Investments Ii Exam 1

Front 1

Behavioralism bias

Back 1

Motivation
Stock prices in the 1990s did not appear to match “fundamentals,” 
e.g., high price earnings ratios
Evidence of refusal to sell losers
Economics discipline is exploring behavioral aspects of decision making

Front 2

Critiquing the Behavioral Critique

Back 2

It provides stories that fit individual situations but there is not coherent theory put forth and some behaviors contradict others.
Much of the empirical support for the behavioralist ideas in investments comes from one specific time period, the late 1990s.
Behavioralism has less to say about informational efficiency and more to do with allocational efficiency/
The behavioral literature is very weak at providing solutions to these problems.
It seems to me that most of the behavioral problems stem from a lack of training in economics. Many of them derive from overreliance on historical or statistical data rather than understanding the underlying economics of a given investment. At a minimum being aware of these potential pitfalls in decision making should help investors avoid such errors.

Front 3

Extrapolation bias

Back 3

Analysts tend to excessively extrapolate historical trends when forecasting.
May lead to unsustainably high P/E ratios.

Front 4

Forecasting errors

Back 4

Mental accounting
When cash is needed investors may spend dividends, but refuse to sell a small portion of stock to raise the money.
This may lead to a preference for stocks that pay larger dividends, even though tax liability may be greater.
Regret Avoidance
Regret from losses is greater than joy from gains.
Regret is reduced with ‘shared pain.’
In order to induce investors to buy out of favor stocks, stocks with poor recent performance for example (value stocks), these stocks have to pay a higher expected return.

Front 5

Overconfidence

Back 5

Some people exhibit overconfidence in their ability to pick stocks or have an exaggerated belief that ‘risk’ will hurt the other person but not them. As a result, they bid stock prices too high.
Extrapolation bias
Analysts tend to excessively extrapolate historical trends when forecasting.
May lead to unsustainably high P/E ratios.

Front 6

Conservatism

Back 6

Anchoring Bias & earnings
Many people become anchored to their ideas and will not update their expectations when new information arrives.
This underreaction to news leads to momentum in stock returns.

Front 7

Representativeness bias

Back 7

People are too prone to believe that a small sample is representative of a broad population and infer patterns too quickly.
The notion of representative- ness holds that people commonly do not take into account the size of a sample, apparently reasoning that a small sample is just as representative of a population as a large one. They may therefore infer a pattern too quickly based on a small sample and extrapolate apparent trends too far into the future.

Front 8

Bubbles

Back 8

Periodically stock prices appear to undergo a ‘speculative bubble.’
A speculative bubble is said to occur if prices do not equal the intrinsic value of the security.
Does this imply that markets are not efficient?
Very difficult to predict if you are in a bubble and when the bubble will burst.
Stock prices are estimates of future economic performance of the firm and these estimates can change rapidly.
Risk premiums can change rapidly and dramatically.
With hindsight there appear to be times when stock prices decouple from intrinsic or fundamental value, sometimes for years.
Prices eventually conform to intrinsic value.

Front 9

Prospect Theory

Back 9

An alternative behavioral theory suggesting that investor utility depends on the change in wealth from the start of the investment rather than on the starting level of wealth.
Prospect theory is an example of loss aversion. To the left of zero in Panel B an investor is in the domain of losses and becomes risk seeking. In other words, if you think you are going to take a loss, you are more likely to take a risk in hopes of avoiding the loss, even if it is not a good gamble. I have conducted a test in class that demonstrates people do exhibit loss aversion.

Front 10

Anomalies to EMH

Back 10

Small Firm in January Effect
Results are driven by returns in the first two weeks of January
May be related to higher ESTIMATION risk of smaller firms
Extra return may be more apparent than real due to higher trading costs and illiquidity
Book to Market Ratios
High book to market ratio may indicate the stock is out of favor (a value stock) and hence a good buy. It may also contain more financially distressed firms which would explain the higher return. FF find that using this factor, the traditional beta becomes insignificant. This may imply inefficient pricing or it may indicate that this variable is proxying for a risk premium factor.
Long Term Reversals
Post-Earnings Announcement Drift (Momentum)
Rendleman, Jones and Latane’ results. These have been updated many times. Note the continual drift up after the earnings announcement date for the firms with the highest earnings surprises and the continual drift down for the firms with poor earnings surprises. This is termed the short term momentum effect and is counter to market efficiency. You apparently CAN earn +ARs from this one, although logically this seems unlikely.

