Module 6 Concept Word Problems

Example of markets having no memory

An investor should not buy or sell shares based on apparent trends or cycles in returns.

Respond to the following comment: "Efficient market, my eye! I know lots of investors who do crazy things."

As stated before, there is plenty of room for irrational investors (i.e., crazy or simply dumb investors) in an efficient market. We just need a core of smart investors or for the irrationalities to cancel each other out (recall the wisdom of the crowds) in order for the markets to be efficient.

The efficient-market hypothesis assumes that successive price changes are independent (True or False)

True (Recall again that in an efficient market, security prices reflect all available information. This means that they should only change in response to new information. New information is, by definition, unpredictable (otherwise it wouldn't be new). Therefore, security price changes are unpredictable. So, security price changes are independent of one another. In other words, we cannot infer anything about the future change in a security price based on its past changes.)

Analysis by security analysts and investors helps keep markets efficient. (True or False)

True (Recall that one of the ironies of the EMH is that it depends on a core group of investors who do not believe that markets are efficient. It is the very action of these investors (which almost surely includes security analysts or at least includes investors who act on the research produced by these analysts) that help keep markets efficient. For example, if security analysts think that a stock is overvalued, then their selling of it will reduce the stock price closer to its intrinsic value. The buying and selling activities of these "informed" investors help ensure that the market is efficient for those of us "uninformed" investors who do not spend our days following stocks in real time.)

The efficient-market hypothesis assumes that forecasts are unbiased (True or False)

True (The EMH does not assume that investors have perfect foresight but it does assume that they are unbiased in their forecasts)

The semi-strong form of the efficient-market hypothesis states that prices reflect all publicly available information. (True or False)

True (The EMH states again that security prices reflect all available information. And the definition of available information is what distinguishes the strong form from the semi-strong form from the weak form. And, just to be complete, the strong form defines available information as public and private information, the semi-strong form defines available information as publicly available information, and the weak form defines available information as past prices and, in some versions, past trading volume.)

If the efficient-market hypothesis is correct, managers will not be able to increase stock prices by creative accounting that boosts reported earnings (True or False)

True (The correct answer is "True," but I should emphasize that the EMH does not assume that the market cannot be fooled by accounting tricks because the EMH is presumed to refer to the semi-strong version of the EMH. So, if managers use creative accounting to mask bad news about a firm, then the market can be fooled if that bad news is truly private information. In other words, if there was virtually no way for the market to see through the creative accounting.)

Psychologists have observed that people tend to put too much weight on recent events when forecasting (True or False)

True (This is called the recency effect)

Stock price cycles or patterns tend to self-destruct as soon as investors recognize them through:

trading by investors

What are puzzles and anomalies?

1. Puzzles and anomalies are abnormal behavior of stocks that apparently contradicts the efficient market hypothesis. There are quite a few of them. For example, stocks of small firms have provided abnormally high returns compared to stocks of large firms.

Explain how incentive and agency problems can contribute to mispricing of securities or to bubbles. Give examples.

17. Any time there is a separation of ownership and control, it is possible that the resulting agency costs will lead to market distortions. Many people hire others (explicitly or implicitly) to manage their money, and these managers may not have the same incentives to push for the best price. Over large markets, we might expect many of these distortions to have less impact, but some imperfections may remain. One example of this is the mortgage securitization market. Because banks were paid a fee for packaging the securities and did not retain the risks of ownership, they may not have pushed for adequate underwriting. This may have lead to easy credit terms and a housing market bubble.

On May 15, 1997, the government of Kuwait offered to sell 170 million BP shares, worth about $2 billion. Goldman Sachs was contacted after the stock market closed in London and given one hour to decide whether to bid on the stock. They decided to offer 710.5 pence ($11.59) per share, and Kuwait accepted. Then Goldman Sachs went looking for buyers. They lined up 500 institutional and individual investors worldwide, and resold all the shares at 716 pence ($11.70). The resale was complete before the London Stock Exchange opened the next morning. Goldman Sachs made $15 million overnight. What does this deal say about market efficiency? Discuss.

17. The market is most likely efficient. The government of Kuwait is not likely to have non-public information about the BP shares. Goldman Sachs is providing an intermediary service for which they should be remunerated. Stocks are bought by investors at (higher) ask prices and sold at (lower) bid prices. The spread between the two ($0.11) is revenue for the broker. In the U.S., at that time, a bid-ask spread of 1/9 ($0.25) was not uncommon. The 'profit' of $15 million reflects the size of the order more than any mispricing.

Fama and French show that average stock returns on firms with small market capitalizations have been significantly higher than average returns for "large-cap" firms. What are the possible explanations for this result? Does the result disprove market efficiency? Explain briefly.

