnormal trading returns

True (the relationship between stock returns and the prior information is not consistent over time.)

Intrinsic Value > Market Value

Undervalued

In semi-strong, technical and fundamental analysis are _________

Useless

Growth or Value stock? Higher than average dividend yield, low price-to-earnings, and low market-to-book ratios.

Value Stock

What kind of efficiency? The security prices fully reflect all past market data, which refers to all historical price and trading volume information. Past trading data are already reflected in current prices and investors cannot predict future price changes by extrapolating prices or patterns of prices from the past

Weak form efficient

Does arbitrage contribute to market efficiency?

Yes. For example, if an asset is traded in two markets but at different prices, the actions of buying the asset in the market in which it is underpriced and selling the asset in the market in which it is overpriced will eventually bring these two prices together. The presence of these arbitrageurs helps pricing discrepancies disappear quickly.

Can significant differences exist in the efficiency of different types of markets?

Yes. Many securities trade primarily or exclusively in dealer or over-the-counter (OTC) markets, including bonds, money market instruments, currencies, mortgage-backed securities, swaps, and forward contracts. The information provided by the dealers that serve as market makers for these markets can vary significantly in quality and quantity, both through time and across different product markets.

A market anomaly may be present if

a change in the price of an asset or security cannot directly be linked to current relevant information known in the market or to the release of new information into the market

Informationally efficient market (efficient market)

a market in which asset prices reflect new information quickly and rationally (All past and present information)

What is Arbitrage?

a set of transactions that produces riskless profits. Arbitrageurs are traders who engage in such trades to benefit from pricing discrepancies (inefficiencies) in markets.

Cross-sectional anomalies were identified based on

analyzing a cross section of companies that differ on some key characteristics

a Classic b Modern Return - Information = Risk Assumed

b Modern (Info can help us decrease risk)

Findings from slow price adjustments should imply

companies that display the largest positive earnings surprises subsequently display superior stock return performance, whereas poor subsequent performance is displayed by companies with low or negative

Result of slow price adjustments

companies that display the largest positive earnings surprises subsequently display superior stock return performance, whereas poor subsequent performance is displayed by companies with low or negative earnings surprise

he validity of any evidence supporting the potential existence of a market inefficiency or anomaly must be

consistent over reasonably long periods

Data Mining

data are examined with the intent to develop a hypothesis, instead of developing a hypothesis first. This is done by analyzing data in various manners, and even utilizing different empirical approaches until you find support for a desired result, in this case a profitable anomaly.

The ___________________________________ is affected by the number of market participants and depth of analyst coverage, information availability, and limits to trading.

efficiency of a market

Behavioral finance uses human psychology, such as behavioral biases, in an attempt to explain investment decisions. Whereas behavioral finance is helpful in understanding observed decisions, a market can still be considered _________ even if market participants exhibit seemingly irrational behaviors, such as herding

efficient

On average, the markets are __________

efficient. (In other words, investors face challenges when they attempt to translate statistical anomalies into economic profits)

Behavioral Finance

examines investor behavior to understand how people make decisions, individually and collectively. Behavioral finance does not assume that people consider all available information in decision-making and act rationally by maximizing utility within budget constraints and updating expectations consistent with Bayes' formula. The resulting behaviors may affect what is observed in the financial markets.

Fundamental analysis is necessary in a well-functioning market because...

fundamental analysis facilitates a semi-strong efficient market by disseminating value-relevant information. And, although fundamental analysis requires costly information, this analysis can be profitable in terms of generating abnormal returns if the analyst creates a comparative advantage with respect to this information

Time series anomalies are

identified using time series of data

Possible reasons for the January effect?

in order to reduce their tax liabilities, investors sell their "loser" securities in December for the purpose of creating capital losses, which can then be used to offset any capital gains. A related explanation is that these losers tend to be small-cap stocks with high volatility. This increased supply of equities in December depresses their prices, and then these shares are bought in early January at relatively attractive prices. This demand then drives their prices up again

