Module 3: Market Efficiency
Definitions/Components: Behavioral Biases: + Loss Aversion + Herding + Overconfidence + Information Cascades + Other Behavioral Biases (Actually know this flashcard, these are not TP. They also overlapped with other subjects/lessons!!)
+ Loss Aversion: ... most financial models, the assumption is that investors are "risk averse"(investors dislike risk, and they require higher expected returns as compensation for exposure to additional risk) ... Behavioral finance asserts that investors exhibit "loss aversion" (i.e., they dislike losses more than they like comparable gains), which results in a strong preference for avoiding losses as opposed to achieving gains.(Advocates of this bias argue that loss aversion is more important to investors than risk aversion) + Herding: a behavioral bias that explains both underreactions and overreactions in financial markets. Herding occurs when investors ignore their own analysis, and instead make investment decisions in line with the direction of the market. + Overconfidence: asserts that 1) investors have an inflated view of their ability to process new information appropriately Overconfident investors are inaccurate when it comes to valuing securities given new information, and therefore stocks will be mispriced if an adequate number of such investors are in the market. 2) overconfident investors tend to maintain portfolios that are less than optimally diversified because they tend to overestimate their stock-picking abilities. - Evidences suggested overconfidence has led to mispricing in most major markets around the world, but the bias has been observed predominantly in higher-growth companies, whose prices are slow to factor in any new information. + Information Cascades: similar but not identical to herding. An information cascade refers to the transfer of information from market participants who are the first to take investment action upon the release of new information, and whose decisions influence the decisions of others. Ex: earnings announcements are difficult to interpret without access to complete financial statements and "noisy" because it is uncertain what current earnings indicate regarding future profitability. In the immediate aftermath of the announcement, if the stock price moves in a particular direction, uninformed traders assume that trades conducted by more informed traders are behind the change in stock price, and are therefore tempted to trade in the same direction themselves, creating an information cascade. + Other Behavioral Biases: 1) Representativeness: investors assess probabilities of future outcomes as being similar to what they are in the current state. 2) Mental accounting: investors keep track of gains and losses from different investments in separate mental accounts. 3) Conservatism: investors are slow to react to changes, and continue to maintain their initial views. 4) Narrow framing: investors focus on issues in isolation.
Definitions/Components: Implications of Efficient Market Hypothesis (not that important flashcard, first 2 points already included in other flashcard)
+ Securities markets are weak-form efficient, past trends in prices cannot be used to earn superior risk-adjusted returns. + Securities markets are also semi-strong form efficient. Therefore, investors who analyze information should consider what information is already factored into a security's price, and how any new information may affect its value. + Securities markets are not strong-form efficient. This is because insider trading is illegal.
Definitions: (I Skipped a few before this, it's trivial in my opinion) Efficient Market and Portfolio Management
+ weak-form and semi-strong form efficient, active management is not likely to earn superior risk-adjusted returns on a consistent basis. Therefore, passive portfolio management would outperform active management [Another word: Passive management will outperform active management in this 2 forms of market. No one wins in strong forms] + implication here is that the role of the portfolio manager is not necessarily to beat the market, but to manage the portfolio in light of the investor's risk and return objectives.
Definitions/Components: Time-Series Anomalies- Calendar Anomalies (Trivial Pursuit I will say!!, skip or quickly scan over)
(None of these are consistent or accurate) January effect: investors have earned significantly higher returns in the equity market during January compared to other months of the year Turn-of-the-month effect: last day in the month is higher Day-of-the-week effect: Monday is negative and rest are positive Weekend effect: Weekends tend to be lower Holiday effect: days before market holiday usually is higher than other days
Definitions/Components: Factors Contributing To and Impeding A Market's Efficiency (Job on exam is to identity, not memorize, mostly common sense)
+ Market participants: Generally speaking, the greater the number of active market participants (investors and financial analysts) that analyze an asset or security, the greater the degree of efficiency in the market. + Information availability and financial disclosure: The availability of accurate and timely information regarding trading activities and traded companies contributes to market efficiency. For a market to be considered efficient, investors should have access to the information necessary to value securities that trade in the market. Further, all investors should have fair and equal opportunity to act on this information. + Limits to trading: activities of arbitrageurs, who seek opportunities to trade on mispricing in the market to earn arbitrage (riskless) profits, contribute to market efficiency. + Transaction costs and information-acquisition costs: Low Transaction costs and information-acquisition cost are efficient market
Definitions/Components: Time-Series Anomalies- Momentum and Overreaction Anomalies (I will say a bit above Trivial Pursuit but quickly scan over)
- Certain short-term share price patterns arise as a result of investors overreacting to the release of new information. Investors tend to inflate stock prices of companies that have released good news and depress stock prices for those that have released bad news.( - overreaction and momentum anomalies go against the assertions of weak-form efficiency in markets.