17. This does present some evidence against the efficient capital market hypothesis. One key to market efficiency is the high level of competition among participants in the market. For small stocks, the level of competition is relatively low because major market participants (e.g., mutual funds and pension funds) are biased toward holding the securities of larger, well-known companies. Thus, it is plausible that the market for small stocks is fundamentally different from the market for larger stocks and, hence, that the small-firm effect is simply a reflection of market inefficiency. But, there are at least two alternative possibilities. First, this difference might just be coincidental. In statistical inference, we never prove an affirmative fact. The best we can do is to accept or reject a specified hypothesis with a given degree of confidence. Thus, no matter what the outcome of a statistical test, there is always a possibility, however slight, that the small-firm effect is simply the result of statistical chance. Second, firms with small market capitalization may contain some type of additional risk that is not measured in the studies. Given the information available and the number of participants, it is hard to believe that any securities market in the U.S. is not very efficient. Thus, the most likely explanation for the small-firm effect is that the model used to estimate expected returns is incorrect, and that there is some as-yet unidentified risk factor.

Example of "trust market prices" relevance to financial managers

A CFO should not speculate on changes in interest rates or foreign exchange rates. There is no reason to think that the CFO has superior information.

Example of "reach the entrails" relevance to financial managers

A financial manager evaluating the creditworthiness of a large customer could check the customer's stock price and the yield on its debt. A falling stock price or a high yield could indicate trouble ahead.

Respond to the following comment: "The trouble with the efficient-market theory is that it ignores investors' psychology."

As suggested before, there is plenty of room for "investor psychology" in an efficient market. Investor psychology is a slippery concept, more often than not used to explain price movements that the individual invoking it cannot personally explain. Even if it exists, is there any way to make money from it? If investor psychology drives up the price one day, will it do so the next day also? Or will the price drop to a 'true' level? Almost no one can tell you beforehand what 'investor psychology' will do. Theories based on it have no content. The trouble with investor psychology is that it can be used after the fact to explain any stock price movement.

Briefly discuss some of the important findings of behavioral finance studies.

Behavioral finance studies have focused on two important areas: (1) attitudes toward risk, and (2) beliefs about probabilities. Behavioral finance focuses on results that can lead to security mispricing. This can be caused by investors' attitude towards risk and the way investors assess probabilities. Prospect theory contributed to the understanding of how investors behave in the face of capital gains and losses. Most investors are either too conservative or overconfident. In other words, investors are not 100% rational 100% of the time. Behavioral finance provided some new interpretations of some long-standing puzzles and anomalies

Example of "there are no financial illusions" relevance to financial managers

Don't assume that accounting choices that increase or decrease earnings will have any effect on stock price.

Give examples of research results or events that raise doubts about market efficiency. Briefly explain why.

Example 1: Evidence that two securities with identical cash flows (e.g., Royal Dutch Schell and Shell Transport & Trading) can sell at different prices. Example 2: Small-cap stocks and high book-to-market stocks appear to have given above-average returns for their level of risk. Example 3: IPOs provide relatively low returns after their first few days of trading. Example 4: Stocks of firms that announce unexpectedly good earnings perform well over the coming months. In each case, there appear to have been opportunities for earning superior profits.

A majority of research supports the theory that past stock movements can predict future asset prices. (True or False)

False

Behavioral Finance and Technical Analysis are basically the same theory. (True or False)

False

The weak form of efficient market theory implies that technical analysis is valuable (True or False)

False

Tests have shown that there is almost perfect negative correlation between successive price changes. (True or False)

False (In contrast to the weak form of the EMH, there is evidence that stock price changes are not independent, but there is no evidence of an almost perfect negative correlation between successive price changes.)

Psychologists have found that, once people have suffered a loss, they are more relaxed about the possibility of incurring further losses. (True or False)

False (Psychologists have found the opposite. People tend to become more risk averse (i.e., less relaxed about the possibility of incurring further losses) when they have suffered a loss.)

The efficient-market hypothesis assumes that there are no taxes (True or false?)

False (Taxes, of course, can affect the valuation of a security but the EMH does not make any assumption about taxes. Remember that an efficient market is one in which security prices reflect all available information. And the existence of taxes is one piece of information that is reflected in security prices when the market is efficient.)

The efficient-market hypothesis assumes that there is perfect foresight (True or False)

False (The EMH does not assume that investors are God-like in their ability to perfectly forecast the future. It merely assumes that investors are unbiased in their forecasts. In other words, investors' forecasts should be correct on average. So, for example, they may be overly optimistic in their forecasts of some firms' dividends and overly pessimistic in their forecasts of other firms' dividends but these forecast errors cancel each other out so that across the entire sample of firms, the forecast error is insignificantly different from zero.)

