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Informational Efficient Markets


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Asymmetric Information
Argues that the financial marketplace contains pockets of inefficiency in the availability and use of information, such that insiders can earn excess returns by selectively trading assets based on the special information they have been able to acquire.
Federal laws for insider trading
Section 10(b) 5 of the U.S. Securities and Exchange Act forbids any "manipulative or deceptive device" in trading securities and other financial assets.
moral hazard
the risk that one party to a transaction will engage in behavior that is undesirable from the other party's point of view
Efficient Market Hypothesis
The hypothesis that actual capital markets, such as the NYSE are efficient.
asymmetric information hypothesis
argues that financial market place contains pockets of inefficiency in the availability and use of information.
weak form of the EMH
argues the current prices of assets contain all information that buyers and sellers have been able to obtain on the past trading of those assets: their price history and past volume of trading
semi-strong form of the EMH
contends that the current price of assets already reflect all publicly available information affecting the value of these instruments, including information about past prices and volume, the financial condition and credit rating of each iss…
strong form of the EMH
argues that current prices capture all the information both public and private, relevant to their value. this includes information possessed by insiders , such as officers, directors, and principal owners of a corporation issuing st…
Informationally efficient capital market
One in which the current price of a security fully, quickly, and rationally reflects all available info about the security. A market that reflects all past and present information.
Passive investment strategy
Does not seek superior risk-adjusted returns. (buying and holding a broad market portfolio)
Active investment strategy
May generate positive risk-adjusted returns in an inefficient market
Market value
observed value of an asset in the marketplace; determined by supply and demand.
Intrinsic (fundamental) value of an asset
Value that a rational investor with full knowledge about the asset's characteristics would willingly pay. Also changes through time as new information is released
Highly efficient markets
Investors can typically expect market values to reflect intrinsic values in what type of market?
If markets are not completely efficient
Active managers will buy assets for which they think intrinsic values are greater than market values and sell assets for which they think intrinsic values are less than market values
The more complex of an asset
the more difficult it is to estimate its intrinsic value
Weak-form market efficiency
States that current security prices fully reflect all currently available security market data. Thus, past price and volume info will have no predictive power about the future direction of security prices because price changes …
Semi-strong form market efficiency
Security prices rapidly adjust without bias to the arrival of all new public info. As such, current security prices FULLY REFLECT ALL PUBLICLY AVAILABLE INFO. Security prices include all past security market info and nonma…
Strong-form market efficiency
The strong form of the EMH states that security prices fully reflect all information from both public and private sources. The strong form includes all types of info: past security market information, public, and pri…
Technical Analysis
Seeks to earn positive risk adjusted returns by using historical price and volume data.
Fundamental Analysis
based on public info such as earnings, dividends, and various accounting ratios and estimates. The semi-strong form of market efficiency suggests that all public information is already reflected in stock prices. As a result, inves…
Event Study
Examine abnormal returns before and after the release of new info that affects a firm's intrinsic value, such as earnings announcements or dividend changes. The null hypothesis is that investors should not be abl…
Investing strategy for a semi-strong form efficient market
Investors should invest PASSIVELY (invest in an index portfolio that replicates the returns on a market index)
Anomaly
Something that deviates from the common rule.
Market anomaly
Something that would lead us to reject the hypothesis of market efficiency
How to avoid data mining
analysts should first ask if there is an economic basis for the relationships they find between certain variables and stock returns and then test the discovered relationships with a large sample of data to deter…
Calendar Anomalies
January effect - the first 5 days of January, stock returns, especially for small firms, are significantly higher than they are the rest of the year.
Overreaction and Momentum Anomalies
The overreaction effect refers to the finding that firms with poor stock returns over the previous 3 or 5 years have better subsequent returns than firms that had high stock returns over the prior per…
Size effect Anomaly
Refers to initial findings that small-cap stocks outperform large cap stocks. Cannot be confirmed in later studies, suggesting that investors had traded on, and thereby eliminated this anomaly or that the initial finding was si…
Value Effect
outperformance by some low P/E, P/B, and high dividend yield stocks. This anomaly contradicts semi-strong form efficiency
Closed-End Investment Fund Discounts
The shares of closed-end investment funds trade at prices that sometimes deviate from the NAV of the fund shares, often trading at large discounts to NAV. Such large discounts are an anomaly because, by arbitr…
Earnings Announcements
news that was not expected by the market. Positive earnings surprises precede periods of positive risk-adjusted post-announcement stock returns, and negative surprises lead to predictable negative risk-adjusted returns.
Behavioral Finance
Examines investment behavior, its effect on financial markets, how cognitive biases may result in anomalies, and whether investors are rational. Traditional finance models, including efficient markets, are based on an assumption that the marke…
Loss Aversion
Refers to the tendency for investors to be more risk averse when faced with potential losses and less risk averse when faced with potential gains.
Investor Overconfidence
if this occurs, securities may be overpriced. However, it appears that this mispricing may be hard to predict, may only be temporary, may not be exploitable for abnormal profits, and may only exist for high-gr…
Behavioral Biases:
Representativeness- investors assume good companies or good markets are Good investments.
Information Cascades
Uninformed traders, when faced with unclear information, watch the actions of informed traders to make their decisions.
rational expectations
use all information avaliable to them to develop these
fundamental value
the market price of an asset equals the best guess of present value of expected future returns in a market where there are rational expectations
efficient markets hypothesis
theory of market pricing behavior that applies rational expectations to the prcing of assets
noise traders
uniformed traders
fads
over reaction to good or bad news about an issue or class of assets
bubble
when the price of an asset is more than its fundamental value
greater fool theory
when there is a price bubble, an investor is not a foold to buy it if there is a greater fool to buy it later for a higher price
program trading
computer-generated orders to buy or sell many stocks at the same time cause rapid adjustments of institutional portfolios
adaptive expections
expectations of changes in prices or returns change graudally over time as data on past prices or returns become avaliable
unforecastable error=
actual price-expected price
Pt=(Dt.1+Pt.1)/(1=i)
price of financial assets at time t equation
PV=dividend amount ((1+g)/(i-g))
PV of dividends when growth is expected forever
PV=price/(1+i)+price next year/(1+i)^2+...
PV of dividends when growth is not expected forever
because of...
businesses should invest more
an increase in difference betweeen domestic and foreign real interest rates
savers should adjust their lending to domestic and foreign borrowers and exchange rates will shift
small-firm effect
savers could have earned above-normal profits by investing in stocks of small firms, even with greater risk taken into account
january effect
people rebalance portfolios each january, possibly to avoid taxes they get rid of their losses in December too
mean reversion
tencency for stocks with high returns today to experience low returns int ehf uture and for stocks with low returns today to epxerience high returns in the future
Value investing
selection of equity investments based on finding securities that are fundamentally undervalued in the makerplace. These tend to be solid companies that are currently out of favor. Look at price/earnings ratio and price/book value ratio.
transaction tax
the higher the cost of transaction, the less likely bubbles will occur, and the less volatile prices are likely to be
margin requirement
minimum proportion of purchase price of shares that an investor must supply from nonborrowed funds set by the Federal Reserve Board