Flashcards For Fine 411 Test 3

Front 1

Define Market Efficiency

Back 1

An efficient capital market is one in which security prices adjust rapidly to the arrival of new information.

Front 2

In an efficient market, what assumption is true?

Back 2

the current prices of securities reflect all relevant information. If the market is efficient, then stocks are properly priced. Actual Price = Intrinsic Value

Front 3

What is the most basic reason why markets cannot be inefficient?

Back 3

investors would reap unending profits simply by purchasing stocks that would appreciate in price and selling stocks that would decrease in price! The forecast of a future price increase would lead to an immediate price increase!

Front 4

What is the "Random Walk" theory?

Back 4

So, as soon as there is information predicting that stock XYZ is underpriced, investors will flock to buy the stock and immediately bid up its price to a fair level.

However, if prices are bid immediately to fair levels, given all available information, it must be that these prices increase or decrease only in response to new information.

New information (by definition) must be unpredictable, which means that stock prices should follow a “random walk.” (like they found in the research in the 1950s)

Front 5

What is the simplified form of the "Random Walk" theory?

Back 5

If stock prices follow a random walk, then future stock prices cannot be predicted based on past stock prices.
Pt = Pt-1 + t

New information is a “surprise”.

Result: When new information arrives, stock prices will adjust immediately.

Front 6

Under the "Random Walk" theory, when do most investors get in?

Back 6

Right when new information comes out

Front 7

Define EMH and its three levels

Back 7

Efficient Markets Hypothesis,Weak Form:
Stock Prices reflect all past market price and volume information.

Semi-strong Form:
Stock Prices reflect all publicly available information about a firm.

Strong Form:
Stock Prices reflect all information (public and private) about a firm.

Front 8

What are some notable characteristics regarding the Weak Form in EMH?

Back 8

Stock Prices reflect all past market price and volume information

Therefore, it is impossible to make abnormal risk-adjusted returns by using past prices or volume data to predict future stock prices.
…do NOT think the stock market is weak form efficient.

…believe that investors are emotionally driven and predictable. Therefore, you can exploit this predictability, as it shows up in past prices and volume.

…are sometimes called “Quants” – use computers to find price patterns to exploit.

Front 9

What are some notable characteristics regarding the Semi-Strong Form in EMH?

Back 9

Stock Prices reflect all publicly available information about a firm.

Therefore, it is impossible to make abnormal risk-adjusted returns by analyzing any public information to predict future stock prices.
do NOT think the stock market is semi-strong form efficient.

…use publicly available information to identify firms that are worth more (or worth less) than everyone else’s estimate of their worth.

Front 10

If you prescribed to the semi-strong form EMH theory, when would you buy stock in a successful investment?

Back 10

Right before it hit big

Front 11

What are some notable characteristics regarding the strong form in EMH theory?

Back 11

Stock Prices reflect all information (public and private) about a firm.

Therefore, it is impossible to make abnormal risk-adjusted returns by analyzing publicly available information or trading based on private or “inside” information.

Front 12

What is the ironic situation regarding the EMH?

Back 12

If the stock market is efficient, you may be better off buying index funds (these are funds that just invest in a broad range of stocks that are components of some index).

However, if everyone buys index funds, the market would not be as efficient because no one is searching for information.

Front 13

What are the two types of investors according to Grossman-Stiglitz Theory?

Back 13

Uninformed: Liquidity or noise traders

- Informed: Spend serious amounts of money to dig up information no one else has

Front 14

What does Grossman-Stiglitz say about information?

Back 14

Informed: Do research until marginal benefit = marginal cost.

(Some of the informed have marginal benefits > marginal costs, some have marginal benefits < marginal costs. On average, marginal benefit = marginal cost.)

Uninformed: Do NO research.

Front 15

What are the conclusions of the Grossman-Stiglitz theory?

Back 15

So, the informed make the market efficient for the uninformed! Justification for professionals!!

