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Reading 55: Market Efficiency and Anomalies - LOS b ~ Q1

1.June Rutherford is preparing a research report on Andronicus Fund, an offshore hedge fund that specializes in identifying market pricing inefficiencies and profiting from the arbitrage opportunities they present. Rutherford includes these statements in her report:

Statement 1: The rate of return that investors require from Andronicus should reflect the risk that the fund managers will not consistently capture positive abnormal returns from the anomalies they have identified.

Statement 2: Arbitrage trading is unlikely to bring about fully efficient prices because Andronicus and other arbitrageurs will not trade if the gains to be captured are less than their transactions costs.

Are Rutherford’s statements correct?

 

Statement 1

Statement 2

 

A)                                        Correct  Correct

B)                                        Correct  Incorrect

C)                                        Incorrect       Correct

D)                                        Incorrect       Incorrect


2.Which of the following statements best describes the limits of arbitrage in correcting market anomalies?

A)   When fundamentals indicate that a stock is overvalued or undervalued, trading based on this information will be immediately profitable.

B)   There is no limitation to arbitrage in correcting anomalies because pairs trading eliminates any risk from stock-specific factors.

C)   There is no limitation to arbitrage in correcting market anomalies because it is a riskless trading activity and once there is a mispricing it will be exploited to its fullest.

D)   Arbitrage is not always riskless as was shown during the internet stock bubble of the 1990s, when traders were short a stock and had to cover their positions at a much higher takeover price.


3.Which of the following statements about arbitrage and market anomalies is most accurate?

A)   Investors of the funds that arbitrageurs and traders use are generally too patient and fail to remove funds in a timely manner when trades go against them.

B)   Arbitrageurs have more capital at their disposal than they require enabling them to pursue any security mispricing.

C)   If an arbitrageur correctly identifies relative mispricings of similar stocks the correction will take place immediately in the marketplace.

D)   In pairs trading, where an arbitrageur purchases the underpriced security and shorts the overpriced security, stock-specific risk remains.


4.Which of the following limits the ability of arbitrage to correct anomalies?

A)   Arbitrage is a relatively riskless activity, which has led to consistently reduced profits for many arbitrageurs, thereby reducing their interest in correcting market anomalies.

B)   There is no limitation of arbitrage in correcting anomalies because arbitrageurs will use their capital to pursue any trade, attractive or not, to eliminate the mispricing.

C)   There is no guarantee that even correctly identified relative mispricings of similar stocks will be corrected in the near term.

D)   Arbitrageurs are sophisticated traders but their short supply precludes the correction of market anomalies.


5.At a recent seminar on Capital Market Efficiency, David Thorngate, a seasoned arbitrageur wanted to dispel the notion that all arbitrage trades are successful. During his speech, he made the following statements regarding arbitrage and the ability of arbitrageurs to correct market anomalies:

Statement 1: There are limits on the ability of arbitrage to bring about efficient prices. Arbitrage is frequently not riskless. Just because fundamentals indicate that one stock is undervalued or overvalued relative to another does not mean that trading on this information will be profitable.

Statement 2: Even in "pairs trading," where an arbitrageur buys the underpriced security and shorts the overpriced security, significant risk from stock-specific factors remains. So, there is no guarantee that even correctly identified relative mispricings of similar stocks will be corrected in the near term.

Are Statement 1 and Statement 2 as made by Thorngate correct?

 

Statement 1

Statement 2

 

A)                                        Incorrect       Correct

B)                                        Incorrect       Incorrect

C)                                        Correct  Incorrect

D)                                        Correct  Correct

答案和详解如下:

1.June Rutherford is preparing a research report on Andronicus Fund, an offshore hedge fund that specializes in identifying market pricing inefficiencies and profiting from the arbitrage opportunities they present. Rutherford includes these statements in her report:

Statement 1: The rate of return that investors require from Andronicus should reflect the risk that the fund managers will not consistently capture positive abnormal returns from the anomalies they have identified.

Statement 2: Arbitrage trading is unlikely to bring about fully efficient prices because Andronicus and other arbitrageurs will not trade if the gains to be captured are less than their transactions costs.

Are Rutherford’s statements correct?

 

Statement 1

Statement 2

 

A)                                        Correct  Correct

B)                                        Correct  Incorrect

C)                                        Incorrect       Correct

D)                                        Incorrect       Incorrect

The correct answer was A)

Both of Rutherford’s statements are correct. The required rate of return from a strategy that takes advantage of pricing anomalies should include a premium for strategy risk. Market prices can remain less than perfectly efficient if the transactions costs of the arbitrage trades that would force them closer to efficient prices are greater than the gains that the trades offer.