The efficient-market hypothesis assumes that investors are irrational (True or False)

False (The EMH essentially says that the market is rational. In other words, security prices are unbiased reflections of intrinsic value, where intrinsic value can be defined as the present value of the unbiased forecast of the cash flows that a security will generate.)

In efficient markets, the expected return on each stock is the same

False (The EMH states that there is a positive relation between risk and expected return. In other words, investors can only expect a higher return from an investment if they are willing to take on more risk. Or, put another way, risk averse investors are induced into accepting more risk with a higher expected return. Because there is no reason to believe that every stock has the same risk, there is no reason to believe that the expected return on each stock is the same.)

The efficient-market hypothesis assumes that there are no transaction costs (True or False)

False (Transaction costs do make it more difficult for investors to exploit any difference between a security's price and its intrinsic value but the EMH does not assume that there are no transaction costs.)

The various lessons of market efficiency are: I. markets have no memory II. trust market prices III. read the entrails IV. there are no financial illusions V. the do-it yourself alternative VI. seen one stock, seen them all

I, II, III, IV, V, and VI

Briefly explain why, in a competitive securities market, successive price changes are random.

In a competitive market, prices reflect all available information. The only reason prices change is due to new information arrival. By definition new information arrives randomly. Therefore, security prices change randomly. If security prices did not change randomly, intelligent traders could profitably trade upon the recognition of such a pattern. Competition among traders would then act to change prices, in reaction to such trades, thus helping erase the originally discovered pattern.

The study of behavioral finance has best helped explain which of the following investor behaviors? Investors tend to sell their losing stocks and retain stocks that have capital gains. Investors are often unable to short-sell unfavorable stocks. Investors are generally too slow to update their beliefs in the face of new evidence. Investors often create undiversified portfolios.

Investors are generally too slow to update their beliefs in the face of new evidence.

Geothermal Corporation has just received good news: its earnings increased by 20% from last year's value. Most investors are anticipating an increase of 25%. Will Geothermal's stock price increase or decrease when the announcement is made?

It will decrease because an efficient market responds to NEW information. Since it was expecting an increase of 25% but the increase was only 20%, then the new information is bad news.

Which of the following observations would provide evidence against the strong form of efficient market theory?

Managers who trade in their own firm's stocks make superior returns.

Which of the following observations appear to indicate market inefficiency? Which of the following observations appear to indicate market inefficiency? Explain whether the observation appears to contradict the weak, semi-strong, or strong form of the efficient-market hypothesis. a. Tax-exempt municipal bonds offer lower pretax returns than taxable government bonds. b. Managers make superior returns on their purchases of their company's stock. c. There is a positive relationship between the return on the market in one quarter and the change in aggregate profits in the next quarter. d. There is disputed evidence that stocks that have appreciated unusually in the recent past continue to do so in the future. e. The stock of an acquired firm tends to appreciate in the period before the merger announcement. f. Stocks of companies with unexpectedly high earnings appear to offer high returns for several months after the earnings announcement. g. Very risky stocks on average give higher returns than safe stocks.

One of the ways to think about market inefficiency is that it implies there is easy money to be made. The following appear to suggest market inefficiency: (b) strong form (d) weak form (f) semi-strong form

The collections of evidence against market efficiency are referred to as "puzzles" or anomalies (True or False)

True

Many commentators have blamed the subprime crisis on "irrational exuberance." What is your view? Explain briefly.

Opinion question; answers will vary. Some of the blame may indeed rest with borrowers who held overly-optimistic views of housing market appreciation and of their ability to repay mortgages. Similarly, purchasers of mortgage backed securities may have unwisely believed that these instruments offered an adequate return. Alternative explanations include inaccurate ratings, agency cost problems (where loan originators lacked incentives to underwrite the loans effectively), the purchase activity and implicit government backing of Fannie Mae and Freddie Mac, and other information asymmetry problems.

Respond to this comment: "The random-walk theory implies that events are random, but many events are not random. If it rains today, there's a fair bet that it will rain again tomorrow."

Random-walk theory as applied to efficient markets means that fluctuations from the expected outcome are random. Suppose there is an 80 percent chance of rain tomorrow (because it rained today). Then the local umbrella store's stock price will respond today to the prospect of high sales tomorrow. The store's sales will not follow a random walk, but its stock price will, because each day the stock price reflects all that investors know about future weather and future sales.

State the semistrong form of market efficiency and its implications.