If active managers fail to use information properly or have excessive transaction costs, they will do worse than a passive portfolio.

In equilibrium, investors should earn the same return investing in a passive index fund as in an actively managed fund after research & transaction costs.

Front 16

What is the "Hard Truth" about efficient markets?

Back 16

No easy money, any abnormal profits eaten up by excess expenses

Front 17

Define excess return

Back 17

(Asset Return – RFR)

Front 18

Define non-risk adjusted abnormal return

Back 18

Abnormal Returni,t = (Ri,t – RFRt) – (Rm,t - RFRt)

Front 19

Define the equation for alpha and show how it is derived from CAPM

Back 19

CAPM: E(Ri) = RFR + βi[E(Rm)-RFR]

E(Ri) - RFR = βi[E(Rm)-RFR]

(Ri,t – RFRt) = i + i(Rm,t - RFRt)

i = (Ri,t – RFRt) - i(Rm,t - RFRt)

Front 20

What is alpha defined as?

Back 20

Risk-Adjusted Abn. Return

Front 21

What does skewness have to do with distinguishing luck and skill in regards to abnormal returns?

Back 21

A management firm can have one really large positive (+) return that takes a long time to “undo” in a long-term average performance measurement.

This “skewness” in performance results makes it difficult to distinguish luck from skill.

Front 22

What are the biggest problems with efficient market testing?

Back 22

1) Luck vs. skill
2) Selection bias (don't give away the secret)
3) Difficult to measure/calculate abnormal returns

Front 23

If you find investors who beat the market on a risk-adjusted basis, it could be because of...

Back 23

The market is actually inefficient

- OR -

The CAPM is not correct (model/specification error)
Benchmark problem (measurement error)
The investors got LUCKY!

Front 24

What is the difference of opinion between academics and the financial industry on efficient markets?

Back 24

The markets are efficient. All relevant information is immediately incorporated into market prices. Patterns cannot be found within stock markets that can be exploited for risk-less profit.”

Financial Industry:
“The markets are not efficient in the short-run. There are times in which mispriced securities can be found and exploited to earn above-average profits.”

Front 25

What is the joint or dual hypothesis problem?

Back 25

If the pricing model is wrong, then any conclusions about abnormal risk-adjusted returns using this model are wrong.

Front 26

What are the five biggest challenges to testing efficient markets?

Back 26

1) Benchmark or Measurement Error
2) Using a forward-looking model and testing with historical or ex-post data
3) Specification or Model Error
4) Behavioral Finance
5) Arbitrage

Front 27

Describe the serial correlation method of testing the Weak Form EMH

Back 27

Positive (+) Serial Correlation:

(+) returns follow (+) returns for a given stock or (-) returns follow (-) returns for a given stock
Called “momentum” or “inertia”

Negative (-) Serial Correlation:

(+) returns follow (-) returns for a given stock or (-) returns follow (+) returns for a given stock.
Called “reversals”

Front 28

How are the results of the serial correlation method of Weak Form EMH interpreted?

Back 28

If we find (+) or (-) serial correlation, this is evidence against the weak-form EMH as it implies that past prices can be used to predict future prices.

Technical analysis looks for such patterns to exploit and earn abnormal returns.

Front 29

What are the findings of those who tested the serial correlation method of Weak Form EMH?

Back 29

In the ‘50s and ‘60s it was shown that in general:

1. No evidence of serial correlation. The price of a stock is just as likely to rise after a previous day’s increase as after a previous day’s decline.

2. Therefore, it was concluded that stock prices follow a random walk and the Weak Form holds true.
Lo and MacKinlay (1988) tested to see if there is positive serial correlation of weekly stock returns for NYSE stocks.

They found weak evidence of positive serial correlation (most prevalent in small stocks).

Not clear if results are economically significant.

Front 30

What is the second method for testing Weak Form EMH?

Back 30

Use historical price information to analyze “abnormal returns” over various time horizons.

