Efficient Market Hypothesis and Behavioral Finance

These flashcards cover key concepts from the Efficient Market Hypothesis and Behavioral Finance, aiding in understanding core principles for exam preparation.

Which of the following statements is true about the efficient market hypothesis?

1. It implies perfect forecasting ability.

2. It implies that prices reflect all available information.

3. It implies an irrational market.

4. It implies that prices do not fluctuate.

5. It results from keen competition among investors

false, true, false, false true

What is market efficiency?

Market efficiency exists when prices reflect all available information. To be efficient in the weak form, the market must incorporate all historical data into prices. Under the semi-strong form of the hypothesis, the market incorporates all publicly available information in addition to the historical data. In strong form efficient markets, prices reflect all publicly and privately available information.

The efficient market hypothesis______.

implies that security prices properly reflect information available to investors and implies that active traders will find it difficult to outperform a buy-and-hold strategy.

A finding that______ would provide evidence against the semi-strong form of the efficient market theory.A finding that would provide evidence against the semi-strong form of the efficient market theory.

low P/E stocks tend to have positive abnormal returns and one can consistently outperform the market by adopting the contrarian approach exemplified by the reversals phenomenon

Suppose you purchase a stock every time the price declines more than 5% in a day and sell it 7 days later. If this resulted in superior returns which form of EMH would it contradict?

This result would suggest that superior returns could be achieved using market trading data and contradicts weak form EMH

Suppose we find a correlation coefficient of .92 between the periods 1990-1999 and 2000-2009. Does this support the efficient markets hypothesis?

No, this finding does not support the efficient market hypothesis. We would expect the correlation coefficient to be 0 if EMH is true. Since the co-efficient is .92 it implies that one could have used historic trading data to earn alpha which violates the EMH.

An investor is able to earn excess returns using financial statement analysis and business acumen. Which form of EMH is being violated?

According to the semi-strong form EMH excess returns cannot be achieved using publicly available information.

Which of the following price adjustment processes are inconsistent with the EMH?

1. Delayed reaction

2. Efficient market reaction

3. Overreaction and correction

delayed reaction, overreaction and correction

Aerotech, an aerospace technology research firm, announced this morning that it hired the world’s most knowledgeable and prolific space researchers. Before today, Aerotech’s stock had been selling for $100. Assume that no other information is received over the next week and the stock market as a whole does not move. What do you expect will happen to Aerotech’s stock?

1. The stock price jumps to $118 on the day of the announcement. In subsequent days it floats up to $123, and then falls back to $116.

2. The stock price jumps to $116 and remains at that level.

3. The stock price gradually climbs to $116 over the next week.

Which scenario(s) indicates market efficiency? Which do not? Why?

Only scenario (2) indicates market efficiency. In that case, the stock price rises immediately to the level that reflects the new information, eliminating all possibility of abnormal returns. In the other two scenarios, there are periods during which an investor could trade on the information and earn abnormal returns

Suppose we take a group of 1,000,000 fund managers and each year we record which half beat the market and which have lagged the market. Suppose that after 10 years we find that 976 managers have outperformed in each of the 10 years. Does this contradict the EMH?

No, this does not suggest anything other than what we would expect to arise from randomness.  .5^10*1,000,000 =976.52

You have recently been promoted to CEO of Jay Tire, a publicly traded company. You decide to do some insider trading using the information you are privy to as an executive. At the end of the year, you crunch the numbers and find you have not earned any excess return despite using insider information. Which form of EMH if any have you violated?

Strong form EMH states stock prices reflect all relevant information including material non-public information. Your finding is consistent with strong form EMH.

Assume the market is weak-form efficient. If this is true, technical analysts ____ earn excess returns and fundamental analysts ___  earn excess returns.

1. Could; could

2. Could; could not

3. Could not; could not

4. Could not; could

1. Could not; could

Suppose the market is semi strong-form efficient. Can you expect to earn excess returns if you make trades based on

1. Your broker’s information about record earnings for a stock?

2. Rumors about a merger of a firm?

3. Yesterday’s announcement of a successful new product test?

You can’t gain excess returns from either of these options.

1. Earnings information is in the public domain and reflected in the current stock price.

2. If the rumours were publicly communicated, the prices would have already adjusted for the possibility of a merger. If the rumour is information that you received from an insider, you could earn excess returns, although trading on that information is illegal.

3. The information is already public, and thus, already reflected in the stock price.

The efficient market hypothesis implies that all mutual funds should obtain the same expected risk-adjusted returns. Therefore, we can simply pick mutual funds at random. Is this statement true or false?

The statement is false because every investor has a different risk preference. Although the expected return from every well-diversified portfolio is the same after adjusting for risk, investors still need to choose funds that are consistent with their particular risk aversion level.

Define Alpha:

Represents the excess return of an investment compared to its expected return, considering its risk level (beta).

1. The “Market Model” regression applied to past monthly returns in IBM’s stock price produces the following estimates, which are believed to be stable over time:  

r_ibm= 0.50 %  + 1.5 x r_M where  

r_ibm is the return on the IBM stock and r_M is the return on the market. 

On the day IBM announced an acquisition of another company its stock price increased by 12 percent. If the market index on the same day increased by 3%, what is the impact of the acquisition event on IBM’s stock price in terms of abnormal returns?

