Week 5 - Efficient Capital Markets And Behaviour Finanace

Question 1

What three things are included and contribute to the valuation of a firm?

Answer 1

1) Asset Value (NPV)
2) Future Cash flows
3) Discount Rate (Cost of Capital)

Question 2

What is the ‘Efficient Market Hypothesis’ (EMH)? And When is a market considered to be efficient?

Answer 2

The ‘Efficient Market Hypothesis’ is concerned with how good the market is at reflecting value-relevant information.

Markets are said to be efficient when the price of a security fully respect all information available.

Question 3

What does ‘Random Walk Theory’ proportion to be true?

Answer 3

Stock prices have the same distribution and move independently of each other. Therefore, it assumes that past movement cannot be used to predict future trends in the long term. (Markets have no memory of what has happened before)

Question 4

‘Efficient Market Theory’ (EMT) is based on 3 things, What are they?

Answer 4

1) Investors are assumed to be rational.
2) Some are not rational, therefore lading to random trades.
3) Any irrational investors are cancelled out by rational arbitrageurs.

Question 5

If investors are rational, they value securities at their fundamental value (Which is what?). Because of the fact they value firms at their fundamental value, the price of a firm reflects…

Answer 5

• NPV of its future cash flows is calculated with a risk-adjusted discount rate.
• The price of a firm reflects all information available almost immediately

Question 6

The irrational investor strategies are up correlated (because they’re random), therefore…

Answer 6

Their trades whether Buy or Sell are cancelled out

Question 7

What is affected by the trading of irrational investors?

Answer 7

The Trading Volume is affected

Question 8

The Term ‘Market Arbitrage’ means…

Answer 8

Arbitrage is the method of simultaneously buying and selling the same or very similar assets and profiting from the imbalance in prices.

Market Arbitrage exists as a result of market inefficiencies (Differences in information)

Question 9

The efficiency of a market is impacted with respect to the information available. What are the 3 forms of efficiency?

Answer 9

Weak form:
- The market price of an asset reflects all information contained in the history of past prices.

Semi-Strong form:
- The market price of an asset reflects all relevant publicly available information.

Strong form:
- The market price of an asset reflects all relevant information, both public and private.

Question 10

When can abnormal returns be made from stock trading?

Answer 10

When there is a difference in information between investors.

This often occurs from ‘Insider Trading’ that can bring in abnormal profits.

Question 11

Give three arguments against the theory of ‘Market Efficiency’

Answer 11

1. Stock market crash of 1987 occurred out of nowhere with no surprising information being released.
2. Temporary anomalies - January has consistently higher returns than any other month.
3. Speculative Bubbles - A crowd of investors can behave as one and alter the price of stocks.

Question 12

Post-Earnings announcement drift means that when a firm releases…

Answer 12

Earnings announcements that are higher or lower than expected, their share price will continue to go up or down for several months rather than just in the immediate future.

This is a violation of the Semi-Strong form

Question 13

What leads to individual investors failing to diversify their portfolios effectively?

Answer 13

• Familiarity bias

- Relative Wealth Concerns