Definitions: Strong-Form of the Efficient Market Hypothesis (Know these points)(The important one)
1) Strong-form EMH contends that stock prices reflect all public and private information. It implies that no group of investors has sole access to any information that is relevant in price formation. Basically, there is no information out there that has not already been accounted for in current market prices. 2)Strong-form EMH encompasses weak-form and semi-strong form EMH and assumes perfect markets where information is cost free and available to all. Under strong-form EMH, no one can consistently achieve abnormal risk-adjusted returns, not even company insiders. Note: This strong form EMH is not possible. Market won't be able to react private information because insider trading is illegal.
L1EQ-TBPI33-1503 United Oil Corporation is a blue-chip company in the petroleum industry, based in Colorado. Paleo Group Inc. purchased various fuels from United Oil and transported them to client locations at a 40% margin for more than two decades. However, over the past five years, Paleo's performance was dramatically regretful. The auditors of Paleo had raised serious debates during the audit for the year 2013, especially on the liquidity position of the company. By the end of the first quarter of 2014, rumors of a takeover of Paleo by United Oil were reported by the financial media. However, many of these reports started claiming the backing of "unidentified top-level directors" of both companies from the first week of May. On May 15, in a press conference, officials of United Oil declared that the company will not acquire Paleo. However, United Oil will provide a substantial cash loan to Paleo on a long-term basis. A new legislation, which regulates the oil and petroleum industry, was passed by the government during January 2014. The act necessitated spending large amounts of money on disposal of waste oils and protection of the environment. The act came into existence in the first week of May, and the share prices of United Oil came down by 25% in a week. Which of the following comments about market efficiency of United Oil's shares is most likely true? The market is highly efficient, as the share prices of United Oil decreased as soon as the new legislation came into force. The market is inefficient, as the investors of United Oil pursued short-term goals instead of preferring long-term investment benefits. The market is inefficient, as the market value of United Oil's shares does not appear to reflect its intrinsic value between January and May.
Ans: The market is inefficient, as the market value of United Oil's shares does not appear to reflect its intrinsic value between January and May. The fact that the share prices of United Oil came down by 25% in the first week of May shows that investors reacted to the new legislation only once the act came into existence. However, the act was passed by the government in January itself. Thus, the price of United Oil's shares was not reflecting all available information between January and May. The 25% slip in the market value proves that the market value and the intrinsic value of United Oil's shares were altogether different between January and May.
L1EQ-TBPI31-1503**(very good question) Based solely on the given information, which of the following is the most likely conclusion about the efficiency of the stock exchange market of Western Credit? Period 1: June 1, 2012, to June 7, 2012 On June 4, 2012, Paleo Group Inc. sold 20% of its 50% holding in Western Credit Corporation through an OTC market in multiple transactions. However, the market price of Western Credit's stocks remained unchanged in the exchange during the period even after the sale of shared. Period 2: October 1, 2012, to October 7, 2012 On October 4, 2012, Western Credit Corporation filed for Chapter 11. The share prices came down by around 80% immediately after the news of the filing came out. Leading up to the filing, the financial news media had reported multiple credit defaults by the company. Reports on a probable insolvency filing were doing rounds in the financial press. Also, on October 4, 2012, John Samuels, the CEO, was convicted under the criminal law for corporate fraud. The market was inefficient in Period 1. The market was inefficient in Period 2. The market was inefficient in both Period 1 and Period 2.