On a day that the market goes up by 3%, you would predict from the Market Model regression that the stock should rise by an expected value of 0.50% + 1.5*3% = 5%. If the stock actually rises by 12%, firm-specific news that day caused an additional stock return of 12% -5% = 7%. This is the abnormal return for the day.

1. The “CAPM” regression model applied to past monthly excess returns in IBM’s stock price produces the following estimates, which are believed to be stable over time:  

R_ibm =  0.50% +1.5x R_M      where  

R_ibm is the excess return on the IBM stock and R_M is the excess return. 

IBM had an excellent month, having beat earnings estimates and its stock price increased by 12 percent during the month. The broad market index during the same month increased by 3%, what is the impact of the positive earnings on IBM’s stock price in terms of abnormal returns? Assume a risk-free rate is 1%.

CAPM regression forecasted return on the stock should be 0.50% + 1.5*(3-1) % = 3.5%.  IBM’s actual excess return was 12% – 1% =11%, meaning that there was a positive abnormal return of 11% - 3.5% = 7.5 %. Do note, that the “1%” in both the CAPM regression formula and IBM’s excess return formula is the risk-free rate as given in the question

Farnam Glass Co. has earned exceptionally large profits for many years. Does this violate any form of EMH?

The efficient market hypothesis states that stock prices reflect all available information at any given time. The efficient market hypothesis does not state that businesses can not earn learn large profits consistently, only that this information would be fully reflected in prices.

Which of the following is true/false according to the efficient market hypothesis?

1. Low beta stocks are consistently under-priced

2. High beta stocks are consistently overpriced

3. It is possible to earn alpha

a. & b. false; EMH relates to consistently generating alpha, the fact that high or low beta stocks may return more or less than the market does not mean investing in either will consistently generate alpha.

Which of the following are used by technical analysts?

1. Historical Prices

2. Financial Statements

3. Historical Volumes

4. Investor sentiment

1, 3, and 4.

A. Suppose two companies enter into a lawsuit. When the lawsuit is over, we are given the following information. r_a=3.1%, r_b=1.8% and r_{m = 2%.}

R_a=.3%₊1.3r_m          

 R_b=.1%+.9r_m

Which company likely won the lawsuit?

We would expect the company which won the lawsuit to outperform (gain excess returns) and the company which lost the lawsuit to underperform. FIND ALPHA

ra=..3%+1.3rm

ra=2.9%

rb=.1%+.9rm

rb=1.9%

Which of the following topics related to behavioral finance deals with idea that investors experience more pain from a loss than pleasure from a comparable gain?

1. Frame dependence

2. Prospect theory

3. Clustering illusion

4. Mental accounting

Prospect theory

Frame dependence

The theory that the way people react to situations differs depends on the way they are presented. For example, risk surrounding potential gain or risk surrounding potential loss.

Prospect theory

A theory that gains, and losses have disproportionate impacts on people. A loss is felt more than a gain of equal proportion.

Clustering illusion

A theory that people interpret random events as trends. A random clustering of data points is a normal result of randomness but often interpreted as a trend. If the coin has landed on heads 4 times it seems more likely that it will land on heads again.

Mental accounting

The theory that people treat money differently based on subjective factors. For example, an investor may invest money they earned from a winning trade more aggressively than money invested from earned income. The investor has sorted his funds into different mental categories despite there being no objective reason for doing so.

______ are good examples of the limits to arbitrage because they show that the law of one price is violated.

1. Siamese Twin Companies

2. Closed-end funds

3. Open-end funds

4. Equity carve-outs

1, 2, 4

A Siamese twin company:

Occurs if the same company was traded separately, perhaps with multiple listings. For example, a 50% equity stake was valued differently on the Euronext and NYSE.

An equity carve-out:

A certain business line that is separated from or “carved out” of the larger business. For example, an ice cream business decided to spin off its cone business. Each current shareholder will receive two shares of the spin-off.

Closed-end funds:

They trade in the open market like stocks. However, they frequently sell for a value less than that of the assets to which they hold a claim.

Open-end funds:

Are not exchange traded like closed-end funds and do not violate the law of one price.

An example of _____ is that a person may reject an investment when it is posed in terms of risk surrounding potential gains but may accept the same investment if it is posed in terms of risk surrounding potential losses.

1. framing

2. regret avoidance

3. overconfidence

4. conservatism

5. None of these is correct.

1. framing

Disposition Effect:

The disposition effect states investors tend to sell assets that made gains relatively quickly and tend to hold onto investments that have lost value.

Regret Avoidance:

The investor feels that that they will regret their decision more if they lose money by making an unconventional decision as opposed to a conventional one

Conservatism Bias:

States that when presented with new information do not change their vies right away to reflect to the new information but instead require a period of time.

Mental Accounting:

The investor is placing different value on a dollar in their RRSP or cash account based on subjective characteristics.

Describe which characteristic each of the following exhibits:

1. Investors are reluctant to sell stocks with paper losses.

2. Investors are reluctant to bear the loss caused by an uncommon or unconventional choice.

3. When new information arises, investors do not update their beliefs right way but instead take time to update their beliefs.

4. Investors have a lower risk tolerance in their RRSP than in their cash account.

1. disposition affect

2. regret avoidance

3. conservatism bias

4. mental accounting