2.Which of the following statements best describes the limits of arbitrage in correcting market anomalies?

A)   When fundamentals indicate that a stock is overvalued or undervalued, trading based on this information will be immediately profitable.

B)   There is no limitation to arbitrage in correcting anomalies because pairs trading eliminates any risk from stock-specific factors.

C)   There is no limitation to arbitrage in correcting market anomalies because it is a riskless trading activity and once there is a mispricing it will be exploited to its fullest.

D)   Arbitrage is not always riskless as was shown during the internet stock bubble of the 1990s, when traders were short a stock and had to cover their positions at a much higher takeover price.

The correct answer was D)

There are limits on the process of arbitrage to bring about efficient prices. Arbitrage is frequently not riskless. Just because fundamentals indicate that one stock is overpriced relative to another, or absolutely over or underpriced doesn’t mean that trading based on this information will be immediately profitable. One risk with shorting overvalued stocks during the internet stock bubble of the late 90s was that a stock a trader sold short would be taken over at a significantly higher price. The fact that the acquiring firm paid too much for shares offers no solace to short sellers who have to cover their positions at the takeover price.


3.Which of the following statements about arbitrage and market anomalies is most accurate?

A)   Investors of the funds that arbitrageurs and traders use are generally too patient and fail to remove funds in a timely manner when trades go against them.

B)   Arbitrageurs have more capital at their disposal than they require enabling them to pursue any security mispricing.

C)   If an arbitrageur correctly identifies relative mispricings of similar stocks the correction will take place immediately in the marketplace.

D)   In pairs trading, where an arbitrageur purchases the underpriced security and shorts the overpriced security, stock-specific risk remains.

The correct answer was D)

Even in pairs trading, where an arbitrageur buys the underpriced security and shorts the overpriced security, significant risk from stock-specific factors remains.


4.Which of the following limits the ability of arbitrage to correct anomalies?

A)   Arbitrage is a relatively riskless activity, which has led to consistently reduced profits for many arbitrageurs, thereby reducing their interest in correcting market anomalies.

B)   There is no limitation of arbitrage in correcting anomalies because arbitrageurs will use their capital to pursue any trade, attractive or not, to eliminate the mispricing.

C)   There is no guarantee that even correctly identified relative mispricings of similar stocks will be corrected in the near term.

D)   Arbitrageurs are sophisticated traders but their short supply precludes the correction of market anomalies.

The correct answer was C)

There is no guarantee that even correctly identified relative mispricings of similar stocks will be corrected in the near term. Investors of the funds that arbitrageurs and traders use can be notoriously impatient, removing funds when trades go against them or if results are not consistently good. Since capital is limited, in periods where there are many apparent mispricings, arbitrageurs will direct capital only to pursue the most attractive trades, leaving other mispricings unexploited.


5.At a recent seminar on Capital Market Efficiency, David Thorngate, a seasoned arbitrageur wanted to dispel the notion that all arbitrage trades are successful. During his speech, he made the following statements regarding arbitrage and the ability of arbitrageurs to correct market anomalies:

Statement 1: There are limits on the ability of arbitrage to bring about efficient prices. Arbitrage is frequently not riskless. Just because fundamentals indicate that one stock is undervalued or overvalued relative to another does not mean that trading on this information will be profitable.

Statement 2: Even in "pairs trading," where an arbitrageur buys the underpriced security and shorts the overpriced security, significant risk from stock-specific factors remains. So, there is no guarantee that even correctly identified relative mispricings of similar stocks will be corrected in the near term.

Are Statement 1 and Statement 2 as made by Thorngate correct?

 

Statement 1

Statement 2

 

A)                                        Incorrect       Correct

B)                                        Incorrect       Incorrect

C)                                        Correct  Incorrect

D)                                        Correct  Correct

The correct answer was D)

There are limits on the ability of arbitrage to bring about efficient prices. Arbitrage is frequently risky. Just because fundamentals indicate that one stock is overpriced relative to another, or absolutely over or underpriced, doesn’t mean that trading based on this information will be profitable.

Even in pairs trading, where an arbitrageur buys the underpriced security and shorts the overpriced security, significant risk from stock-specific factors remains. There is no guarantee that even correctly identified relative mispricings of similar stocks will be corrected in the near term.

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