Front 11

Bond pricing

Back 11

Bond Pricing Between Coupon Dates
The flat price or quoted price assumes the bond is purchased on a coupon payment date.
If the bond buyer purchases a bond between payment dates the buyer’s invoice price = flat price + accrued interest.
Prices and Yields (required rates of return) have an inverse relationship
When yields get very high the value of the bond will be very low
When yields approach zero, the value of the bond approaches the sum of the cash flows

Front 12

Term structure of interest rates

Back 12

First note that bond prices move inversely to interest rates. This is easy to explain. Ask students how they would respond if they are holding a bond paying them 6% interest, and similar new bonds coming out now pay 7%. They would sell the 6% bond and buy the 7%. The selling action on the 6% will reduce the bond’s price until it gives a 7% yield rate. The mathematics is easy to explain as well.

Front 13

Relative strength

Back 13

A simple relative strength ratio could be constructed as ΔPi / ΔIndex.
Increases in the relative strength ratio indicate the stock is outperforming the index and could indicate a buy or bullish signal.

Front 14

Loss aversion

Back 14

. Under the disposition effect investors exhibit loss aversion so that they are reluctant to sell on bad news and price converges slowly to its new fundamental value. While some investors undoubtedly behave this way, this seems unlikely to be a true description of market prices.

Front 15

Convexity

Back 15

First note that bond prices move inversely to interest rates. This is easy to explain. Ask students how they would respond if they are holding a bond paying them 6% interest, and similar new bonds coming out now pay 7%. They would sell the 6% bond and buy the 7%. The selling action on the 6% will reduce the bond’s price until it gives a 7% yield rate. The mathematics is easy to explain as well.
Note the curvilinear relationship between bond prices and yields. This is called convexity. Different bonds have different curvatures or convexities.

Front 16

EMH

Back 16

Competition among investors should imply that stock prices fully and accurately reflect publicly available information very quickly. Why?
Else there are unexploited profit opportunities.
Once information becomes available, market participants quickly analyze it & trade on it & frequent, low cost trading assures prices reflect information.
Questions arise about efficiency due to:
Unequal access to information
Structural market problems
Psychology of investors (Behavioralism)
Notice that semi-strong efficiency implies weak form efficiency holds (but NOT vice versa)
Strong form efficiency would imply that both semi-strong and weak form efficiency hold.

Front 17

Weak EMH

Back 17

The relevant information is historical prices and other trading data such as trading volume.
If the markets are weak form efficient, use of such information provides no benefit “at the margin.”

Front 18

Semi-Strong EMH

Back 18

The relevant information is "all publicly available information, including past price and volume data."
If the markets are semi-strong form efficient, then studying past price and volume data & studying earnings and growth forecasts provides no net benefit in predicting price changes at the margin.

Front 19

Strong EMH

Back 19

The relevant information is “all information” both public and private or “inside” information.
If the markets are strong form efficient, use of any information (public or private) provides no benefit at the margin.
SEC Rule 10b-5 limits trading by corporate insiders, (officers, directors and major shareholders). Inside trading must be reported.

Front 20

Random walk

Back 20

Why are price changes random?
In very competitive markets prices should react to only NEW information
Flow of NEW information is random
Therefore, price changes are random
Idea that stock prices follow a “Random Walk”
Random Walk: stock price changes are unpredictable.
Expected price change is positive over time
But random changes are superimposed on the positive trend
E(pricej,t) > E(pricej,t-1) t = time period
Deviations from the trend should be unpredictable.
the + trend line is there becuase firms invest in + NPV projects on average

Front 21

Dow Theory

Back 21

Three types of trends, only two are important
Every stock has price peaks and troughs but if a series of peaks and troughs are rising it is a buy signal especially if volume is heavier during the peaks than the troughs
3 Trends: Primary: Months or years, Intermediate, Daily to Weekly, maybe a month, Minor is mostly intraday and can be ignored.