In general, this method involves investing in stocks that have performed in a certain manner in the past to see if these stocks will provide abnormal returns in the future.

Front 31

What is the general formula for abnormal returns?

Back 31

ARi,t = Actual Ri,t – Benchmarki,t


i = stock/portfolio
t = time index

Front 32

What are the two methods for finding abnormal returns when testing Weak Form EMH?

Back 32

1) Method #1: “Market Model”
Actual Ri,t – Actual Rm,t

2) Method #2: Actual vs. Expected

a) Use the CAPM (or another model) to calculate a risk-adjusted, predicted return

b) Subtract the predicted return from the actual return

c) = Alphai if using the CAPM

Alphai = Actual Ri,t – (RFRt + Bi[Actual Rm,t – RFRt])

Front 33

Describe CAR

Back 33

Cumulative Abnormal Return

Methodology:

Addition of a series of abnormal returns.

For example, a “3-day CAR” would use a pricing model like the CAPM to calculate alpha for each of the three days. Then, the three calculated alphas would be summed to get the “3-day CAR.”

Front 34

Describe Tests of Weak Form EMH Short Horizons

Back 34

test whether buying stocks that have done well in the past and selling stocks that have done poorly in the past generates significant positive abnormal returns over future holding periods.

Measure stock rates of return over the past 3 – 12 months.

Rank the stocks from highest to lowest and then divide the sample into deciles. “Losers” are the bottom decile and “winners” are the top decile.

Follow the “Losers” & “Winners” returns for the next 3 – 12 months.

Front 35

What are the results of Short Horizons Weak Form EMH Tests?

Back 35

Winners outperforms losers over the short run. Most significance is found over the next 6 months based upon the past 12 months.

Possible abnormal profit opportunities.

Conjecture: Momentum in the short-run

Front 36

Describe Test of Weak-Form EMHLong-Term Horizons

Back 36

DeBondt and Thaler (1985):

Create Loser and Winner portfolios based on past 36 months of CARs. Top decile are Winners, bottom decile are Losers.

Examine CAR’s for next 36 months.

Conjecture: “Losers” outperforming “winners” is an overreaction, followed by a correction.

Front 37

What are the three ways to Semi-Strong Form EMH Test?

Back 37

1) Event Studies
2) Long-run abnormal return studies
3) Anomalies

Front 38

What are the results of Event Result Semi Strong EMH Testing?

Back 38

Most (but not all) studies support the Semi-Strong Form of the EMH.

Those that support it include analyses of stock splits, mergers and most corporate reorganizations.

One study that doesn’t offer support is the event of a security being listed on an exchange (shows positive abnormal returns after the listing announcement).

Front 39

What is the Evidence of Long-Run Abnormal Risk-Adjusted Returns in Semi Strong EMH Testing?

Back 39

After quarterly earnings surprises (+ or – depending on the surprise) (Bernard and Thomas, 1989)

After IPOs and after seasoned equity offerings (-) (Loughran and Ritter 1995)

After share repurchase announcements (+) (Ikenberry, Lakonishok, Vermaelen, 1995)

After dividend initiations (+) and omissions (-) (Michaely, Thaler, Womack, 1995)

Front 40

How was Bernard and Thomas, 1989Quarterly Earnings Surprises test conducted?

Back 40

Measure the abnormal risk-adjusted return after an earnings surprise.

Earnings Surprise =
Actual Quarterly EPS – Forecasted Earnings

If the stock market is efficient, any surprise when earnings are announced should be reflected rapidly in the stock price and (+) or (–) alphas should not be possible trading on the information after it is released.
Rank the magnitude of earnings surprises and place stocks from highest to lowest into decile portfolios.

See if trading on earnings surprises results in subsequent abnormal returns.

Remember: Cumulative Abnormal Returns (CARs) are the daily alphas summed up over time.

