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15 Cards in this Set

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Explain what is meant by an efficient capital market. What are its implications? (N-F-P) Why can the market be expected to be efficient? I-C-R-Q

-An efficientmarket is a market in which the prices of securities quickly and fully reflectall available information.




Implications are as follows:


-Today’s pricechange is independent of yesterday’s price change.


-Investors shouldonly be expected to make a normal rate of return in the long run (i.e. theexpected return corresponding to the level of risk they face).


-Firms shouldexpect to receive a fair value for the securities they issue.


-Deviations fromfundamental value are random and it is equally likely that a security will beunder or overvalued.




Markets can be expectedto be efficient because:


-There is a largenumber of rational, profit-maximising, price-taking investors who actively participate in the market.


-Information is costless and widely available.


-Information is generated in a random fashion.


-Investors react quickly to new information.

Outlinethe three forms of market efficiency identified by Fama (1970).

Fama (1970)identifies three forms of market efficiency:


-Weak form –prices reflect all historical information.


-Semi-strong form– prices reflect all current, publicly available information.


-Strong form –prices reflect all information, both public and private.

Howcan we test the EMH? What is meant by the joint hypothesis problem?




A-L



-We can test the EMH by testing whether we have abnormal returns i.e. . will be 0 if the EMH holds. However, this leads to a joint hypothesis problem, which is the problem that in order to test the EMH we are also testing a model of expected return (e.g. CAPM for expected return). If > 0 this could represent either inefficiency or a poor model of expected return estimation.




-Another test of the EMH is to test autocorrelation of stock returns. That is, we investigate whether lagged returns (i.e. past returns) can be used to predict future returns.


The EMH saysthis is not possible, therefore autocorrelation will be 0. 2.

Outline the empirical evidence for and against market efficiency.




F-J-F

Empirical evidence for market efficiency:


-Fama (1965) –Finds statistically significant correlation coefficients on a sample of 30 DowJones Industrial stocks. But these are so small they are economicallyinsignificant. Supports EMH because implies investors cannot use the pasthistory of stock prices to gain future profits.




-Jensen (1969) –Sample of mutual funds achieved a risk-adjusted return of 0%. Return actuallyfell to -0.9% per year after accounting for expenses.




-Fama et al.(1969) – Found that stocks had sharp increases in prior to stock splitannouncements. However, abnormal returns after the split announcement were verystable. Indicates any implications of a stock split are reflected in the priceimmediately following the announcement, and not in the event itself.

Outline the empirical evidence for and against market efficiency.




O-S-J-H

-Overreaction tostock prices (DeBondt and Thaler, 1985). This suggests investors can predictfuture returns based on past information. Although Fama and French (1996) arguethis is due to a poor measure of risk – anomaly disappears under their 3-factormodel.




-Size effect(Banz, 1981 and Reinganum, 1981). However, authors say this is due to amisspecification of the CAPM not evidence against efficiency.




-January effect(Rozeff and Kinney, 1976; Keim, 1982). This has largely disappeared over time,however.




-Halloween effect(Bouman and Jacobsen, 2002). Works in 36/37 of their sample countries. Butdisputed by Lucey and Zhao (2008).

SupposeXYZ plc announced to the market that its profits over the last quarter dropped15%, compared to the previous quarter. However, its share price is up 2% fromyesterday. Is this evidence against market efficiency? Explain.

This is notevidence against the EMH. There may be other reasons why the stock priceincreased. Profits may not have fallen by as much as originally expected, forinstance.

Doyou think emerging markets will be more or less efficient than developedmarkets? Do you think they are more likely or less likely to be affected bymarket sentiment? Explain.

Probably lessefficient.


In emerging markets information is not as widely available as indeveloped markets.


Moreover, government intervention in markets (e.g. theChinese stock market stops trading if the market index falls by 7%) mayprohibit efficient price discovery.

Discussthe main behavioural biases that impact investor behaviour and outline somecommonly observed patterns of investor behaviour in financial markets.

-Perception (e.g.we see what we want to see).


-Memory (e.g. wecan believe misinformation). ·


-Framing (e.g.how things appear matter).


