ADM 3352 Study Guide - Final Guide: Capital Asset Pricing Model, Equity Premium Puzzle, Oddlot Entertainment

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Forms of the Efficient Market Hypothesis: Negative alphas on stocks will quickly disappear.
1- Weak-form Efficiency: future prices cannot be predicted by analyzing prices from the
past; excess returns cannot be earned in the long run by using investment strategies
based on historical share prices or other historical data. Technical analysis techniques
will not be able to consistently produce excess returns although some forms of
fundamental analysis may still provide excess returns. There are no patterns to share
prices. This soft EMH does not require that prices remain at or near equilibrium, but
only that market participants not be able to systematically profit from market
ieffiieies. Assues the ates of etu o the aket should be independent; thus,
rules that traders use to buy or sell a stock are invalid. (momentum)
2- Semi-strong-form Efficiency: Share prices adjust to publicly available new information
very rapidly, such that no excess returns can be earned by trading on that information.
This implies that neither fundamental analysis nor technical analysis will be able to
reliably produce excess returns. An investor cannot benefit over the market by trading
on new public information. “toks ith high diided ields ted to have positive long-
u aoal etus.
3- Strong-form Efficiency: Share prices reflect all information, public and private, and no
one can earn excess return. If there are legal barriers to private information becoming
public, as with insider trading laws, strong-form efficiency is impossible. A market needs
to exist where investors cannot consistently earn excess return over a long period of
tie. “hould e epeted to podue a fe doze sta pefoes. No iesto ould
be able to profit above an average investor even if he was given new private
information. (insiders, exchange specialists, analysts, money managers)
Note: A violation of the semi-strong-form is also a violation of the strong-form.
Behavioral Biases:
- Mental Accounting: Tendency for people to separate their money into separate
accounts based on a variety of subjective criteria. Investors take risks with their gains
that they would not take with their principal.
- Regret Avoidance: ‘efuse to adit to theseles thee ade a poo iestet
decision. Investors blame themselves more when an unconventional or risky bet turns
out badly. I ol u lage ap seuities. M hilde ould ee fogie e if I
iested i sall ap ad it delied i pie.
- Representative Bias: Arriving at a conclusion based on facts that suggest (represent) it
without delving deeper into it. Inferring a pattern too quickly based on a small sample
- Disposition Effect: Tendency to label investments as winners or losers; can lead an
investor to hang onto an investment that no longer has any upside or sell a winning
investment too early to make up for previous losses. Delays correction of mispricing.
Based on poor performance, I want to sell my shares once the share prices rise to my
original ost.
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- Survivorship Bias: Estimating risk premiums from the most successful country and
ignoring evidence from stock markets that did NOT survive for the full sample period
will impart an upward bias in estimates of expected returns.
Prospect Theory Loss-Aversion: Assumes losses and gains are valued differently; individuals
make decisions based on perceived gains instead of perceived losses. If 2 choices are put before
an individual, both equal, with one presented in terms of potential gains, and the other in terms
of possible losses, the former option will be chosen.
- The utility function in prospect theory has change in wealth as its argument.
- Individuals are risk averse for prospects that lead to positive changes in wealth.
- Individuals are loss averse for prospects that lead to negative changes in wealth.
- Individuals are risk lovers for prospects that lead to negative changes in wealth.
- Conventional view- utility depends on level of wealth
- Behavioural view- utility depends on changes in current wealth
Odd-Lot Theory: Odd-lot purchases / Odd-lot sales; values > 1 are bearish signals.
A random walk occurs when prices changes are random and unpredictable. Thus, the best
estimate of the next price is the current price.
The conditional CAPM with human capital yields a better fit for empirical returns than the
conventional CAPM.
Studies found that the estimated slope of the security market line (SML) was less than the
average excess market return that the CAPM would predict.
Studies found that the second-pass estimate of the SML was flatter than the theoretical SML
with an intercept more than the theoretical value.
In Canada, a major problem in attempting to estimate security parameters in the CAPM is the
prices quoted as closing by the exchange are unavailable and the thin trading problem.
Cahats etesio of the Faa-French three-factor model includes a fourth factor to measure
Pastor and Stambaugh added a liquidity factor (LIQ).
Equity Premium Puzzle: Mehra and Prescott observed that historical excess returns on risky
assets in the U.S. are too large to be consistent with economic theory and reasonable levels of
risk aversion.
- Barberis and Huang explain this puzzle as irrational behavior. They believe that the
result is due to Loss Aversion and Narrow Framing.
- Narrow Framing: Making investment decisions without considering the context of his
total portfolio.
- Constantinides reasons: Potential job loss during an economic downturn, life-cycle
considerations, habit formation. NOT complete markets.
- Jorion and Goetzman hypothesize that the equity risk premium puzzle is due to
survivorship bias.
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Fama and French 3-Factor Model:
- Market risk
- Outperformance of small versus big companies (SMB)
- Outperformance of high book/market versus small book/market companies. (HML)
In 2015, Fama and French added 2 factors to their Fama and French 3-fator model:
- RMW: robust minus weak (profitability)
- CMA: conservatively minus aggressively (investment policy)
The effet of liuidit o a assets epeted etu is oposed of transactions costs and
liquidity risk.
Defined Benefit Pension Plans: make pension payments to beneficiaries based on years of
service and salary.
Hedge Funds:
- Offer performance-based fees to managers
o Performance fee is earned when the fund is above its high-water mark and earns
more than a specified benchmark.
- Can apply leverage
Sheltering investment from taxes:
- Assets whose returns are primarily in the form of capital gains.
- Registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs)
Confidence Index:
- Higher values are BULLISH signals.
- Always less than 100%
- Leading indicator of stock market trends NOT bond
- The ratio of percentage form of the average yield on 10 top-rated corporate bonds
divided by the average yield on 10 intermediate-grade corporate bonds.
Chapter 6 Optimal Risky Portfolios
Market Risk also called systematic risk (nondiversifiable).
Firm-specific risk can be eliminated by diversification. Also called non-systematic risk.
Portfolio risk (variance) depends on the correlation between the returns of the assets in the
Covariance and correlation coefficient provide a measure of the way that the returns of 2 assets
move together.
The smaller the correlation (), the greater the risk reduction potential.
If = +1.0, no risk reduction is possible.
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