Ans: The market was inefficient in Period 2. Period 1 A trade can be executed between two participants in an OTC market without other market players being aware of the price at which the transaction was effected. This lack of transparency in OTC market transactions means that Western's exchange market is not likely to respond to the OTC transactions quickly. Since there is no information on whether the share sales were communicated to the other market participants, we cannot conclude whether the market is efficient or not. Period 2 The share prices reacted aggressively to the news of the insolvency filing. This has happened after the media reports of multiple credit defaults and the corporate fraud. This means the market had failed in responding to these events and incorporating the effects on a timely manner. Therefore, the market was informationally inefficient during this period.
Definitions: Weak-Form Efficient Market Hypothesis (Know these points)(The important one)
In summary: - 1) Proponents of weak-form EMH assert that abnormal risk-adjusted returns cannot be earned by using trading rules and technical analysis, which make investing decisions based on historical security market data. (In other words, Fundamentalist, Arbitragers, Insiders can make abnormal return) - 2) Weak-form EMH assumes that current stock prices reflect all security market information, including historical trends in prices, returns, volumes, and other market-generated information such as block trades and trading by specialists. (In other words, Weak EMH reflects all market public information but it doesn't include nonmarket public info) (A lot of develop countries has this market) Add-on: From CFA question: With respect to the efficient market hypothesis, if security prices reflect only past prices and trading volume information, then the market is: weak-form efficient. strong-form efficient. semi-strong-form efficient. Ans: weak-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.
Definitions: Semi-Strong Form Efficient Market Hypothesis (Know these points)(The important one)
In summary: -1) Proponents of the hypothesis assert that investors cannot earn abnormal risk-adjusted returns if their investment decisions are based on important material information after it has been made public. They stress that security prices rapidly adjust to reflect all public information. (In other words, both technical and fundamental can't make abnormal returns But, others such as Arnbitruagers and insiders can) -2) Semi-strong form EMH assumes that current security prices fully reflect all security market information and nonmarket/other public information. It encompasses weak-form EMH and also includes nonmarket public information such as dividend announcements, various financial ratios, and economic and political news in the set of information that is already factored into market values.
Intro: Behavioral finance (Common sense, you know these, TP)
- looks at investor behavior to explain why individuals make the decisions that they do, whether these decisions are rational or irrational. - "Behavioral Biases" individuals do not always make "efficient" investment decisions, nor do they always act rationally due to the presence of behavioral biases
Definitions: Anomaly
- occurs when a change in the price of an asset cannot be explained by the release of new information into the market. + If markets are efficient, trading strategies designed to exploit market anomalies will not generate superior risk-adjusted returns on a consistent basis. + exception to the notion of market efficiency (an anomaly) would occur if a mispricing can be used to earn superior risk-adjusted returns consistently.
Quick Recap: Market Value or Market Price
- the price at which the asset can currently be bought or sold. It is determined by the interaction of demand and supply for the security in the market.
Quick Recap: Intrinsic Value or Fundamental Value
- value of the asset that reflects all its investment characteristics accurately. Intrinsic values are estimated It's challenging to find intrinsic value because it's derived from forecasting its FCF.
Quick Recap: Informationally Efficient Market (an efficient market)
- where security prices adjust rapidly to reflect any new information. It is a market where asset prices reflect all past and present information.
L1R48TB-AC006-1605 (I have a feeling they will test you like this question, linking anomaly to EMH! REMEMEBR THIS!!) Given the following anomalies, which is inconsistent with weak-form market efficiency? Day-of-the-week effect. Value effect. Earnings surprise.
Ans: Day-of-the-week effect. Day-of-the-week rule is strictly based on stock price performance on Mondays vs. other days of the week. Its existence would be a violation of the weak form of EMH.
L1EQ-TBPI39-1503 Which of the following actions will least likely strengthen a strong-form efficient market? Permitting short-selling transactions. Opening the market for foreign investors. Strong prohibitions on insider trading.
Ans: Strong prohibitions on insider trading. Prices incorporate all public and private information in a strong-form efficient market, 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. However, this is not likely because of the strong prohibitions against insider trading that can be found in most countries.