In a relatively inefficient market, active investors may try to develop an ______________ ________________ of intrinsic value

independent estimate

efficiency is very strict in the sense of viewing a market as _________ if active investing can recapture any part of the costs, such as research costs and active asset selection

inefficient

Representativeness

investors assess new information and probabilities of out-comes based on similarity to the current state or to a familiar classification

Narrow Framing

investors focus on issues in isolation and respond to the issues based on how the issues are posed (Makes decisions without considering entire portfolio)

Mental accounting

investors keep track of the gains and losses for different investments in separate mental accounts and treat those accounts differently

Conservatism

investors tend to be slow to react to new information and continue to maintain their prior views or forecasts

Cascades are rational, but they may lead to an ......

overreaction

What is "Window Dressing?"

portfolio managers sell their riskier securities prior to 31 December. The explanation is as follows: many portfolio managers prepare the annual reports of their portfolio holdings as of 31 December. Selling riskier securities is an attempt to make their portfolios appear less risky. After 31 December, a portfolio manager would then simply purchase riskier securities in an attempt to earn higher returns

Size effect

results from the observation that equities of small-cap companies tend to outperform equities of large-cap companies on a risk-adjusted basis (follow up studies have not confirmed this effect, though)

Active Returns

returns earned by strategies that do not assume that all information is fully reflected in market prices (Ex: Active fund managers or hedge funds)

Define a strong-form efficient market

security prices fully reflect both public and private information

Closed-End Investment Fund Discounts Anomaly

shares should trade at a price approximately equal to their net asset value (NAV) per share, which is simply the total market value of the fund's security holdings less any liabilities divided by the number of shares outstanding. An abundance of research, however, has documented that, on average, closed-end funds trade at a discount from NAV. Most studies have documented average discounts in the 4-10 percent range, although individual funds have traded at discounts exceeding 50 percent and others have traded at large premiums

What is the January Effect? (Turn-of-the-year Effect)

stock market returns in January were significantly higher compared to the rest of the months of the year, with most of the abnormal returns reported during the first five trading days in January (most frequently observed for the returns of small market capitalization stocks.)

Value effect

studies have shown that value stocks, which are generally referred to as stocks that have below-average price-to-earnings (P/E) and market-to-book (M/B) ratios, and above-average dividend yields, have consistently outperformed growth stocks over long periods of time. If the effect persists, the value stock anomaly contradicts semi-strong market efficiency because all the information used to categorize stocks in this manner is publicly available

How do researchers test whether a market is strong-form efficient?

testing whether investors can earn abnormal profits by trading on nonpublic information

Define Technical Analysis

the analysis of historical trading information (primarily pricing and volume data) in an attempt to identify recurring patterns in the trading data that can be used to guide investment decisions.

Define fundamental analysis

the examination of publicly available information and the formulation of forecasts to estimate the intrinsic value of assets. Fundamental analysis involves the estimation of an asset's value using company data, such as earnings and sales forecasts, and risk estimates as well as industry and economic data, such as economic growth, inflation, and interest rates.

Earnings Surprise (unexpected part of the earnings announcement)

the portion of earnings that is unanticipated by investors and, according to the efficient market hypothesis, merits a price adjustment. Positive (negative) surprises should cause appropriate and rapid price increases (decreases).

Loss Aversion

the tendency of people to dislike losses more than they like comparable gains. This results in a strong preference for avoiding losses as opposed to achieving gains

Risk Aversion

the tendency of people to dislike risk and to require higher expected returns to compensate for exposure to additional risk. (Behavioral finance allows for the possibility that the dissatisfaction resulting from a loss exceeds the satisfaction resulting from a gain of the same magnitude)

Explain what would happen if a market restricts trading for foreigners on some stocks

this limitation reduces the number of market participants, restricts the potential for trading activity, and hence reduces market efficiency

Define illegal insider trading

trading in securities by market participants who are considered insiders "while in possession of material, nonpublic information about the security