Front 22

House money

Back 22

“in the money” = no longer better their own money
More risky with winnings
Mental Accounting

Front 23

Magnitude issue

Back 23

Even small changes in performance may be worthwhile for managers of large investments.
Eg. $5 billion dollar portfolio. Use research to 
improve results by 1/10 of a percent per year 
= $5 million in value.
Even small changes in performance may be worthwhile for managers of large investments. Eg. $5 billion dollar portfolio. Use research to improve results by 1/10 of a percent per year = $5 million dollars in value. Problem is that these small changes in performance would be virtually impossible to measure since the standard deviation of portfolios like S&P 500 is 20% per year. “Large portfolios may have more benefit to research”.

Front 24

Lucky event issue

Back 24

If 10,000 people flip fair coins 50 times we can expect 2 people to flip 75% or more heads.
In a large group of stock analysts, some will be correct most of the time in their picks, and they will look very smart even though their results are due to pure chance!
10,000 people to flip coins 50 times. 2 people would likely flip 75% or more heads.
Model mispecification: When we do risk adjustments. Who says we have the correct risk model.

Front 25

Selection bias

Back 25

“I have this foolproof new trading scheme that will make me millions. I want to tell everyone about it.”
We only learn about the schemes that don’t really work, or only worked in the past.
Would anyone publish a money making scheme. The literature only sees the schemes that don’t work.

Front 26

Expectations Theory

Back 26

Long term rates are a function of expected future short term rates
Upward slope means that the market is expecting higher future short term rates
Downward slope means that the market is expecting lower future short term rates

Front 27

Bond indenture

Back 27

Contract between the bond holder and the company

Front 28

Interest rate risk

Back 28

When you get locked into a 10 yr bond, there is a chance for the interest rate for the market to change, and may increase/reduce the value

Front 29

Framing errors

Back 29

Regret Avoidance
Regret from losses is greater than joy from gains.
Regret is reduced with ‘shared pain.’
In order to induce investors to buy out of favor stocks, stocks with poor recent performance for example (value stocks), these stocks have to pay a higher expected return.

Front 30

Standard utility theory of investments:

Back 30

Investors desire more wealth and less risk
Wealth provides diminishing marginal utility, thus a gain of $1,000 provides less utility than the utility loss from losing $1,000.
This gives rise to risk aversion.

Front 31

10. Which of the following most appears to contradict the proposition that the stock market is weakly efficient?
a. Over 25% of mutual funds outperform the market on average.
b. Insiders earn abnormal trading profits.
c. Every January, the stock market earns abnormal returns.

Back 31

10. c
This is a predictable pattern in returns, which should not occur if the stock market is weakly efficient.

Front 32

11. Suppose that, after conducting an analysis of past stock prices, you come up with the following observations. Which would appear to contradict the weak form of the efficient market hypothesis? Explain.
a. The average rate of return is significantly greater than zero.
b. The correlation between the return during a given week and the return during the following week is zero.
c. One could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall.
d. One could have made higher-than-average capital gains by holding stocks with low dividend yields.

Back 32

11. c
This is a classic filter rule, which would appear to contradict the weak form of the efficient market hypothesis.

Front 33

12. Which of the following observations would provide evidence against the semistrong form of the efficient market theory? Explain.
a. Mutual fund managers do not on average make superior returns.
b. You cannot make superior profits by buying (or selling) stocks after the announcement of an abnormal rise in dividends.
c. Low P/E stocks tend to have positive abnormal returns
d. In any year approximately 50% of pension funds outperform the market.

Back 33

12. c
The P/E ratio is public information so this observation would provide evidence against the semi-strong form of the efficient market theory.

Front 34

1. The semistrong form of the efficient market hypothesis asserts that stock prices:
a. Fully reflect all historical price information.
b. Fully reflect all publicly available information.
c. Fully reflect all relevant information including insider information.
d. May be predictable.

Back 34

b
Public information constitutes semi-string efficiency, while the addition of private information leads to strong form efficiency.

Front 35

2. Assume that a company announces an unexpectedly large cash dividend to its shareholders. In an efficient market without information leakage, one might expect:
a. An abnormal price change at the announcement
b. An abnormal price increase before the announcement
c. An abnormal price decrease after the announcement
d. No abnormal price change before or after the announcement

Back 35

a
The information should be absorbed instantly.

