EXAM 2 FIN 4318
Sortino Ratio Equation
(Avg return - rf)/downside risk
Sharpe Ratio Equation
(Avg return - risk free)/ St Dev
Treynor Ratio Equation
(Return - risk free)/ Beta
Compare the two managers by computing the Sortino ratio.
A = 0.345% B = 0.415% B is better
Assume that you believe that markets learn slowly and that you use relative strength in stock prices (stock price is high today, relative to the price in a prior period) and volume shifts as your technical indicators. Which of the following combinations would make you most bullish on a stock?
A stock has high relative strength and increasing trading volume.
Jensen's Alpha Equation
Actual return - Expected return [CAPM -> Rf + Beta (Rm- Rf)]
In long period returns (3 to 5 year returns), there is evidence of negative serial correlation, where the losers of the last period tend to become winners over the next few Assume that you decide to take advantage of this by adopting a contrarian strategy of buying the stocks that have gone down the most in the past five years. Which of the following would concern you about this portfolio?
All answers are true
In the random walk hypothesis, the asset price follows a random walk, where the price movement in each period is completely uncorrelated with movements in prior periods. For prices to follow a random walk, which of the following assumptions needs to hold?
All answers are true
What are the categories of technical indicators?
All of the above
Looking at returns across the weekdays, it seems likely that Mondays have been the worst day of the week to invest in stocks over the last few decades. One explanation that is offered for the Monday effect is that companies report a disproportionate amount of bad news after the close of trading on Friday and that the Monday reaction reflects the bad news. If this story holds, which of the following would you expect to see in Monday returns?
Almost all of the negative return should come from stocks opening lower on Monday than from returns over the course of the day.
Beta = 1.05 Actual Return = 18% Risk - free rate = 3% Market return = 12%. Compute Jensen's alpha for this fund.
Alpha= 5.5%
If markets are efficient, which of the following would you never expect to see?
An asset or stock that is mispriced
Goldilocks time horizion
Building on the theme of time horizons, success at charting can be very sensitive to how long you hold and investment.
Sharpe Ratio
Characterizes how well the return of an asset compensates the investor for the risk taken.
What are benchmarks to assess investment performance?
Comparison to indicies. Risk and return models like the Sharpe Ratio, Jensen's alpha, Treynor Index, and Sortino Ratio.
What is weak form efficiency?
Current prices reflect all information contained in past prices, suggesting that technical analysis would not be useful.
What is strong form efficiency?
Current prices reflect all information, both public and private, and no investor can consistently find undervalued stocks.
What is semi-strong form efficiency?
Current prices reflect all publicly available information, including financial statements and news reports.
Jensen's Alpha
Determines the abnormal return of a security or portfolio of securities over the theoretical expected return.
What is the main reason for passing the Sarbanes - Oxley act?
Enron bankruptcy
Who developed the Efficient Market Hypothesis (EMH) and when?
Eugene Fama in 1970. He later won the Nobel prize.
True or False: It is a smart investment approach to trade only on momentum.
False
Prior to the market crash in 2008, a lot of investors purchased complex derivative securities backed by pools of mortgages ( remember the Big Short movie). Some researchers explained this behavior by using behavioral finance. Which of the following biases may be used as an explanation for the purchase of the complex derivative securities?
Herd Behavior
How does trading volume affect price momentum?
Higher trading volume strengthens and sustains momentum more than low trading volume.
Mutual fund cash positions
Historically, the argument goes, mutual fund cash positions have been greatest at the bottom of a bear market and lowest at the peak of a bull market. Hence investing against this statistic may be profitable.
What is behavioral finance's challenge to market efficiency?
Investors are not always rational and points to patterns in stock prices, price bubbles, and reactions to news as evidence.
What is serial correlation in stock prices?
It measures the relationship between price changes in consecutive time periods, indicating how past price changes affect future price changes.
What are the seasonal and temporal irregularities in stock prices indicated by empirical studies?
January effect Weekend effect Mid-day swoon
What is the chart on the left and right show?
Left: Positive serial correlation (Momentum) Right: Negative serial correlation (Contrarian or reversal)
Short term returns tend to have what type of serial correlation?
Low to no serial correlation
Odd lot trading
Many small traders deal in transactions of fewer than 100 shares, or odd-lots. Some analysts believe small investors are generally wrong.
What are the effects of serial correlation in short term returns?
Market Liquidity effect Bid-ask spread effect.
What are the groups indicated under the nature of irrationality?
Market participants overreact to new information Market participants are slow learners Investors change their mind frequently and often irrationally Some investors lead markets External forces that govern up & down movements that override fundamentals.