Front 41

What were the results of Bernard and Thomas, 1989 Quarterly Earnings Surprises test?

Back 41

For positive earnings surprises:

Larger earnings surprises lead to higher positive abnormal returns.

The upward drift in the stock price continues a couple of months after the earning announcement!

For negative earnings surprises:

Larger negative earnings surprises lead to larger losses as measured by the abnormal return.

The downward drift in the stock price continues a couple of months after the earning announcement!

Front 42

What are the two most important anomalies when testing Semi Strong Form EMH

Back 42

1) The Size Effect
2) The BV/MV Effect

Front 43

Define Size and BV/MV as they pertain to anomalies of the Semi Strong Form EMH Testing

Back 43

Size = Price * Shares Outstanding

BV / MV = Book Value / Market Value

Ratio that compares how the market is pricing the book value of assets. The lower the ratio, the more the market is rewarding the firm for potential future growth.

Front 44

What does the CAPM predict if it is "correct"?

Back 44

it means that βi (an asset’s sensitivity to the market portfolio) is the only variable needed to properly reflect the non-diversifiable risk we “care about” in estimating an asset’s expected future return

Front 45

Equation for CAPM

Back 45

E(Ri) = RFRt + βi[E(Rm,t) – RFRt]

Front 46

Fama-French made what interpretation of the size anomaly?

Back 46

See that small cap stocks have higher betas than large cap stocks. Fama and French concluded that size is driving the relationship between beta and return, not beta itself!

Also see that within the small cap groupings, some portfolios of stocks with lower betas have higher returns! The same is true within the large cap groupings. This argues against “beta.”

Front 47

What are the possible sources of risk for small caps?

Back 47

Neglected by analysts and institutional investors, so there is less information, which implies higher risk.

Less Liquidity: Higher trading costs (+4%). Bid-ask spreads are wider, and broker commissions are larger. Large trades can “move the market” easier.

Front 48

What did FF92 find after controlling for size?

Back 48

portfolios of stocks with high BV/MV ratios (value stocks) earn higher adjusted returns than portfolios of low BV/MV ratios (growth stocks).

Suggests that risk is related to both size and BV/MV ratios.

Front 49

What is the value puzzle?

Back 49

It is not evident why value stocks should be riskier than growth stocks. Value stocks actually have lower standard deviations than growth stocks after controlling for size!

Front 50

What was the basic result of FF92

Back 50

Smaller firms have higher future returns
Firms with higher BV/MV ratios have higher future returns
Beta is not significantly related to future stock returns
Fama, once a strong proponent of the CAPM, now claimed that beta was dead.

Front 51

What is the FF93 model

Back 51

Size and BV/MV represent risk factors not explained by beta. Add these 2 additional factors as explanations for return.

Ri-RF = α + ß1*(Rm-RF) + ß2*Sizei + ß3*B/Mi

Front 52

What is the basic idea of passive management?

Back 52

A. Basic Idea: The market is fairly efficient. Therefore, it is very difficult to overcome a 1 – 2% cost of running an active equity portfolio. So don’t try to beat the market, just match its performance at the lowest cost possible.

Front 53

What are the two main passive investment strategies?

Back 53

1. Buy and Hold




2. Index Portfolio Strategy -- Construction Techniques

Front 54

What are the Construction Techniques of Index Portfolio Strategy?

Back 54

1) Full Replication
2) Sampling
3) Quadratic Optimization or Quadratic Programming
4)

Front 55

What measures help us track the performance of an index and how do they help?

Back 55

1. R-squared – This measure tells us what fraction of the movement in the index’s returns can be explained by the returns of the fund. The fund wants this number to be as close to 1 as possible.
2. Beta – We want a beta close to one, which shows that the risk level taken in the Fund approximates that of the index it is tracking
3. With Sign Tracking Error – For each period, take the difference between the Fund’s return and the return of the index it is tracking. Then sum these differences
4. Without Sign Tracking Error – For each period, take the absolute difference between the Fund’s return and the return of the index it is tracking. Sum these differences

Front 56

What is the basic idea of active portfolio management?