Front 36

3. Which one of the following would provide evidence against the semistrong form of the EMH?
a. About 50% of pension funds outperform the market in any year.
b. You cannot make abnormal profits by buying stocks after an announcement of strong earnings.
c. Trend analysis is worthless in forecasting stock prices.
d. Low P/E stocks tend to have positive abnormal returns over the long run.

Back 36

b
Since information is immediately included in stock prices, there is no benefit to buying stock after an announcement.

Front 37

A random walk occurs when:
a. Stock price changes are random but predictable
b. Stock prices respond slowly to both new and old information
c. Future price changes are uncorrelated with past price changes
d. Past information is useful in predicting future prices

Back 37

c
A random walk reflects no other information and is thus random.

Front 38

6. A market anomaly refers to:
a. An exogenous shock to the market that is sharp but not persistent
b. A price or volume event that is inconsistent with historical price or volume trends
c. A trading or pricing structure that interferes with efficient buying and selling of securities
d. Price behavior that differs from the behavior predicted by the EMH

Back 38

d
Unexpected results are by definition an anomaly.

Front 39

a. Investors are slow to update their beliefs when given new evidence

Back 39

Conservatism bias

Front 40

b. Investors are reluctant to bear losses due to their unconventional decisions.

Back 40

Regret avoidance

Front 41

c. Investors exhibit less risk tolerance in their retirement accounts versus their other stock accounts.

Back 41

Mental accounting

Front 42

d. Investors are reluctant to sell stocks with “paper” losses.

Back 42

i. Disposition effect

Front 43

e. Investors disregard sample size when forming views about the future from the past.

Back 43

Representativeness bias

Front 44

2. After reading about three successful investors in the WSJ you decide that active investing will also provide you with superior trading results. What sort of behavioral tendency are you exhibiting?

Back 44

2. Representativeness bias. The sample size is not considered when making future decisions.

Front 45

3. What do we mean by fundamental risk, and shy may such risk allow behavioral biases to persist for long periods of time?

Back 45

3. Fundamental risk means that even if a security is mispriced, it still can be risky to attempt to exploit the mispricing. This limits the actions of arbitrageurs who take positions in mispriced securities. Thus, the bias may persist since no one takes advantage of it.

Front 46

4. What are the strong points of the behavioral critique of the efficient market hypothesis? What are some problems with the critique?

Back 46

4. The premise of behavioral finance is that conventional financial theory ignores how real people make decisions and that people make a difference. Behavioral finance may site examples of market inefficiencies, but they give no insight into how to exploit such phenomenon. The strength of their argument relies upon observed market inefficiencies and unexplained market behavior. There are many anomalies, yet many can be reverse engineered or explained. Also, while anomalies exist, they rarely meet the test of statistical significance.

Front 47

5. What are some possible investment implications of the behavioral critique?

Back 47

5. An unfortunate consequence of behavioral finance (BF) is a tendency for investors to assume more than actually is claimed by the field. While BF is highly critical of EMH and claims to offer alternative theories, it does not propose to be a predictor of future returns. Investors should be wary of people purporting to offer excess returns under the façade of BH. Such claims are likely to be false.

Front 48

6. Which one of the following would be a bullish signal to a technical analyst using moving average rules?
a. A stock price crosses above its 52-week moving average.
b. A stock price crosses below its 52-week moving average.
c. The stock’s moving average is increasing.
d. The stock’s moving average is decreasing.

Back 48

6. Statement b, that a price has moved above its 52 week moving average is considered a bullish sign.

Front 49

8. Consider a bond with a 10% coupon and with a ytm of 8%. If the bond’s ytm remains constant, then in one year, will the bond price be higher, lower, or unchanged? Why?

Back 49

8. The bond price will be lower. As time passes, the bond price, which is now above par value, will approach par.

Front 50

21. A bond has a current yield of 9% and a yield to maturity of 10%. Is the bond selling above or below par value? Explain.

Back 50

21. If the yield to maturity is greater than current yield, then the bond offers the prospect of price appreciation as it approaches its maturity date. Therefore, the bond is selling below par value.

