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114 Cards in this Set
- Front
- Back
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Expectations are... |
very important in our financial system. |
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Expectrations of returns, risk, and liquidity impact... |
asset demand. |
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We have expectations of... |
what returns things are going to have. |
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Inflationary expectations... |
impact bond prices |
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Expectations not only affect our understanding of markets, but also how... |
financial institutions operate |
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What is the efficient market hypothesis? |
framework for understanding what information is useful and what is not |
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R = |
(income + capital gains)/beginning price |
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Re = |
Pet+1 - Pt + C / Pt |
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The efficient market hypothesis views the expectations as equal to... |
optimal forecasts using all available information |
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Re = |
R* |
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Rof = |
R*
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Prices in the market get del by... |
all the actors' trading and reflect all of the information that they have |
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(R*=Rof) This equation tells us that... |
current prices in a financial market will be set so that the optimal forecast of a security's return using all available information equals the security's equilibrium return. |
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Financial economists state it more simply: |
A security's price fully reflects all available information in an efficient market |
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What is weak-form? |
All past price history is reflected, but not necessarily all public information. |
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What is strong-form? |
All information possible is reflected in the price, including private inside information. |
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What is semi-strong? |
all public information |
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When an unexploited profit opportunity arises on a security, investors will... |
rush to buy until the price rises to the point that the returns are normal again. |
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If we thought that a firm would earn 2$ a share, but they earned 2.50 a share, it means that... |
the stock was underpriced |
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Why is it called an unexploited profit opportunity? |
so-called because, on average, people would be earning more than they should, given the characteristics of that security. |
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In an efficient market... |
all unexploited profit opportunities will be eliminated |
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Not every investor needs to be aware of.. |
every security and situation |
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As long as a few investors keep their eyes open for unexploited profit opportunities, they will... |
eliminate the profit opportunities that appear because in doing so, they make a profit. |
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There is no need for anyone to look for good deals because... |
prices are what they should be. However, with no analysis, this information would be incorrect. |
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A relatively small number of people looking out for opportunities is... |
good enough |
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Why does the efficient market hypothesis make sense? |
If Rof > R* then Price increases and Rof decreases If Rof < R*, then Price decreases and Rof increases Until Rof = R* |
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All unexploited profit opportunities are.. |
eliminated |
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Efficient market condition holds even if there are... |
uninformed, irrational participants in the market |
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Three favorable evidence |
1. Investment analysts and mutual funds don't beat the market. 2. Stock prices reflect publicly available info 3. Stock prices and exchange rates close to random walk |
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One point for stock prices reflect publicly available info: |
anticipated announcements don't affect stock price |
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If predictions of the change in price is big, Rof> R* leads to/... |
predictions of a small change in price |
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Teachnical analysis does not... |
outperform market |
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When you use past price movements to predict, look for... |
patterns and determine the price of the stock based on graphs |
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Performance of Investment Analysts and Mutual Funds should not... |
be able to consistently best the market |
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The "Investment Dartboard" often... |
beats investment managers |
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Mutual funds not only do not... |
outperform the market on average, but when they are separated into groups according to whether they had the highest or lowest profits in a chosen period, the mutual funds that did well in the first period do not beat the market in the second period. |
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Past performance isn't an... |
indication of future performance. |
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Investment strategies using inside information is the only... |
"proven method" to beat the market. |
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In the US, it is illegal to trade on... |
such information, but that is not true in all countries. |
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Do Stock Prices Reflect Publicly Available Information as the EMH predicts they will? |
If information is already publicly available, a positive announcement about a company will not, on average, raise the price of its stock because this information is already reflected in the stock price. |
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Early empirical evidence confirms: favorable earnings announcements or announcements of stock splits... |
do not, on average, cause stock prices to rise. |