L1EQR48-LIC005-1510 Which of the following supports the semistrong form of the EMH? Momentum effects. The performance of stocks with a low price/book value ratio. The performance of stocks that have announced a change in accounting methods.
Ans: The performance of stocks that have announced a change in accounting methods. Momentum effects and the outperformance of low price/book value stocks are both anomalies of the semistrong form of the EMH. The performance of stocks that have announced a change in accounting methods supports the semistrong form of the EMH. Studies find that analysts look at the true value of companies rather than the effects of a change in the way financial performance is reported.
L1R47TB-BW004-1612 Which of the following, if regulated and restricted by a government, lead to a more efficient market? Short selling Hedging Use of information that is not publicly disseminated
Ans: Use of information that is not publicly disseminated The third choice is correct. If nonpublic information is restricted or regulated, the market will have more "equal" knowledge of market information, causing greater participation, eventually leading to a more efficient market.
L1R48TB-AC023-1605 The risk-adjusted performance of passively managed portfolios in a semi-strong-form efficient market is expected to be: better than actively managed portfolios. equal to actively managed portfolios. worse than actively managed portfolios.
Ans: better than actively managed portfolios. In a semi-strong-form efficient market, abnormal returns are not possible since public information is reflected in prices. Passively managed portfolios do not incur costs of excessive trading and research.
L1R48TB-AC009-1605 In a strong-form efficient market and relative to the risk-adjusted performance of passively managed portfolios, that of actively managed portfolios is expected to be: better. equal. worse.
Ans: worse. In a strong form efficient market, abnormal returns are not possible since all information, private and public, is reflected in prices.
Facts:(important)(The important one) Summary from Question Forum: L1EQ-PQ4709-1410 Question: Under which of the following efficient market hypotheses is an investor most likely to earn an abnormal return based on dividend announcements? (Weak form, Semi-strong form, or Strong form) Correct answer: Weak-form EMH asserts that abnormal returns cannot be easily earned by using trading rules and technical analysis. It encompasses security market information but not other public information.
Answer: Weak-form EMH holds that you cannot earn excess returns by past price and volume information alone. Therefore, under weak form, you could earn excess returns from public announcements. CFAI: "In the weak-form efficient market hypothesis, security prices fully reflect all past market data, which refers to all historical price and trading volume information. If markets are weak-form efficient, 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." Semi-strong form: No excess returns from publicly available information. You could earn excess return from insider information. Strong form: No excess returns from any information.
Intro: Market Efficiency: Efficient Market Inefficient Market
Efficient Market: 1) difficult to find inaccurately priced securities. 2) Therefore, superior risk-adjusted returns cannot be attained in an efficient market, 3) and it would be wise to pursue a passive investment strategy, which entails lower costs. Inefficient Market: 1) securities may be mispriced and 2) trading in these securities can offer positive risk-adjusted returns. 3) In such a market, an active investment strategy may outperform a passive strategy on a risk-adjusted basis.
TestBank:
M3L1: L1R48TB-AC023-1605 L1EQ-TBPI33-1503*** L1EQ-TBPI31-1503*** L1R47TB-BW004-1612* L1R48TB-AC021-1605 L1R48TB-AC001-1605* (There's more but we didn't finish yet) M3L2: L1R48TB-AC006-1605** L1R47TB-BW010-1612 L1EQR48-LIC010-1510 L1EQR48-LIC005-1510** (There's more but we didn't finish yet)
Definitions/Components: Cross-Sectional Anomalies: (I will say Trivial Pursuit but just quickly scan over)
Size Effect: (Trivial Pursuit, no conclusion from studies) Value Effect: low P/E stocks have experienced higher risk-adjusted returns than high P/E stocks. These results go against semi-strong form market efficiency. However, when the Fama and French three-factor model is used instead of the CAPM to predict stock returns, the value stock anomaly disappears.( No real anomaly)
Module 3 L1: The Concept of Market Efficiency and Forms of Market Efficiency
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LOS Describe market efficiency and related concepts, including their importance to investment practitioners.
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*** If prices reflect all public and private information, the market is best described as: weak-form efficient. strong-form efficient. semi-strong-form efficient.
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.
