Comprehensive Guide to EMH, Bond and Stock Strategies, and Financial Models

What does the Efficient Market Hypothesis (EMH) suggest?

Prices of securities fully reflect relevant information about securities.

What is weak-form EMH?

Prices should reflect all information contained in past trading data.

What does weak-form EMH imply about trading on past data?

It will be impossible to consistently make an abnormal, risk-adjusted return by trading on past data.

What is semi-strong form EMH?

Prices should reflect all publicly available information.

What does semi-strong form EMH imply about trading on public information?

It will be impossible to consistently make an abnormal, risk-adjusted return by trading on public information.

What is strong-form EMH?

Prices reflect all relevant information, including insider information.

What does strong-form EMH imply about trading on insider information?

It will be impossible to consistently make an abnormal, risk-adjusted return by trading on public or private information.

What is active investing?

Seeking out mispriced stocks to trade, requiring research and frequent trading.

What is passive investing?

A buy and hold approach, exemplified by index funds.

What is the implication of strong-form efficiency for investors?

Investors should adopt a passive strategy.

What does portfolio theory maintain in an efficient market?

It does not lose importance.

What is the relationship between bond prices and interest rates?

Bond prices and yield to maturity (YTM) are inversely related.

What is Macaulay Duration?

A measure of interest rate sensitivity, calculating the weighted average time until payment of the bond's cash flows.

What does higher duration indicate?

Greater sensitivity to interest rate changes.

What is convexity in bond pricing?

A measure of the curvature of a bond's interest rate sensitivity.

What is a callable bond?

A bond that allows the issuer to repurchase it at a pre-specified call price prior to maturity.

What is the purpose of immunization in bond portfolios?

To shield the portfolio's future value from interest rate movements.

What is cash flow matching?

Buying bonds that pay cash flows at the exact time and in the amount of future liabilities.

What is a derivative security?

A security whose value is derived from the price of another financial asset.

What is a European call option?

An option that gives the investor the right to buy a security at a fixed price on a specific date.

What does it mean if a call option is 'in the money'?

If exercising the option would produce a positive payoff.

What is a European put option?

An option that gives the investor the right to sell the underlying security for a strike price on the expiration date.

What is a straddle in options trading?

A long position in both a call option and a put option.

What is a protective put?

A strategy involving a long position in the underlying stock and a long position in a put option.

What is a covered call?

A strategy involving a short position in a call option and a long position in the underlying stock.

What does the Efficient Market Hypothesis (EMH) state?

Prices of securities fully reflect relevant information about the securities.

What are the three forms of the Efficient Market Hypothesis?

Weak-form EMH, Semistrong-form EMH, Strong-form EMH.

What information does the weak-form EMH reflect?

All information contained in past trading data, including past prices and volume.

What is a key implication of weak-form EMH?

It is impossible to consistently make an abnormal, risk-adjusted return by trading on past trading data.

What does the semistrong-form EMH include beyond weak-form information?

All publicly available information, such as financial statements and economic conditions.

What is the implication of semistrong-form EMH for trading?

It is impossible to consistently make an abnormal, risk-adjusted return by trading on public information.

What additional information does the strong-form EMH consider?

All relevant information, including insider information.

What is the main difference between active and passive investing?

Active investing seeks out mispriced securities, while passive investing follows a buy and hold approach.

What is an example of active investing?

Day trading or hedge funds.

What is an example of passive investing?

Index funds.

What does the term 'random walk' imply in weak-form EMH?

Prices will follow a random path, and future price expectations are independent of past prices.

What is the 'small firm effect' anomaly?

Small stocks outperform large stocks, even on a risk-adjusted basis.

What is the Book-to-Market (B/M) effect?

High B/M stocks (value stocks) outperform low B/M stocks (glamour stocks) on a risk-adjusted basis.

What is post-earnings announcement drift (PEAD)?

Firms with positive earnings surprises tend to earn positive abnormal returns over the following three months.

What is the significance of short-term momentum in weak-form anomalies?

A portfolio of best-performing stocks over the past 6 months outperforms past 'losers' over the next 6 months.

What do long-term reversals indicate in market behavior?

A portfolio of 'losers' over the past five years outperforms 'winners' over the following three years.

What role do analysts play in efficient markets?

They generate information and incorporate it into prices, helping markets remain efficient.

What is a multifactor return model?

A model that allows stocks to have different sensitivities to various macro risk factors.

What does the CAPM equation represent?

A single-factor model that predicts a stock's expected return based on its risk.

What is the Carhart Four-factor Model?

An extension of the CAPM that includes additional factors to explain stock returns.

What is the bond indenture?

The legal agreement between the issuer and bondholder outlining the terms of the bond.

What happens if a bond issuer defaults?

Bondholders can force the issuer into bankruptcy.

What are the two markets where bonds can trade?

Primary market (when first issued) and secondary market (after issuance).

What does the volatility of residuals in factor models measure?

The stock's firm-specific risk.

What does the intercept (α) in factor models indicate?

The difference between the stock's realized excess return and that predicted by the model.

What is the maturity date of a bond?

The date by which the bond must be repaid and retired.

What is the par value of a bond?

The amount that must be repaid at maturity, usually $1,000.

How are bond prices typically quoted?

As a percentage of par value.

What are coupons in the context of bonds?

Contracted interest payments paid at regular intervals over the bond's life.

What is yield to maturity (YTM)?

The discount rate that equates the present value of a bond's remaining promised cash flows to its market price.

What is the relationship between bond prices and YTM?

Bond prices and YTM are inversely related.

What does Macaulay Duration measure?

Interest rate sensitivity of a bond.

What is the duration of a zero-coupon bond?

It equals its time to maturity.

What is convexity in bond pricing?

A measure of the curvature of a bond's interest rate sensitivity.

What is a callable bond?

A bond that allows the issuer to repurchase it at a pre-specified call price prior to maturity.

What is the purpose of bond portfolio immunization?

To shield a bond portfolio's future value from interest rate movements.

What is cash flow matching?

Buying bonds that pay cash flows at the exact time and in the amount of future liabilities.

What is duration matching?

Matching bond portfolio duration to the duration of liabilities to achieve immunization.

What is a derivative security?

A security whose value is derived from the price of another financial asset.

What are the four broad categories of financial derivatives?

Options, forward contracts, futures contracts, and swaps.

What is a European call option?

An option that gives the investor the right to buy a security at a specified price on a specific date.

What does it mean for an option to be 'in the money'?

It means exercising the option would produce a positive payoff.

What is a protective put strategy?

A strategy involving a long position in the underlying stock and a long position in a put option.

What is a covered call strategy?

A strategy involving a short position in a call option and a long position in the underlying stock.

What is a straddle option strategy?

A strategy involving a long position in both a call option and a put option on the same stock with the same strike and expiration.

What is the effect of interest rate changes on bond prices?

Interest rate changes can drastically alter bond prices.

What happens to bond prices when YTM increases?

Bond prices decrease.

What happens to bond prices when YTM decreases?

Bond prices increase.

What is the relationship between bond duration and coupon rates?

Bonds with lower coupon rates have greater duration.

What is the significance of a bond's convexity?

Higher convexity results in a more positive percentage price change.

What is the yield-to-call?

The yield on the bond assuming it is called at the first opportunity.

What is the primary risk associated with callable bonds?

The call feature places a ceiling on potential capital gains from declining rates.

What is the primary advantage of duration matching over cash flow matching?

Duration matching is much less restrictive and applicable in almost any context.