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What is a stock split? |
a division of a share of stock into multiple shares, which is usually followed by higher earnings |
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Future changes in stock prices should... |
be unpredictable |
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If stock is predicted to rise, people will... |
buy to equilibrium level. |
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If stock price is predicted to fall, people will... |
sell to equilibrium level. |
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If stock prices were predictable, thereby causing the above behavior, price changes would... |
be near zero, which has not been the case historically. |
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the study of past stock price data, searching for patterns such as trends and regular cycles, suggesting rules for when to buy and sell stocks |
technical analysis |
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The EMH suggests that... |
technical analysis is a waste of time. |
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The simplest way to understand why technical analysis is a waste is to use... |
the random-walk result that holds the past stock price data cannot help predict changes. |
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Technical analysis, which relies on such data to produce its forecasts, cannot... |
successfully predict changes in stock prices. |
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Even the weak-form market efficiency would rule out... |
technical analysis as being useful |
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Could you make a bundle if you could predict foreign exchange rates? |
Of course |
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EMH predicts that FX rates should be... |
unpredictable |
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Empirical tests show that... |
FX rates are not very predictable |
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Six unfavorable evidences for Efficient Market Hypothesis |
1. Small firm effect 2. January effect 3. Market overreaction 4. Excessive Volatility 5. Mean reversion 6. New information is not always immediately incorporated into stock prices |
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What is the small-firm effect |
small firms have abnormally high returns |
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What is the january effect? |
high returns in january |
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What is the overview of the efficient market hypothesis? |
reasonable starting point, but not the whole story |
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The small-firm effect is an... |
anomaly. |
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Many empirical studies have shown that... |
small firms have earned abnormally high returns over long periods of time even when the greater risk of these firms have been considered. |
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What is the joint hypothesis problem? |
the only way we can test these models are against the market. So if the model doesn't match what happened, what's wrong, the model or the people |
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The small-firm effects seems to have diminished in recent years but is still... |
a challenge to the theory of efficient market |
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various theories have been developed to explain the small firm effect, suggesting that it may be due to... (5) |
rebalancing of portfolios by institutional investors tax issues low liquidity of small-firm stocks large information costs in evaluating small firms an inappropriate measurement of risk for small-firm stocks |
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What is the turtle effect? |
Sea turtles are delivered on the beach and they have to make it to the sea, a lot of them get picked up by predators. There's only a few that make it. The idea that the outside return comes from a small firm that just blows up. |
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The January effect is the tendency of stock prices to experience... |
an abnormal positive return in the month of January that is predictable and, hence, inconsistent with random-walk behavior. |
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Investors have an incentive to sell stocks before the end of the year in December because they can then... |
take capital losses on their tax return and reduce their tax liability. Then when the New Year starts in Janaury, they can repurchase the stocks, driving up their prices and producing abnormally high returns |
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Although the January explanation seems sensible, it does not explain why... |
institutional investors such as private pension funds, which are not subject to income taxes, do not take advantage of the abnormal returns in January and buy stocks in December, thus bidding up their price and eliminating abnormal returns. |
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recent research suggests that stock prices may overreact to news announcements and that the pricing errors are corrected only slowly |
market overreaction |
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When corporations announce a major change in earnings, say, a large decline, the stock price may... |
overshoot, and after an initial large decline, it may rise back to more normal levels over a period of several weeks. |
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Market Overreaction violates the EMH because an investor could earn abnormally high returns, on average, by... |
buying a stock immediately after a poor earnings announcement and then selling it after a couple of weeks when it has risen back to normal levels. |
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Firms that have done well in the past 6 months tend to... |
do well over the next six months |
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Stocks that have done poorly for the past three years tend to... |
do better |
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Stocks that have done all over the past three years tend to... |
do worse. |
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When new information comes out, the stock price starts to... |
reflect that information |
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the stock market appears to display... |
excessive volatility. |
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Fluctuations in stock prices may be much greater than is... |
warranted by fluctuations in their fundamental value. |
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Researchers have found that fluctuation in the S&P 500 stock index could not be justified by...
