Test 6 Review

What is confirmation bias?

-"you do not get a second change at a first impression" -people tend to filter info and focus on info supporting their opinions

What does a rising put/call ratio indicate?

-a sign of broad investor pessimism and a coming market decline -a signal of buy opportunity

What is the small-firm effect?

-aka neglected-firm effect -stocks of small firms can earn abnormal returns

What is overreaction?

-attaching or anchoring one's thoughts to a reference point even though there may be no legal relevance or is not pertinent to the issue in question -fairly common in situations where decisions are being made in situations that are novel or new to the decision maker

What is fundamental analysis?

-research on determinants on stock value -assumes stock price equal to discounted value of expected future cash flow

What are the EMH implications?

-technical analysis -fundamental analysis -passive portfolio management -rational portfolio management

What is overconfidence?

-usually concerns an investor that listens mostly to himself/herself -an investor with overconfidence usually mostly relies on their skill and capabilities to do their homework and make their own decisions

True or False: the forward price is the price the forward contract buyer needs to pay to the seller to enter the contract.

False the forward price is paid at maturity; there is no contract entry payment

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

Where are forward contracts traded?

OTC

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.

Which one of the following would be a bullish signal to a technical analyst using moving average rules? a. A stock price crosses above its 52-week moving average. b. A stock price crosses below its 52-week moving average. c. The stock's moving average is increasing. d. The stock's moving average is decreasing.

Statement a, that a price has moved above its 52-weekmoving average, is considered a bullish sign.

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.

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 is undervalued by the market. You are less pessimistic about the firm's prospects than the beliefs built into the stock price.

What are market anomalies?

a semi-strong test which includes: P/E effect, book-to-market effect, small-firm effect, and January effect

Which of the following phenomena would be either consistent with or a violation of the EMH? 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.

What are forward contracts?

an agreement to buy or sell an asset at a certain future time for a certain price

What is gambler's fallacy?

an incorrect assumption from the world of possibilities

Which of the following statements are true if the EMH 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.

What type of market deals with futures contracts?

broker's market

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.

When is a futures contract settled?

daily

What type of market deals with forward contracts?

dealer's market

What does weak form EMH rely on to get abnormal returns?

fundamental analysis and insider info

What does semi strong form EMH rely on to get abnormal returns?

insider info

Long position versus short position

long = buyer short = seller

What are funds deposited in clearing house also called?

margins

What is daily settlement?

marking to market = the margin account is adjusted to reflect the trader's gain or loss

When is the forward price paid?

maturity

Are forward contracts standardized?

no

Can people predict the direction of the market or an individual stock in the short term?

no

Do futures contracts have default risk?

no

Do technicians deny the value of fundamental analysis?

no

Does behavioral finance reject traditional finance's views?

no

What does strong form EMH rely on to get abnormal returns?

nothing

What are moving averages?

the moving average of a stock price is the average price over a given interval

What is short ratio?

the ratio of number of shares sold short in a stock to the stock's average daily trading volume

What is the put/call ratio?

the ratio of outstanding put options to outstanding call options

What is passive portfolio management?

-establishing well-diversified portfolios without attempting to find mispriced securities -buy and hold to avoid frequent trading costs -create an index fund to replicate the performance of a broad-based index of stocks

What is rational portfolio management?

-even if all stocks are priced fairly, each still poses firm specific risk that can be eliminated through diversification -rational security selection calls for the selection of well-diversified portfolio providing the systematic risk level wanted

What are the four premises of behavioral finance?

-investors are normal -markets are not efficient -the behavioral portfolio theory governs -risk alone does not determine returns

What are the four premises of traditional finance?

-investors are rational -markets are efficient -the mean-variance portfolio theory governs -returns are determined by risk (beta)

What is hindsight bias?

-looking back after the fact is known -may lull the investor into believing they can perform better or more efficiently when armed with this bias

What are the two types of settling for a forward contract?

1) physical delivery 2) cash settlement

Who merged in 2007 to form CME group?

CBOT and CME

How does a turkey ham manufacturing factory hedge the risk of cost increase if they plan to purchase turkey from local farmers after two weeks? What is the benefit generated by this contract? What is the cost of this contract?

Enter a long position in a forward contract(be a buyer in a forward contract)and fix the purchase price of turkey. This will fix the cost in the future so it eliminates the risk of turkey price increase; however, this sacrifices the profit if in the future the market price of turkey decreases.

What is random walk?

assets are changing continually over very small intervals of time and the asset prices are being altered by random amounts

When is a forwards contract settled?

at the end of the contract

What is anchoring?

attaching one's thoughts to a reference point even though there may be no legal relevance or is not pertinent to the issue in question

Which of the following observations would provide the evidence against the semi-strong form of 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.

Which of the following would most appear to contradict the proposition that the stock market is weakly efficient? Explain. a. Over 25% of mutual funds outperform the market on average. b. Insiders earn abnormal trading profits. c. Every January, the stock market earns abnormal returns.

c. This is a predictable pattern of returns, which should not occur if the stock market is weakly efficient.

An analyst has just received new info regarding his investment in a particular stock. The new info conflicts with his earlier forecast of what the stock price should be in that it is lower than his forecast. However, he is not willing to integrate the new info onto his forecast and to revise it accordingly. What behavioral trait best describes the analyst's actions?

confirmation bias

Which of the following is a consistent strategy with a belief in the efficient market hypothesis? a) waiting to purchase a stock until it increases above the 40-day moving average b) searching for undervalued securities c) comparing the calculated value of a security, through fundamental analysis, to the market value of stock d) selecting a random set of stocks for a portfolio

d) selecting a random set of stocks for a portfolio

Where are futures contracts traded?

on exchange

What is mental accounting?

people segregate certain decisions

What is herding?

people tend to follow the masses or the "herd"

What is the P/E effect?

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

What is spot price?

price for the asset traded right now

What is the prospect theory?

provides that people value gains and losses differently and will base their decisions on perceived gains rather than perceived losses

What is clearing house?

requires the two parties of a futures contract to deposit funds with the clearing house to ensure that they will live up to their obligations

What is technical analysis?

research on recurrent/predictable price patterns and on proxies for buy/sell

What is the book-to-market effect?

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

When is anchoring common?

situations where decisions are being made in a novel situation or a new to the decision maker

What is weak form efficient market hypothesis?

stock prices already reflect all info contained in history of trading

What is semi strong form efficient market hypothesis?

stock prices already reflect all public info

What is strong form efficient market hypothesis?

stock prices already reflect all relevant info, including inside info

What is the January effect?

stocks have a tendency to decline in value during December and to move up in January

Why are forward contracts known as zero-sum game?

the gain (loss) to the party in a forward contract is always equal to the loss (gain) of the other the sum equals zero

What is short interest?

the total number of shares of stock currently sold short in the market

What happens if the balance in the margin account falls below the maintenance margin?

the trader receives a call and is expected to top up the margin account to the initial margin level by the end of the next day

What is bullish?

to buy

What does hedging risk mean?

to eliminate or lower risk

What is bearish?

to sell

What are extra funds deposited in a margin call known as?

variation margin

Are futures contracts standardized?

yes

Do forward contracts have default risk?

yes