Quiz 2 FIN 3050

Chapter 7, 19/20

Efficient markets hypothesis

states that investors cannot consistently beat the market

What is indicated about the market when the investor (1) beats the market and (2) does not beat the market,

(1): the market is inneficient

(2): the market is efficient

How do you detirmine if an investment is superior to another

By comparing abnormal returns

Abnormal Return on an investment is:

the difference between what the investment earned and what other investments with the same risk earned

A positive abnormal return means that an investment:

has outperformed other investments with similar risk

What is another way of saying beating the market

consistently earning a positive abnormal return

3 economic forces leading to market efficiency

(1) investor rationality

(2) independent deviations from rationality

(3) arbitrage

What does rational mean in the terms of the investor

investors dont systematically overvalue or undervalue financial assets with any information

If an investor always made perfectly rational investment decisions:

earning abnormal return would be near impossible

Equivalent risk assets have the same expected returns if:

everyone is fully rational

Independent deviations from rationality:

irrational investors dont all have similar beliefs

arbitrage

buying cheap stocks and selling expensive stocks

When is a market efficient

when their respective information is not useful in earnign a positive abnormal return

insider trading is generally:

illegal, though not always

the sets of info used in the three forms of market efficiency are

nested

three forms of market efficiency

strong, semi strong, weak

nested means:

the information set in the one form includes info from the weaker form

weak form efficient market

info from the past prices and volume figures provided no value in beating the market

technical analysis

using past prices and volumes to predict future prices

if a market is weak-form efficient, what is useless

technical analysis is of no use in beating the market

semi-strong efficient market

public information is of no use in beating the market

If a market is semi strong efficient; what is useless

fundamental analysis is useless

semi strong efficency is what because of its lack of info

hotly disputed

strong form effiency

even private info is useless

Driving force toward market efficiency is

competition and the profit motive

why do investors constantly appraise and subsequent trading activity?

to ensure prices never differ much from their efficient market price

basis point =

0.0001

if a firm were to have $1,000,000, with an improvement of 20 basis points, what does this mean

(0.0020 × 1 million) = or 2 million willing to spend to boost performance

What create the incentive to unerearth relevant information

smal performance enhancements

the fundemental characteristic of an efficient market is that:

prices are correct in the sense they reflect relevant information

No matter how often a particular stock price path has related to susbsequent stock price changes in the past:

no assurance that the relationship with further occur again

Predicted returns are not:

economically important (the predictability is not sufficient to earn an abnormal return)

is it difficult to predict stock market prices

yes

a random walk is related to what

weak form efficency

a random walk means:

no recognizable pattern to the path that a stock price follows can be predicted using history

efficient market reaction

price adjusts to new information

delayed reaction

price partially adjusts to new info, then gradually reflects ne winfo

overreaction and correction

price overadjusts to new info then falls back to correct price

event study

A research method designed to help study the effects of news on stock prices.

Abnormal Return (Formula) =

Observed Return - Expected Return

according to the efficient markets hypothesis;

the abnormal return today should relate only to information released that day

Informed traders:

investors making decisions based on public info

Material non-public information

Any information that could reasonably be expected to affect the price of a security.

tipper

someone who has hidden material nonpublic information

tippee:

someone who recieved the material nonpublic information

who can make legal insider trades and how

the companys corporate insiders by complying with SEC and their trades are posted publically

market efficiency is hard to test for 4 reasons

(1) risk adjustment problem

(2) relevant info probelem

(3) dumb luck problem

(4) data snooping problem

risk adjustment problem

challenge in measuring risk

relevant info problem

no way to tell if you have all relevant info

dumb luck problem

peopel just get lucky

data snooping

testing many patterns with historical data

short term stock price and market movements appear to be:

difficult to predict accurately

the market reacts quickly to

new information

if the markets are efficient, what happens to asset allocation and security selection

asset allocation becomes important

security selection becomes less important

Good investment strategy

hold a broad based market index

market anomolies

price patterns contradicting market efficiency hypothesis

market anomaly size and characteristic

small; dissapear when discovered and not easily used in trading

why is mondays return negative

its used over a 3 day period not 24 hour

january effect

large % of small stocks historically occured in early January and appears in many world markets

Turn of the year Days

last week in daily returns for year then first 2 weeks in daily returns for next year

balance sheet

provides a snapshot view of companys assets + liabilities on a particular date

income statement

measures operating performance over accounting period with revenues + expenses

statement of cash flows

reports how cash was made and where its used

gross margin (formula)

(gross profit/net sales)

Operating margin (formula)

(Operating income / Net Sales)

Return on Assets (Formula) and what it means

(Net income / Total Assets) ; net income stated as a percentage of total assets

ROE (formula) and what it means

(Net income / SE) ; net income stated as a percentage of SE

Pro forma financial statements

statements prepared using certain assumptions about future income, cash flow, and other items

Long term debt levels do not relate to what

level of sales

% of sales approach

accounts vary with level of predicted sales

Selecting securities without regards to perceived economic cycles or industry specific information is what type of approach

bottom up

top down analysis

Global Economy→ Industry Analysis→ Company Analysis

with decreased strength of dollar

U.S companies getting most revenue from international countries is good

with increased strength of dollars

industrial companies > consumer staple companies

One of the most important measures of health of an economy is

GDP

What does GDP measure

market value of g/s produced over time

Nominal GDP

the dollar value of economic output in terms of the current year

Real GDP

the value of economic output adjusted for inflation

Real GDP is more consistent with

standard of living across time periods

4 stages of business cycle

Peak, contraction, trough, expansion

an investor who can successfully identify patterns in the cycle might be able to predict:

which sectors in the economy are better suited for short-term growth

Cyclical sectors sensitivity level and examples

high sensitivity; industrials and materials

Defensive sectors sensitivity level and examples

little sensitivity; health care and consumer staples

leading economic indicators

economic data changing in advance of the economcy

lagging economic factors

economic data that changes behind the economy

coincident economic factors

economic data that changes with the economy

factor affected return rate on international investments

exchange rate

What % of GDP is consumer spending

70%

the process of moving investment dollars from one industry to another is called

rotational investing

Porters 5 Forces

(1) Threat of New Entrants - new firms entering the market

(2) Bargaining Power of Buyers - difficulty in switching to another seller

(3) Bargaining Power of Suppiers - do suppliers have power to raise prices

(4) Threat of Substitute Products - Consumers switching to new product because old one got more expensive

(5) Intensity of Rivalry - Rivals within same industry

securities in ______ are often labled as semi-strong efficient

developed countries

securities in ______ are often labled as weak form efficient

developing

positive alpha shows:

performance exceeding risk adjusted performance

what does the Sharpe Ratio measure

excess return over risk free rate per unit of volatility

what does a higher sharpe ratio indicate

better risk adjusted performance

coefficient of variation compares

risk per unit of return

short run price moves look ____ and are

random; hard to predict

the generalities of market efficiency and their meanings

(1) Predictability - short term moves are hard to predict

(2) Reaction - Markets adjust quickly

(3) Non-obvious alpha - beating markets isnt clear

the value effect

stocks with low valuation outperforming higher valuated stocks

bubble:

prices soar