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the subsequent fluctuations in the dividends of the stocks making up this index. |
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Other research finds that there are smaller fluctuations in stock prices when... |
stock markets are closed, which has produced a consensus that stock market prices appear to be driven by factors other than fundamentals |
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some researchers have found that stocks with low returns today tend to have high returns in the future, and vice versa |
mean reversion |
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Stocks that have done poorly in the past are more likely to do well in the future because... |
mean reversion indicates that there will be a predictable change in the future price, suggesting that stock prices are not a random walk. |
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Newer data is less conclusive. Nevertheless, |
mean reversion remains controversial |
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New information is not always... |
immediately incorporated into stock prices |
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Although generally true, recent evidence suggests that stock prices do not... |
instantaneously adjust to profit announcements |
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On average stock prices continue to rise for some time after the announcement of... |
unexpectedly high profits, and they continue to fall after surprisingly low profit announcements. |
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How valuable are published reports by investment advisors? (2) |
not very
It's public information once it's been public. It should already be in the price. |
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Should you be skeptical of hot tips? |
Yes. The EMH indicates that you should be skeptical of hot tips since, if the stock market is efficient, it has already priced the hot tip stock so that its expected return will equal the equilibrium return. |
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The hot tip is.. |
not particularly valuable and will not enable you to earn an abnormally high return |
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As soon as the information hits the street...
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the unexploited profit opportunity it creates will be quickly eliminated |
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The stock's price will... |
already reflect the information, and you should expect to realize only the equilibrium return |
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Do stock prices always rise when there is good news? |
No. In an efficient market, stock prices will respond to announcements only when the information being announced is new and unexpected. |
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If good news was expected (or as good as expected), there will be... |
no stock price response. |
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If good news was unexpected (or not as good as expected), there will be... |
a stock price response. |
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Unexpected causes... |
price movements |
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Investors should not try to... |
outguess the market by constantly buying and selling securities. |
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The constant buying and selling of securities does nothing but... |
incur commissions costs on each trade. |
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Not a good idea to go out and try to pick winners... |
You'll eat up whatever gains you might've had with fees and commissions. |
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The investor should pursue a... |
buy and hold strategy |
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What is a buy and hold strategy? |
purchase stocks and hold them for long periods of time |
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Buy and hold strategy leads to the same returns on average, but the investor's... |
net profits will be higher because fewer brokerage commissions will have to be paid |
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It is frequently a sensible strategy for a small investor, whose costs of managing a portfolio may be high relative to its size, to... |
buy into a mutual fund rather than individual stocks. |
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Because the EMH indicates that no mutual fund can consistently outperform the market, an investor should... |
not buy into one that has high management fees or that pays sales commissions to brokers but rather should purchase a no-load (commission-free) mutual fund that has low management fees. |
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Two points for Efficient markets prescription for investor |
best to buy a mutual fund that allows you to be diversified Find funds with low fees |
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A strong view of EMH states that.(2) |
1. expectations are rational 2. prices are always correct and reflect market fundamentals |
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The strong view of EMH has three important implications: |
1. One investment is just as good as any other 2. Prices reflect all information. 3. Cost of capital can be determined from security prices as siting in capital budgeting decisions |
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Stock picking is.. |
pointless (there are still risk levels |
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The strong view, however is... |
not what EMH really means. |
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What does EMH really mean? |
IT means that stock prices are unpredictable. The existence of market crashes and bubbles cast serious doubt on this stronger view. |
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a situation in which the price of an asset differs from its fundamental market value |
bubble |
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A way that bubbles could be rational? |
You think things are overpriced but if you think that someone is willing to pay more, you might buy the stock anyway. |
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Dissatisfaction with using the EMH to explain events like 1987's Black Monday have rise to the new field of behavioral finance, in which... |
concepts from psychology, sociology, and other social sciences are applied to understand the behavior of securities prices |
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EMH suggests that... |
"smart money" would engage in short sales to combat overpriced securities, yet short sale volume is low, leading to behavior theories about "loss aversion" |
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What is loss aversion? |
people hate losses more than they like gains |
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Other behavior analysis points to investor overconfidence as... |
perpetuating stock price bubbles. |
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EMH only implies that... |
prices are unpredictable, which is not as strong as stating that prices are correct |