Front 51

22. Is the coupon rate of the bond in the previous problem more or less than 9%?

Back 51

22. The coupon rate is below 9%. If coupon divided by price equals 9%, and price is less than par, then coupon divided by par is less than 9%.

Front 52

28. Assume that two firms issue bonds with the following characteristics. Both bonds are issued at par.

ABC bonds XYZ bonds
Issue size $1.2 billion $150 million
Maturity 10 years* 20 years
Coupon 9% 10%
Collateral First mortgage General debenture
Callable Not callable In 10 years
Call price None 110
Sinking fund None Starting in 5 years
*Bond is extendable at the discretion of the bondholder
For an additional 10 years

Back 52

• The ABC debt is a larger issue and therefore may sell with greater liquidity.
• An option to extend the term from 10 years to 20 years is favorable if interest rates ten years from now are lower than today’s interest rates. In contrast, if interest rates are rising, the investor can present the bond for payment and reinvest the money for better returns.
• In the event of trouble, the ABC debt is a more senior claim. It has more underlying security in the form of a first claim against real property.
• The call feature on the XYZ bonds makes the ABC bonds relatively more attractive since ABC bonds cannot be called from the investor.
• The XYZ bond has a sinking fund requiring XYZ to retire part of the issue each year. Since most sinking funds give the firm the option to retire this amount at the lower of par or market value, the sinking fund can work to the detriment of bondholders.

Front 53

35. The yield curve is upward-sloping. Can you conclude that investors expect short-term interest rates to rise? Why or why not?

Back 53

1. If the yield curve is upward sloping, you cannot conclude that investors expect short-term interest rates to rise because the rising slope could be due to either expectations of future increases in rates or the demand of investors for a risk premium on long-term bonds. In fact the yield curve can be upward sloping even in the absence of expectations of future increases in rates.

Front 54

39. The yield to maturity on one-year zero coupon bonds is 8%. The yield to maturity on two-year zero coupon bonds is 9%. a. What is the forward rate of interest for the second year?

Back 54

a. The forward rate (f2) is the rate that makes the return from rolling over one-year bonds the same as the return from investing in the two-year maturity bond and holding to maturity:
1.08 × (1 + f2) = (1.09)2 ==> f2 = 0.1001 = 10.01%

Front 55

39. The yield to maturity on one-year zero coupon bonds is 8%. The yield to maturity on two-year zero coupon bonds is 9%. b. If you believe in the expectations hypothesis, what is your best guess as to the expected value of the short-term interest rate next year?

Back 55

b. According to the expectations hypothesis, the forward rate equals the expected value of the short-term interest rate next year, so the best guess would be 10.01%.

Front 56

39. The yield to maturity on one-year zero coupon bonds is 8%. The yield to maturity on two-year zero coupon bonds is 9%. c. If you believe in the liquidity preference theory, is your best guess as to next year’s short-term interest rate higher or lower than in (b)?

Back 56

c. According to the liquidity preference hypothesis, the forward rate exceeds the expected short-term interest rate next year, so the best guess would be less than 10.01%.

Front 57

40. The following table contains spot rates and forward rates for three years. However, the labels got mixed up. Can you identify which row of the interest rates represents spot rates and which one the forward rate?
Year: 1 2 3
Spot or forward rate? 10% 12% 14%
Spot or forward rate? 10% 14.0364% 18.1078%

Back 57

40. The top row must be the spot rates. The spot rates are (geometric) averages of the forward rates, and the top row is the average of the bottom row. For example, the spot rate on a two-year investment (12%) is the average of the two forward rates 10% and 14.0364%:
(1.12)2 = 1.10 × 1.140364 = 1.2544

Front 58

41. Consider the following $1,000 par value zero coupon bonds:

Bond Years til Maturity Yield to Maturity
A 1 5%
B 2 6
C 3 6.5
D 4 7

According to the expectations hypothesis, what is the market’s expectation of the one-year interest rate three years from now?

Back 58

41. Using a financial calculator, PV = 100, t=3, pmt=0, r=6.5. Price or FV = 120.795. Using a financial calculator, PV = 100, t=4, pmt=0, r=7.0. Price or FV = 131.080.
Setting PV = -120.795, FV = 131.080, t=1, pmt=0, solving for r produces the answer of 8.51%.