Investments Chapter 8 PPT

Assume that the serial correlation coefficient for a stock's daily returns is 0.58. If the stock's return today was -0.39%, do you want to buy or short-sell the stock when the market opens tomorrow? a. buy b. short sell c. insufficient info. d. hold

(B) You want to short-sell the stock because you expect the tomorrow's return to be negative due to the positive correlation coefficient.

Selection Bias Issue

- Investors who find successful investment schemes are less inclined to share findings - Observable outcomes preselected in favor of failed attempts

Look at 8.4 mutual fund and analysts performance

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You are analyzing the performance of a group of 500 mutual fund managers. If markets are efficient, approximately how many would you expect to have ranked in the top half (or beat the market) in terms of performance for six consecutive years? A. 8 B. 10 C. 9 D. 11 E. 6

A 500(1/2)^6 = 8

Define Efficient Market Hypothesis

A capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security price s

Post earnings announcement price drift

Abnormal return on announcement day, momentum continues past market price; Sluggish response of stock price to firm's earnings announcement

Assume that a company announces an unexpectedly large cash dividend to its shareholders. In an efficient market without information leakage, one might expect: a. an abnormal price change at the announcement b. an abnormal price increase before the announcement c. an abnormal price decrease after the announcement d. no abnormal price change before or after

Answer: a. The information should be absorbed instantly.

The semistrong form of the efficient market hypothesis asserts that stock prices: a. fully reflect all historical price information b. full reflect all publicly available information c. fully reflect all relevant information including insider information d. May be predictable

Answer: b. Public information constitutes semi-string efficiency, while the addition of private information leads to strong form efficiency.

According to the efficient market hypothesis: a. high beta stocks are consistently overpriced b. low beta stocks are consistently overpriced c. positive alphas on stocks will quickly disappear d. negative alpha stocks consistently yield low returns for abitrageurs

Answer: c. Stocks producing abnormal excess returns will increase in price to eliminate the positive alpha.

Which one of the following would provide evidence against the semistrong form of the efficient market theory? a. about 50% of pension funds outperform the market in any year b. you cannot make abnormal profits by buying stocks after an announcement of strong earnings c. trend analysis is worthless in forecasting stock prices d. low p/e stocks tend to have positive abnormal returns over the long run

Answer: d. The P/E ratio is public information so this observation would provide evidence against the semi-strong form of the efficient market theory.

Passive investment strategy

Buying well-diversified portfolio without attempting to find mispriced securities

Risk Premiums or inefficiencies?

Fama and French: market phenomena can be explained as manifestations of risk premium Lak. and Vishny: evidence of inefficient market

Weah Form EMH (random walk) *stock prices reflect *Investors cannot profit from technical analysis as

HISTORICAL INFO Stock prices reflect all information contained in historical trading Investors cannot profit from technical analysis as information in past market data is well known and thus does not predict returns

Lucky Event Issue

Lucky investments receive disproportionate attention

The debate concerning the degree to which financial markets are informationally efficient rages on. Settling the debate is difficult due to these issues: (3)

Magnitude Issue Selection bias issue Lucky event issue

Index fund:

Mutual fund which holds shares in proportion to market index representation

A successful firm like Microsoft has consistently generated large profits for years. Is this a violation of rate EMH?

No, this is not a violation of the EMH. Microsoft's continuing large profits do not imply that stock market investors who purchased Microsoft shares after its success already was evident would have earned a high return on their investments.

At a cocktail party, your co-worker tells you that he has beaten the market for each of the last three years. Suppose you believe him. Does this shake your belief in efficient markets?

No. The notion of random walk naturally expects there to be some people who beat the market and some people who do not. The information provided, however, fails to consider the risk of the investment. Higher risk investments should have higher returns. As presented, it is possible to believe him without violating the EMH.

If prices are as likely to increase as decrease, why do investors earn positive returns from the market on average?

Over the long haul, there is an expected upward drift in stock prices based on their fair expected rates of return. The fair expected return over any single day is very small (e.g., 12% per year is only about 0.03% per day), so that on any day the price is virtually equally likely to rise or fall. However, over longer periods, the small expected daily returns cumulate, and upward moves are indeed more likely than downward ones.

Strong Form EMH

PRIVATE/INSIDE *stock prices already reflect all relevant information including inside information *investors cannot profit from trading on inside information . Even insiders with private information are unable to earn abnormal risk adjusted returns

Semistrong form EMH *stock prices reflect all *The market response to new info. is __ and __ *Investors cannot profit from ____ analysis

PUBLIC/PAST AND CURRENT *stock prices already reflect all public information *the market response to new information is quick and accurate *investors cannot profit from fundamental analysis

Briefly explain the roles or responsibilities of portfolio managers in an efficient market environment.

Portfolio managers have several roles and responsibilities even in perfectly efficient markets. The most important responsibility is to identify the risk/return objectives for a portfolio given the investor's constraints. In an efficient market, portfolio managers are responsible for tailoring the portfolio to meet the investor's needs, rather than to beat the market, which requires identifying the client's return requirements and risk tolerance. Rational portfolio management also requires examining the investor's constraints, including liquidity, time horizon, laws and regulations, taxes, and unique preferences and circumstances such as age and employment.