Event Study
Method of testing semi-strong form. Examine abnormal returns before and after the release of new information that affects a firm's intrinsic value.
Size effect
Momentum trading is stronger at small market caps
What is the bid-ask spread effect on serial correlation?
Negative serial correlation in returns due to the price "bounce" between bid and ask prices.
According to the Efficient Market Hypothesis, can an investor consistently outperform the market?
No
What are some examples of behavioral biases?
Overconfidence Disposition effect - pride and regret Familiarity Risk taking Herd behavior Unwillingness to admit mistakes
What is the most common reaction to new information?
Overreaction
Sortino Ratio
Penalizes only those returns falling below a user specific target or required rate of return, while sharpe ratio penalizes both upside and downside risk.
What did investors use as tools for predicting future price movements?
Price charts and patterns
What are the key assumptions of technical analysis?
Price is determined by supply and demand. Market factors are rational and irrational. Prices tend to move in trends. Trends shift due to changes in demand and supply, detectable through market actions.
Growth effect
Price momentum is stronger for higher growth companies with higher P/B ratios
Blooper
Rational markets can make mistakes
Market efficiency
Refers to the degree to which market prices reflect all available relevant information.
Treynor Ratio
Relates excess return over the risk free rate to additional risk taken, however systematic risk is used instead of total risk.
What is the market liquidity effect on short-term returns?
Serial correlation can occur because some stocks may not trade consistently, leading to price changes when they do trade.
Assume the market return is 14% with a standard deviation of 20%, and risk-free rate is 8%. The average annual returns for Managers D, E, and F are 13%, 17%, and 16% respectively. The corresponding standard deviations are 18%, 22%, and 23%. What are the Sharpe ratios for the market and managers?
SharpeM= 0.30 SharpeD= 0.28 SharpeE= 0.41 SharpeF= 0.35 E provides a better return for the same risk.
What is the strategy of short term returns?
Short selling in the top decile Buying the stocks in the bottom decile Hold Repeat
What are the four classes of empirical evidence on price patterns?
Short-term price behavior (minutes & hours) Daily & weekly price movements Medium-term returns (many months or yearly) Long-term price movements (five-year returns)
As you go from days to weeks and even months, the serial correlation in returns becomes positive. This momentum effect suggests that stocks that have done well will continue to do well and stocks that have done badly will continue to under perform. If you decide to play the momentum game, which of the following groups of stocks offers the most promise of continuing momentum?
Small market cap stocks where momentum has been accompanied by high trading volume
With technical trading rules that follow informed investors, you track the groups of investors that you believe either know more than you do or pick stocks better than you do and try to replicate what they do. Which of the following would be a bearish indicator?
Specialist short selling on a stock increases, relative to prior periods.
Which of the following markets will be expected to be most efficient?
Stock market in London
What is the reaction of stock prices to new information in an efficient market?
Stock prices quickly incorporate new information, leaving no opportunities for abnormal returns.
What is the January Effect?
Stocks tend to perform better in January compared to other months of the year.
What is price momentum in the medium term?
Stocks that have performed well in the last six months tend to continue to perform well, and those that have performed poorly tend to continue to perform poorly.
There is evidence that January is the best month of the year to invest in One story that has been told to explain this is that tax loss selling at the end of the prior year pushes down the stock prices of the companies where there is such selling and that it is the rebound that creates the January effect. If this were true, which of the following groups of stocks should be the biggest beneficiaries of the January effect?
Stocks that went down the most in the prior year
Weekend effect
Stocks, on average, seem to do much worse on Mondays than on any other day of the week.
Mid-day swoon
Stocks, on average, tend to do much be worse in the middle of the trading day than at the beginning and end of day.
What are potential issues in the short term returns strategy?
Tend to buy small market cap companies with low P/B ratios (high risk) High trading/turnover strategy and high transaction costs reducing the excess returns Overreaction to information
Loss aversion
Tendency of individuals to prefer avoiding losses over making equivalent gains, often leading to irrational decision-making.
What is herd behavior in finance?
Tendency of investors to follow the crowd, often leading to irrational market trends and price bubbles.
Portfolio study
Tests investment strategies by creating portfolios of firms with specific characteristics and examining their returns over multiple periods.
What does market efficiency not imply?
That stock prices cannot deviate from their true value or that no investor will ever beat the market; it suggests that deviations are random and that some investors will outperform due to luck.
What is an example of an event that increased market efficiency?
The Sarbanes-Oxley Act of 2002, which required greater financial transparency, made financial statements more credible and reduced equity market volatility.
