Tutorial 3

Q1

Momentum and reversal

• With momentum we observe positive correlation in returns, whereas with reversal we observe negative correlation in returns

--- ADD IMAGE FOR clarity

Momentum is the observed tendency for rising asset prices or securities return to rise furtherm and falling prices to keep falling.

• But an increase in price

Value and growth stocks

• Stock prices for value stocks are low relative to accounting measures such as earnings, cash flow, or book value,
• Whereas stock prices for growth (or glamour) stocks are high relative to earnings, cash fow, and book value, at least in part because the market anticipated/predicts high future growth

Fundamental risk and noise-trader risk

• Fundamental risk arises because of the potential for rational revaluation as new information arrives and
• Noise-trader risk arises because mispricing can be more severe in the short turn. Some people may not be happy

• Noise trader risk should be in the short term only.

Carve-out and stub value

• A carve-out is an offering of shares in a subsidiary company. When a company sell a minority interest of a subsidiary interest to outside investors
  • Allows a company to capitalise on a business segment that may not be part of core business

Stub value is the implied standalone value of the parent company without the subsidiary

• Stub is a security that is created as a result of a corporate restructuring such as a bankruptcy, or recapitalisation in which a portion of a company's equity is separated from the company's stock

Q2 (on ipad)

Q3

• When you are managing your own money, you are subject to fundamental risk and noise-trader risk. Plus some arbitrageurs will normally have a limited pool of capital to use for arbitrage purposes.

If you are managing other people's money, you will often have more capital in your control. But you will be subject to a different sort of wealth control. Because they have the power to hire and fire, your horizon is of necessity short. In fact, many who are attempting to exploit arbitrage opportunities are subject to this reality. They are managing money for individuals (pooling their money through hedge funds).

4. *What is data snooping? What sort of empirical evidence is useful for obviating this critique?

It is always possible to detect correlations in data merely due to randomness

• Data snooping is the act of analyzing a dataset to 'death' so as to detect correlations, which are then termed anomalies
• Correlations should exhibit some consistency

• Same data will increase the likelihood of overfitting
• Multiple testing
• Selection bias (people you select will be more significant in some hypothesis)

Q5 *What are the three supports or (conditions) on which market efficiency rests? Why is it that only one of them is required?

IMPORTANT

The three supports are (1) investor rationality, (2) uncorrelated errors and (3) unlimited arbitrage.

• If the first holds, prices will be on average right and markets will be efficient.
• If the first does not hold, but the second does hold, while errors will be made, once again on average prices will be right.
• If the first two do not hold, but the third does hold, while prices have the potential to diverge from value because errors are often one-sided, arbitrageurs will notice such opportunities and swiftly take action so as to eliminate mispricing.

• unlimited value of arbitrage (3)
• If one of the three conditions hold, the 'average price' would be right

Q6 *Define market efficiency. What are the key assumptions of an efficient market hypothesis (EMH)?

Market efficiency is a situation where the prices of securities reflect all available information at any given time. The Efficient Market Hypothesis (EMH) assumes that all investors have costless access to currently available information about the future, they are rational, and they adjust their expectations instantly to reflect new information.

Prices will react instantaneously and without bias to the release of information in such a way that abnormal returns cannot consistently be made.

• All information reflected in the current price
• cannot create arbitrage - there is no way to 'beat' the market

EMH assumes that all investors:

1. have costless access to currently available information about the future
2. They are rational, and
3. They adjust their expectations instantly to reflect new information

7. Discuss the different forms of market efficiency. How do they differ from one another?

There are three forms of EMH: weak, semi-strong, and strong.

• The weak form states that all past prices of a stock are reflected in today's stock price.
• The semi-strong form suggests that all public information is calculated into a stock's current share price.
• The strong form implies that all information—public and private—is accounted for in a stock's current share price.

Q8. *Identify some of the main challenges to market efficiency. Give specific examples for each.

1. Information asymmetry, where one party has more or better information than the other, creating an imbalance in the transaction. For example, a seller might know about an issue with a product that the buyer doesn't.
2. Behavioral biases like overconfidence or herd behavior can lead to irrational decisions, causing price distortions. For example, during the dotcom bubble, investors kept buying overpriced tech stocks, leading to a market crash.
3. Market manipulation, such as insider trading or price rigging, also pose challenges. The case of Enron is a notable example of market manipulation.

Purchase a large amount of one stock, change the demand and supply of the stock and manipulate the market

Q9. Discuss the concept of information asymmetry

Information asymmetry occurs when one party has more or better information than the other. This can lead to market inefficiencies as the party with more information can exploit their knowledge to gain an unfair advantage. For example, insider trading, where trades are made based on non-public material information, directly challenges market efficiency.

• trade on information before it is available to the public

Q10 *What role does irrational behavior play in challenging the Efficient Market Hypothesis?

Irrational behavior, as explained by behavioral finance, suggests that investors often behave irrationally, driven by cognitive biases rather than by objective information. This challenges the EMH as it contradicts the assumption of investor rationality. Examples of irrational behavior include overconfidence, anchoring, and herd behavior

11. *What is meant by “behavioral finance”? How does it challenge traditional views on market efficiency?

Behavioral finance combines cognitive psychological theory with conventional economics and finance. It challenges the traditional views on market efficiency by introducing concepts of cognitive biases that can lead to irrational financial decisions, thus, market inefficiencies.

Q12

Market manipulation distorts prices and creates false trading volumes, undermining the integrity of financial markets. For instance, the 2010 “Flash Crash” in the United States was an example where high-frequency trading algorithms were blamed for causing a brief massive drop in the stock market.

• Flash crash in the United States was an example where high frequency trader algorithms were blamed for causing a brief massive drop in the stock market
• Large sell order

Q13

High-frequency trading (HFT) uses complex algorithms to transact a large number of orders at very fast speeds. While some argue that HFT provides liquidity, others contend that it can cause market disruptions and create an uneven playing field, thus challenging market efficiency

• creates market manipulations and market disruptions

Q15

Regulation helps to maintain market efficiency by ensuring fair trade, preventing market manipulation, and reducing information asymmetry. However, over-regulation can pose a challenge to market efficiency as it might stifle innovation and create barriers to entry, which may limit competition and create market distortions.

Q16

• on iPad

Q17

• Conservatism, people are slow to update their beliefs and underreact
• Regret avoidance, want to decrease their potential losses in the future. Reluctant to bear loss
• Mental accounting - people will value their money for different aims, differently
• Disposition effect - do not want to realise their losses.
• Representativeness bias - Investors disregard sample size when forming views about the future from the past