Book to market effect

Shares of high book-to-market firms can generate abnormal returns

Neglected firm effect

Stock of little-known firms can generate abnormal returns due to less monitoring by analysts.

Which version of the efficient market hypothesis (weak, semistrong, or strong-form) focuses on the most inclusive set of information?

Strong-form efficiency includes all information: historical, public, and private

Briefly discuss the implications of the efficient market hypothesis for investment policy as it applies to: (a) technical analysis in the form of charting (b) fundamental analysis

Technical analysis involves the search for recurrent and predictable patterns in stock prices in order to enhance returns. The EMH implies that technical analysis is without value. If past prices contain no useful information for predicting future prices, there is no point in following any technical trading rule. (ii) Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. The EMH predicts that most fundamental analysis is doomed to failure. According to semistrong-form efficiency, no investor can earn excess returns from trading rules based on publicly available information. Only analysts with unique insight achieve superior returns. In summary, the EMH holds that the market appears to adjust so quickly to information about both individual stocks and the economy as a whole that no technique of selecting a portfolio using either technical or fundamental analysis can consistently outperform a strategy of simply buying and holding a diversified portfolio of securities, such as those comprising the popular market indexes.

If markets are efficient what should be the correlation coefficient between stock returns for two non overlapping time periods?

The correlation coefficient should be zero. If it were not zero, then one could use returns from one period to predict returns in later periods and therefore earn abnormal profits.

Good News, Inc., just announced an increase in its annual earnings, yet its stock price fell. Is there a rational explanation for this phenomenon?

The market may have anticipated even greater earnings. Compared to prior expectations, the announcement was a disappointment.

"If all securities are fairly priced, all must offer equal expected rates of return". Comment

The phrase would be correct if it were modified to say "expected risk adjusted returns." Securities all have the same risk adjusted expected return if priced fairly; however, actual results can and do vary. Unknown events cause certainsecurities to outperform others. This is not known in advance, so expectations are set by known information.

Random Walk Theory

The theory that notion stock price changes are random

Support Level

Unlikely for stock/index to fall below

You know that firm XYZ is very poorly run. On a scale of 1 (worst) to 10 (best), you would give it a score of 3. The market consensus evaluation is that the management score is only 2. Should you buy or sell the stock?

You should buy the stock. The firm's management is not as bad as everyone else believes it to be, therefore, the firm isundervalued by the market. You are less pessimistic about the firm's prospects than the beliefs built into the stock price.

You think that a company's management rates a 3 on a 1 to 10 scale where 10 is the highest rating. The market consensus is that the management rates a 4. Do you want to buy or short-sell this company's stock? A. Buy B. Short-sell C. Insufficient information D. Hold

You want to short-sell this company's stock because you think that it is overvalued (means the price will go down) •You think that a company's management rates a 4 on a 1 to 10 scale where 10 is the highest rating. The market consensus is that the management rates a 3. Do you want to buy or short-sell this company's stock? - Buy (undervalued)

Which of the following phenomena would be either consistent with or a violation of the efficient market hypothesis? Explain briefly. A. Nearly half of all professionally managed mutual funds are able to outperform the S&P 500 in a typical year. B. Money managers who outperform the market (on a risk-adjusted basis) in one year are likely to outperform in the following year. C. Stock prices tend to be predictably more volatile in January than in other months. D. Stock prices of companies that announce increased earnings in January tend to outperform the market in February. E. Stocks that perform well in one week perform poorly in the following week.

a. Consistent. Half of all managers should outperform the market based on pure luck in any year. b. Violation. This would be the basis for an "easy money" rule: Simply invest with last year's best managers. c. Consistent. Predictable volatility does not convey a means to earn abnormal returns. d. Violation. The abnormal performance ought to occur in January, when the increased earnings are announced. e. Violation. Reversals offer a means to earn easy money: Simply buy last week's losers.

Your investment client asks for information concerning the page 253 benefits of active portfolio management. She isparticularly interested in the question of whether active managers can be expected to consistently exploit inefficiencies in the capital markets to produce above-average returns without assuming higher risk. The semistrong form of the efficient market hypothesis asserts that all publicly available information is rapidly and correctly reflected in securities prices. This implies that investors cannot expect to derive above-average profits from purchases made after information has become public because security prices already reflect the information's full effects. a. identify and explain 2 examples of empirical evidence that tend to support the EMH implication stated above

a. Some empirical evidence that supports the EMH is: (i) professional money managers do not typically earn higher returns than comparable risk, passive index strategies; (ii) event studies typically show that stocks respond immediately to the public release of relevant news; (iii) most tests of technical analysis find that it is difficult to identify price trends that can be exploited to earn superior risk-adjusted investment returns. CHECK WORD DOCUMENT!