Slow response
The price adjusts slowly to the new information. 30 days elapse before the price completely reflects the new information
Investment advisory opinion
The ratio of advisory services that are bearish; when this ratio reaches the threshold (i.e. 60%) the contrarian starts buying
Insider buying/selling
The ratio of insider buying to selling is often tracked for stocks with the idea that insiders who are buying must have positive information about a stock whereas insiders who are selling are likely to have negative information
What is the biggest risk for a momentum strategy?
The shift in momentum can happen suddenly and not in predictable ways
What is a random walk in stock prices?
The stock price reflects all past price information, making previous price changes irrelevant to future price changes.
Control trading costs
The strategies that come from technical indicators are generally short-term strategies that require frequent and timely trading leading to large trading costs which can erode excess returns.
What are contrarian indicators in technical analysis?
They suggest going against the prevailing market trends, such as odd lot trading and mutual fund cash positions.
How do investors who believe in market efficiency typically invest?
They tend to buy index funds that track overall market performance and support passive portfolio management.
What is the purpose of testing market efficiency?
To determine whether specific investment strategies can earn excess returns after adjusting for risk, transactions costs, and execution feasibility.
What is the objective of an event study?
To examine whether the event causes stock prices to move abnormally.
Assume the market return is 14% and risk-free rate is 8%. The average annual returns for Managers W, X, and Y are 12%, 16%, and 18% respectively. The corresponding betas are 0.9, 1.05, and 1.20. What are the Treynor ratios for the market and managers?
TreynorM= 6% TreynorW= 4.4% TreynorX= 7.6% TreynorY= 8.3% Y is the better performance of the portfolio under analysis.
An analyst wants to evaluate Portfolio X, consisting entirely of US common stocks, using both the Treynor and Sharpe measures of portfolio performance. The following table provides the average annual return for Portfolio X, the market portfolio (S&P 500) and US Treasury Bills during the past 8 years:
TreynorX=1.33. TreynorM=0.06. X outperformed. SharpeX=0.44. SharpeM=0.46, X underperformed.
Machine learning and AI can be used as more sophisticated versions of technical analysis.
True
True or False: Investors who believe markets are efficient tend to invest in index funds.
True
True or False: Loss aversion is a behavioral bias. If we define it in terms of utility function, losses will have steeper utility than gains.
True
True or False: One of the core beliefs of technical trading is that stocks do not have intrinsic values.
True
True or False: One of the major foundations of technical analysis is that prices are driven by supply and demand.
True
True or False: Relative strength is one of the popular momentum indicators.
True
True or False: When we make an assumption that the stock prices follow a random walk, we assume that all relevant information is embedded into the current stock price.
True
How can one succeed as a technical analyst?
Understand human nature and investor behavior. Avoid mistaking random movements for patterns. Match time horizons with indicators. Stay disciplined and follow back-tested strategies. Control trading costs.
What is the role of human behavior in technical analysis?
Understanding and predicting the irrational behavior and psychological biases of market participants.
What are some common pitfalls in testing investment strategies?
Using anecdotal evidence No holdout periods Sampling biases Failure to control for market performance Failure to control for risk. Data mining Survivor Not allowing for transaction costs Not allowing for difficulties in execution.
What are the forms of market efficiency?
Weak form Semi-strong form Strong form
House money effect
When investors become less risk-averse and less careful when dealing with gains perceived as "other people's money."
Bubble
Willful error, suggestive of irrational behavior at some level
Based on the performance of Portfolio X relative to S&P 500 calculated in the first part, briefly explain the reason for the difference in the results using the Treynor measure versus the Sharpe measure.
X has unsystematic risk
Contrarian trading can be based on:
all of the above
Break even effect
investors who have lost money become more reckless about risk taking (often taking bad risks and abandoning good sense) to get back what they have already lost.
Contrarian or reversal strategy is based on:
negative serial correlation
If you have a market that is not liquid and you are computing the returns on a market index, which of the following would you expect to find?
positive serial correlation
Momentum trade is based on:
positive serial correlation
There is evidence that January is the best month of the year to invest in stocks. One story that has been told to explain this is that tax loss selling at the end of the prior year pushes down the stock prices of the companies where there is such selling and that it is the rebound that creates the January effect. If this were true, which of the following groups of stocks should be the biggest beneficiaries of the January effect?
stocks that went down the most in the prior year
Which of the following activities is likely to be useful if the market is only weak form efficient?
studying financial, economic and industry information about a company
Specialist short sales
the assumption is that specialists have more information about future price movements than other investors. investors who use this indicator will often sell stocks when specialists do, and buy when they do
When you go from very short time periods (seconds, minutes) to slightly longer intervals (days), you do find some evidence of negative correlation with individual stocks. While this correlation may be statistically significant, which of the following has to hold for it to have economic significance?
the excess returns have to exceed the trading costs