Back 56

A. Basic Idea: The goal of active management is to earn a portfolio return that exceeds the return of a passive benchmark portfolio, net of transaction costs, on a risk-adjusted basis.

Front 57

What challenges must an investor overcome in active portfolio management?

Back 57

1) Management Fees
2) Transaction Costs
3) Risk Adjustments

Front 58

What are the themes of active management?

Back 58

1. Top Down vs. Bottom Up portfolio construction
2. Tactical Asset Allocation – Moving investments between Equities, Bonds and Cash.
3. Sector Rotation –Attempt to link industry performance to the business cycle (recessions, expansions, etc.)
4. 4. Contrarian Investment Strategy – Buy “out of favor” stocks with the hope that the market is wrong and will correct itself.
5. Price Momentum – Buy stocks that have recently performed well with the expectation such positive performance will continue at least through the short term.

6. Long / Short – Ranking strategy that involves purchasing certain stocks long, while short selling others
7. Market Risk Neutral Investing – goal is to have a portfolio with a beta of 0; therefore the portfolio is not correlated to market risk. Hedge funds often try to apply this strategy.

Portfolio Beta = weighted average of each stock’s Beta.
8. Value vs. Growth Investing – stocks chosen based on one or more characteristics (see below):
9. Style Analysis – Combines Growth vs. Value concept with Capitalization focus:

Front 59

What is the difference between a growth-oriented a value oriented investor?

Back 59

These two investment strategies can be somewhat explained by attitudes toward the following ratio:



P/E Ratio = Current Price Per Share
--------------------------------
Earnings Per Share



A Growth Oriented Investor:

• Will focus on the EPS component of the P/E ratio and its economic determinants

• Will look for companies that are expected to exhibit rapid EPS growth in the future

• Assumes that stock price will continue to appreciate as stocks realize their forecasted earnings growth


A Value Oriented Investor:

• Will focus on the Price component of the P/E ratio, trying to determine if the stock is “cheap” or not

• Will not care greatly about current earnings growth.

• Assumes that the P/E ratio is below some “correct” level and will eventually correct itself

Front 60

What are the Benefits of Professional Asset Management?

Back 60

Investment Knowledge
Diversification
Lower Transaction Costs
Record Keeping

Front 61

What is Institutional Private Management in relation to means of professional asset management

Back 61

Clients each have a separate account,

Characteristics

Very large minimum account sizes

Each account can be managed separately from everyone else’s

Tax-sensitive strategies possible

Client owns actual shares of each stock in a separate account

Market Value Calculation

Each client can easily know his account value by adding up the market values of the securities held in the account.

Any cash in the account is added to the security value to get the total market value.

Fees

Management fees can be negotiated with each client. Fees typically start at 1% on a sliding scale.

Commissions are typically charged per trade.

Both of these fees are usually taken from the available cash in the client’s account.

Front 62

What is Private Management Wrapped accounts?

Back 62

Characteristics

Typically $100,000 minimum account sizes
A brokerage firm (ex. RJ) “sponsors” the wrapped program
Clients choose from a “stable” of managers
Each account can be managed separately from everyone else’s, but typically most accounts with a single manager look similar
Tax-sensitive strategies are possible
Clients own actual shares of stock in a separate account

Market Value Calculation

Each client can easily know his account value by adding up the market values of the securities held in the account.

Any cash in the account is added to the security value to get the total market value.

Fees

One fee, a percentage of each client’s assets, is charged to the account. Typical fee is 2-3% of market value.

This fee covers the management fee and commissions (hence all fees are “wrapped” into one).

The management part of the fee is split between the money manager and the program Sponsor (ex. RJ)

Fees are taken from the available cash in the client’s account, typically quarterly.