-Gambler’sfallacy (e.g. thinking a run of 10 heads in a coin toss must mean the next flipis a tail, even though the odds are still 50/50).


-Ambiguityaversion (e.g. we dislike uncertainty).

Discussthe main behavioural biases that impact investor behaviour and outline somecommonly observed patterns of investor behaviour in financial markets.




H-E-A-T-W

-Home bias.


-Thinking acompany with positive earnings is a good investment over a company withnegative earnings. Assuming prevailing market prices are accurate, both areequally valid investments depending on your level of risk tolerance.


-Valuing assetsto an anchor (e.g. historical average or other players’ valuations).


-Overtrading dueto thrill-seeking and overconfidence.


-Risk-aversion inwomen. Risk-seeking in men.

When corporateexecutives trade the shares of their own company, the share price normallyresponds in a correlated way (i.e. share price increases after buy transactionsand share price falls after sale transactions). Is this evidence of efficientmarkets, behavioural finance, or both? Explain.

Both. It couldmean that prices have changed as a result of new information (i.e. the insidertransaction), or it could mean that investors are simply following insiders andnot analysing the information.

Whatare the challenges that behavioural finance faces?

-No behaviouralmodels to empirically test, leading to questions over robustness of theory.


-Used to explainevents ex-post (after), but can they predict events ex-ante (before)?


-Developing aproxy for behavioural biases (e.g. how do we define ‘irrational’?).


-Does not offersuperior insight as to how exactly we should allocate assets.


-Behaviouralfinance can offer many different theories for the same event. E.g. what causes‘bubbles’? Is it overreaction? Is it conformity? Is it the snake-bit effect?The number of theories put forward for the same event makes it difficult to pindown root causes (is this the brain suffering from an information overload:P?).

Supposean investor makes significant abnormal returns during a market downturn. Howcan this be explained with the EMH? What about behavioural finance?

EMH would arguethe investor was lucky, or accepted greater risk than the market (or less riskin this case, since theoretically safer investments should could beat themarket in a downturn).




Behavioural finance would argue this supports stockmarket anomalies or supports the idea of risk aversion behaviour.

Discussthe main contradictions between the EMH and behavioural finance.

Subject root


Economics(EM)- Psychology(BF)




Rationality of investors


Investors are rational (EM)- Investors are not always rational and can oftenbe irrational(BF)




Role of emotions


Emotions have no place in investment decisionmaking (EM)- Emotions play a strong role in investmentdecision making (BF)




Asset price accuracy


Asset prices are informationally accurate (EM)- Asset prices are not necessarily informationallyaccurate(BF)




Demographics


EMH makes no distinction between the demographicbackground of investors (EM)- Behavioural finance allows for demographicsaffecting valuation decisions(BF)

Doesthe EMH or behavioural finance better explain the financial crisis? Explain.

-EMH explanationsfor the financial crisis:




-Increases ininvestors’ risk appetite caused investments in risky assets




-Governmenthousing policy in the U.S. (e.g. lowering requirements for mortgages; creatinga secondary market for mortgages via Fannie Mae and Freddie Mac who boughtsecuritised mortgages from financial institutions) meant that many people whoshould not have been granted mortgages were. When the Federal Reserve raisedinterest rates and people defaulted on mortgage repayments there was arecession. Market prices then fell – this is exactly what you would expectunder an efficient market. The cause of the recession was the fault of thegovernment, not of the market.




-Volatile assetprices are a reflection of rapidly-changing economic and financialfundamentals.

Doesthe EMH or behavioural finance better explain the financial crisis? Explain.

-Behavioural explanations for thefinancial crisis:




-Overreaction ledto the formation of irrational bubbles.


-Inability tounderstand complex information meant investors did not know the true riskinessof securitised assets (e.g. assuming an AAA-rated ABS has the samecreditworthiness as an AAA-rated ABS CDO).


-Illusion ofcontrol – belief in VaR models that assume normal distributions.


-Conformity –everybody wanting to invest in CDOs even though not many people understoodthem.


-Thrill seeking –investing in risky assets and financial engineering innovations.


-Snake-bit effect– wanting to keep investing in risky assets, encouraged by past gains.