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Empirical Evidence On Efficient Markets

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How is the SCL estimated?
A regression of form equivalent to the excess return under the single index model.
How is the SML estimated?
The excess security return is fit to a second order regression with the beta values based on the beta values determined under the SCL regression. If CAPM holds, we expect this regression to produ…
What is benchmark error?
Use of an inappropriate proxy for the true market portfolio.
What is our final conclusion about the testability of CAPM?
The CAPM is untestable given that we cannot observe the market portfolio exactly and given that we do not know the efficiency of observed proxies.
What is one reason for the inaccuracies produced by Lintner's regression?
We know there were measurement errors in beta. This will cause a upward bias in the regression estimate of beta and a downward bias in the estimate of the first order term.
What modification was made to early empirical tests of the mean-beta relationship?
Instead of analyzing returns on individual securities, returns of diverse portfolios were analyzed. In the event firm specific risks are uncorrelated this significantly reduces the error in statistically estimated betas, but simultaneously reduces the nu…
Given the significant reduction in the number of empirical observations what additional model adjustment is desirable.
We wish to produce diversify portfolios which have betas which are materially different from the other diverse portfolios. (i.e. we want to group stocks with similar betas in the same portfolio)
What regression equation did Fama and MacBeth fit to this adjusted data?
What was the conclusion of Fama and MacBeth's regression analysis?
Their model reasonable supported the CAPM model. However when updated for more recent time periods, the model has deviated substantially from that supported by CAPM.
What do Fama and French use as the Small minus Big tracking portfolio?
The volume weighted portfolio of small stocks (defined as having market cap lower than the median capitalization of NYSE) less portfolio of large stocks (cap larger than median of NYSE).
Liquidity is a priced factor and the associated risk premium is significant.
What did Pastor and Stambaugh conclude about the relevance of liquidity in terms of stock return?
What empirical evidence do Pastor and Stambaugh offer as support that the market incorporates liquidity into current prices.
They separated securities into groups based on liquidity. They calculated alpha factors using models which do not incorporate liquidity and found that as illiquidity increased the alphas correspondingly increased.
What is the equity premium puzzle?
Historical market returns have been too large to be reasonable in light of economic theory and reasonable levels of investor utility.
What impact does the equity premium puzzle have on expected future returns?
The equity premium puzzle suggests that expected future excess market returns need to be lower than historical excess returns of equities.
What is one possible interpretation of the Fama French variables?
The explanatory power of the Fama-French factors for average return may in fact reflect differences in consumption risk of those portfolios.
How do Fama and French explain the equity premium puzzle?
Observed rates of return in the recent half-century were unexpectedly high. And that the forecast of future returns will be lower than past averages.
What suggestion does Constantinides offer with regard to the equity risk premium puzzle?
There are restrictions on borrowing. Incorporating this with habit formation in addition to the regular utility helps explain the higher excess return.
What are efficient Capital Markets?
Informational efficiency: security prices quickly and fully reflect available information in a statistical sense
Market value
observed value of an asset in the marketplace; determined by supply and demand.
Intrinsic value
economic or fair value of an asset; the present value of the asset's expected future cash flows.
Inefficient Markets
market values differ from intrinsic values in predictable ways
Factor Affecting Market Efficiency
Number of market participants
Strong Form
Stock prices reflect ALL information about the firm (private and public)
Weak Form Market Efficiency
Current securities prices fully reflects all currently available security information (price and volume)
Semistrong Form Market Efficiency
Current securities prices fully reflect all publicly available information
Strong Form Market Efficiency
Current securities prices fully reflect both public and private sources of information
Establish portfolio risk/return objectives
Roles for Portfolio Managers in Efficient Markets
Abnormal Profits
if returns are on average greater than equilibrium expected returns, we can reject the hypothesis of efficient prices with respect to the information on which the strategy is based
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…
Market Anomalies
observed market inefficiencies
Calendar effect
Time Series Anomalies
Cross-Sectional Anomalies
Size effect: small cap stocks outperform large-cap stocks
Closed-end funds
Have a fixed number of shares that trade like shares of common stock. Are unmanaged portfolios of stock with each share representing partial ownership of the portfolio. May trade on an exchange. Can be sold to other investors.
Earning Surprises
Slow adjustment
initial overeaction, long-term underperformance
Data Mining
Repeated tests on the same historical data until statistically significant relation is found
Data Snooping
sort through data for strategies that would have worked in the past, without regard to economic rationale that they will work in the future
Implication for Investors
Reported anomalies are not violations of market efficiency but are due to the methodologies used in the test of market efficiency
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.
Investors overestimate their ability to value securities
Gambler's Fallacy
recent result affect estimates of future probabilities
Mental Accounting
considering different investments' performance separately instead of viewing them as a portfolio
Disposition effect
Willing to realize gains but not losses
Information Cascades
Uninformed traders, when faced with unclear information, watch the actions of informed traders to make their decisions.
define and describe, count (who what when where)
gather more info on new areas/concerns (whats going on)
cause and effect (why)
effects of intervention
types of research methods
experimental, asking questions, observations, secondary data analysis
a statement about empirical reality, involving a relationship between two or more variables (independent and dependent)
determine the research strategy
theory, hypothesis, data, empirical generalizations
piquero scale
was significant but, didnt predict real behavior. **very limited**
marginal benefit
benefit gained from consuming the next good
Marginal Cost
Change in cost resulting from a 1-unit increase in output
waste of resources
Consumer Surplus
Difference between what a consumer is willing to pay for a good the the amount actually paid
Producer Surplus
Gain from participating in a market- The difference between amount for which good sells and minimum amount necessary for seller to produce good
total surplus
the sum of consumer surplus and producer surplus
consumer expenditure
price multiplied by the quantity purchased
total revenue
price multiplied by the quantity sold
Total cost
Total economic cost of production, consisting of fixed and variable costs
total benefit
the sum of the marginal benefits
Net benefit to the consumer
Total benefit minus consumer expenditure
Net benefit to the producer
Total revenue minus total cost.
deadweight loss
the avoidable reduction in total surplusbecause something has prevented the market from producing the optimal quantity, Qo.
efficient market
when society's wellbeing is maximized
efficient markets hypothesis
theory of market pricing behavior that applies rational expectations to the prcing of assets
Is there a way to profit from old info?
theory of rational expectations
An economic idea that the people in the economy make choices based on their rational outlook, available information and past experiences. The theory suggests that the current expectations in the economy are equivalent to …
Can rational expectations be wrong?
Yes. People can be wrong. Rational expectations only imply that the surprise return is unforecastable error.
Random Walk theory
The theory that stock price changes are independent of each other, so the past movement or trend of a stock price or market cannot be used to predict its future movement.
When does the market follow a random walk?
when expected return is constant = special case of the hypothesis.
Empirical evidence against random walk theory
We can sometimes predict certain trends in the market
Does this mean EMH is incorrect?
No. because return surprises can still be unforecastable.
Information is costly to collect, so we should not expect prices to reflect all info. Is this correct?
No. Argument ignores the fact that the benefits to information collection are large. Hedge funds and other large institutional investors will take this cost to reap the additional benefits.
versions of the EMH
define eff markets by asking whether hypothetical trading based on an explicitly defined information would earn forecastably higher or lower abnormal returns. If yes --> markets are inefficient