Briefly explain the concept of the efficient market hypothesis (EMH) and each of its three forms—weak, semistrong, and strong—and briefly discuss the degree to which existing empirical evidence supports each of the three forms of the EMH.

a. The efficient market hypothesis (EMH) states that a market is efficient if security prices immediately and fully reflect all available relevant information. If the market fully reflects information, the knowledge of that information would not allow an investor to profit from the information because stock prices already incorporate the information. The weak form of the EMH asserts that stock prices reflect all the information that can be derived by examining market trading data such as the history of past prices and trading volume. A strong body of evidence supports weak-form efficiency in the major U.S. securities markets. For example, test results suggest that technical trading rules do not produce superior returns after adjusting for transaction costs and taxes. The semistrong form states that a firm's stock price reflects all publicly available information about a firm's prospects. Examples of publicly available information are company annual reports and investment advisory data. Evidence strongly supports the notion of semistrong efficiency, but occasional studies (e.g., those identifying market anomalies such as the small-firm-in-January or book-to-market effects) and events (such as the stock market crash of October 19, 1987) are inconsistent with this form of market efficiency. However, there is a question concerning the extent to which these "anomalies" result from data mining. The strong form of the EMH holds that current market prices reflect all information (whether publicly available or privately held) that can be relevant to the valuation of the firm. Empirical evidence suggests that strong-form efficiency does not hold. If this form were correct, prices would fully reflect all information. Therefore even insiders could not earn excess returns. But the evidence is that corporate officers do have access to pertinent information long enough before public release to enable them to profit from trading on this information.

Efficient Market Hypothesis argues that

abnormal returns cannot be consistently realized

Mutual fund manager performance does not indicate that value is ____

added, especially after fees are considered

Which of the following statements are true if the efficient market hypothesis holds? a. It implies that future events can be forecast with perfect accuracy b. It implies that prices reflect all available information c. it implies that security prices change for no discernible reason d. it implies that prices do not fluctuate

b. This is the definition of an efficient market.

Fundamental Analysis: The trick is not to identify firms that are good but to find firms that are

better than everyone else's estimate trouble firms can be great bargains if their prospects are not quite as bad as their stock prices suggest

Which of the following observations would provide evidence against the semi strong form of the efficient market theory? Explain. a. mutual fund managers do not on average make superior returns b. you cannot make superior profits by buying (or selling) stocks after the announcement of an abnormal rise in dividends c. Low P/E stocks tend to have positive abnormal returns d.in any year approximately 50% of mutual funds outperform the market

c. The P/E ratio is public information so this observation would provide evidence against the semi-strong form of the efficient market theory.

In an efficient market, professional portfolio management can offer all of the following benefits except which of the following? a.Low-cost diversification. b. A targeted risk level. c. Low-cost record keeping. d. A superior risk return trade off

d. It is not possible to offer a higher risk-return trade off if markets are efficient.

Fundamental analysis assumes stock price equal to

discounted expected CF's

A "random walk" occurs when:

future price changes are uncorrelated with past price changes

What happens when goods news is made public?

in efficient markets, stock price should jump immediately Standardized unexpected earnings: actual earnings + expected earnings market adjusts to earning info. gradually

Active management assumes market ___

inefficiency

Short run overreaction causing price momentum may lead to

long term reversals

Returns over short horizon (3-12 months)

momentum effect tendency of poorly performing stocks to continue abnormal performance in following periods

Passive Portfolio Management

passive investment strategy and management

Market Anomalies

patterns of return/price contradicting EMH

P/E Effect

portfolios of low P/E stocks have exhibited higher average risk-adjusted returns than high P/E stocks

Analysts are overly ___ about firm prospects

positive

Stock market analysts may add value through their ___

recommendations

Fundamental Analysis

research on determinants of stock value, such as earnings and dividend prospects, expectations for future interest rates, and risk of the firm

Technical Analysis

research on recurrent and predictable stock price patterns and on proxies for buy or sell pressure in the market

Returns over long horizon (3-5 years)

reveresal effect tendency of poorly or well performing stocks to experience reversal in following periods

Passive management is consistent with ___ efficiency

semi strong

Some anomalies have not shown staying power after being reported? (2)

small firm effect book to market

The random walk theory is not useful for

stock price predictability

Small firm effect

stocks of small firms have earned abnormal returns

We do NOT expect markets to be __ __ efficient

strong form *we regulate and limit trades based on inside information

Technical analysts ("chartists") attempt to earn abnormal returns (positive alpha) by

timing the market based on sophisticated charting techniques

The role of portfolio manager in an efficient market is to

to tailor the portfolio to the investors' needs according to their age, tax bracket, risk aversion, and employment, rather than to beat the market.

It is possible to have a random walk around a ___

trend *expected price change is positive over time *positive trend but random around the trend

Fundamental Analysis: Securities analysts examine publicly available information in an effort to identify

undervalued stocks

Define resistance level

unlikely for stock/index to rise above

Either positive or negative autocorrelation implies a

violation

Bubbles and market efficiency

•Speculative bubbles can raise prices above intrinsic value; Even if prices are inaccurate, it can be difficult to take advantage of them