Security prices reflect all publicly available information. If markets are efficient in this sense, then prices will adjust immediately to public announcements

State the strong form of market efficiency.

Security prices reflect all the information that is available to the investors.

State the weak form of market efficiency and its implications.

Security prices reflect the information contained in the record of past prices. This implies that prices will follow a random walk. It is impossible to make consistently superior profits by studying past returns.

Example of "seen one stock, seen them all" relevance to financial managers

Stock issues do no depress price if investors believe the issuer has no private information.

Example of "the do-it yourself alternative" relevance to financial managers

The company should not seek diversification just to reduce risk. Investors can diversify on their own

"If the efficient-market hypothesis is true, the pension fund manager might as well select a portfolio with a pin." Explain why this is not so.

The efficient market hypothesis does not imply that portfolio selection should be done with a pin. The manager still has three important jobs to do. First, she must make sure that the portfolio is well diversified. It should be noted that a large number of stocks is not enough to ensure diversification. Second, she must make sure that the risk of the diversified portfolio is appropriate for the manager's clients. Third, she might want to tailor the portfolio to take advantage of special tax laws for pension funds. These laws may make it possible to increase the expected return of the portfolio without increasing risk.

Respond to the following comment: "Efficient market? Balderdash! I know at least a dozen people who have made a bundle in the stock market."

There are plenty of people who have made a bundle in the stock market despite their irrational investment styles. But there have been many more who have lost a bundle.

Respond to the following comment: "The random-walk theory, with its implication that investing in stocks is like playing roulette, is a powerful indictment of our capital markets."

There is risk in almost everything you do in daily life. You could lose your job or your spouse, or suffer damage to your house from a storm. That doesn't necessarily mean you should quit your job, get a divorce, or sell your house. If we accept that our world is risky, then we must accept that asset values fluctuate as new information emerges. Moreover, if capital markets are functioning properly, then stock price changes will follow a random walk. The random walk of values is the result of rational investors coping with an uncertain world.

Respond to the following comment: "If everyone believes you can make money by charting stock prices, then price changes won't be random."

To make the example clearer, assume that everyone believes in the same chart. What happens when the chart shows a downward movement? Are investors going to be willing to hold the stock when it has an expected loss? Of course not. They start selling, and the price will decline until the stock is expected to give a positive return. The trend will 'self-destruct.'

If a stock's returns follow a random walk pattern, then one should expect to calculate a statistically insignificant autocorrelation coefficient, calculated between each successive day's stock returns. (True or False)

True

List the three forms of market efficiency and explain the bases for them.

Weak Form, Semistrong form, Strong-form (These distinctions are based on the level of information reflected in the security prices. Weak-form efficiency deals with historical prices. Semistrong form deals with publicly available information that also includes historical information. Lastly, strong form includes all information that can be acquired by painstaking analysis of the company and the economy.)

The different forms of market efficiency are:

Weak form, semistrong form, and strong form

Respond to the following comment: "Despite all the limitations, the best guide to a company's value is its written-down book value. It is much more stable than market value, which depends on temporary fashions."

What good is a stable value when you can't buy or sell at that value because new conditions or information have developed which make the stable price obsolete? It is the market price, the price at which you can buy or sell today, which determines value.

If capital markets are efficient, then the sale or purchase of any security at the prevailing market price is generally:

a zero-NPV transaction

List the six lessons of market efficiency

a. Markets have no memory b. Trust market prices c. Read the entrails d. There are no financial illusions e. The do-it-yourself approach f. Seen one stock, seen them all

In order to test the semistrong form of the efficient-market hypothesis, researchers have mostly relied on the: measurement of how rapidly security prices adjust to different news items. measurement of the performance of technical trading strategies over the years. estimation of the serial correlation coefficients (autocorrelations) for securities and markets. all of the options.

measurement of how rapidly security prices adjust to different news items

The semistrong form of efficiency focuses on the economic ineffectiveness of the following type of information:

publicly available information

The statement that stock prices follow a random walk implies that:

the correlation coefficient between successive price changes (autocorrelation) is not significantly different from zero

An actual abnormal stock return is defined as the:

return on the stock minus the return that should have been earned given its riskiness.

One important implication of the efficient markets hypothesis is that most investors: can benefit by purchasing high-beta stocks. should trade actively to help ensure the highest overall gain in their portfolios. should hold IPO stock issues for the long-term. should avoid active trading.

should avoid active trading

Suppose that a lawyer works for a firm that advises corporate firms planning to sue other corporations for antitrust damages. He finds that he can "beat the market" by short selling the stock of firms that will be sued. This hypothetical finding would violate the:

strong-form hypothesis of market efficiency.