Front 63

What are Investment Companies

Back 63

Investment Companies: Sell shares of the fund to investors and invest the proceeds in a portfolio of stocks (popular with individuals).

Characteristics

Typically small minimum investments
Assets are pooled together, so one client is affected by other client actions
No special tax strategies possible
Clients do not own the actual shares of stocks they are invested in
Instead, they own shares of the fund that owns the underlying stocks

Market Value Calculation:Net Asset Value

NAV= (Total Market Value of Portfolio-Fund Expenses)/ Total Fund Shares Outstanding

Front 64

What are the characteristics of a mutual fund?

Back 64

Buy back (redeem) shares or sell additional shares at the NAV. Hold cash to help with redemptions.

May be a sales charge (load) when the fund sells the shares to customers.

May charge a redemption fee when the customers sell their shares back by the fund.

Fund can “cap” out and not accept new investors. Otherwise, the fund will continue to grow by issuing new shares

Front 65

What are the three types of mutual fund fees?

Back 65

Sales and Marketing Fees

Management Fees

Record Fees

Front 66

How do Sales and marketing fees work in mutual funds?

Back 66

Front End Load: Paid when shares are purchased.

Load: from 3% to approximately 8% of NAV

Low-Load: Up to 3%

No-Load: No sales charge

Front 67

What are 12b-1 fees as it relates to mutual funds?

Back 67

12b-1 fees are an alternative to a load to cover advertising & marketing expenses. No-Load and Low-Load funds mainly use these.

Can deduct as much as 0.75% of assets annually to cover fund advertising & marketing.

Front 68

What are the general guidelines for choice of sales and marketing fees in a mutual fund?

Back 68

A: Front-end load. No 12b-1 fees. No Rear-end load.

B: No Front-end load. Small 12b-1 fees. Back-end load that decreases the longer you hold shares.

C: No Front-end load. Larger 12b-1 fees. Shorter back-end load penalty period.

Front 69

What are management fees in mutual funds?

Back 69

Range is typically 0.20% to 1.00%

Index funds have lowest management fees

Front 70

What is an expense ratio?

Back 70

Expense Ratio =
Total Annual Expenses/$ Amt of Fund Assets

Studies find that funds with lower expense ratios earn higher returns than those with higher expense ratios.

Front 71

What are the characteristics of a closed end fund?

Back 71

Fund trades on the secondary market like a stock

Fund does not usually offer additional shares or repurchase shares

NAV computed twice daily for informational purposes

Market price is NOT EQUAL to NAV

Front 72

How do closed end fund fees work?

Back 72

Management and Record fees can be charged within the fund

Sales charges (Loads) do not exist

Commissions are charged to each purchase and sale, exactly like a stock transaction

Front 73

What are the characteristics of ETFs?

Back 73

Alternative to open-end index mutual funds, which can only be bought at day’s end.

ETFs can be traded throughout the day.

Commissions charged like trading a stock.

Front 74

What are some examples of ETFs?

Back 74

SPDR (“spiders”)
SPY tracks the S&P500
DIA (formerly “Diamonds” track the Dow Jones Industrial Average)

International exposure through iShares
EFA tracks the EAFE international index

Sector ETFs (energy, utilities, technology, industrials, transportation, etc.)

Front 75

What are the characteristics of hedge funds?

Back 75

Typically only “qualified” investors

More flexible in their investments: short positions, private placements

More risk typically taken

Higher fees often charged

Front 76

What are the main concerns of mutual funds and CEFs?

Back 76

Turnover: Fraction of portfolio replaced each year.

Mutual funds and CEFs have pass-through-status which means that taxes are paid only by the investor, not the mutual fund.

To accomplish this, the fund must pass on all capital gains and dividends to the client.

Not an issue if in a tax-deferred retirement account

Front 77

A contrarian investment strategy assumes investors will ______ to the arrival of new information, while a price momentum strategy assumes investors will _________

Back 77

overreact, underreact