Equity Investments【Reading 49】Sample capital, efficient, currently, 2012

Gypsy

An efficient capital market:

A) fully reflects all of the information currently available about a given security, excluding risk.

B) fully reflects all of the information currently available about a given security, including risk.

C) does not fully reflect all of the information currently available about a given security, including risk.

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An efficient capital market fully reflects all of the information currently available about a given security, including risk.

hinsafdar

The idea that uninformed traders, when faced with unclear information, observe the actions of informed traders to make decisions, is referred to as:

A) information cascades.

B) herding behavior.

C) narrow framing.

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“Information cascades” refers to uninformed traders watching the actions of informed traders when making investment decisions. Herding behavior is when trading occurs in clusters, not necessarily driven by information. Narrow framing refers to investors viewing events in isolation.

hinsafdar

In behavioral finance theory, how is loss aversion most accurately defined? For gains and losses of equal amounts, investors:

A) dislike losses more than they like gains.

B) like gains more than they dislike losses.

C) dislike for losses and like for gains are proportionate.

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Behavioral finance proposes that investors are loss averse. Loss aversion means investors dislike losses more than they like gains of the same amount.

hinsafdar

Investor overreaction that has been documented in securities markets is most likely attributable to investors exhibiting:

A) risk aversion.

B) loss aversion.

C) conservatism.

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Loss aversion refers to the tendency for investors to dislike downside risks more than upside risks creating asymmetrical risk preferences. This dislike of losses may be a cause of investor overreaction. The standard economic notion of risk aversion assumes symmetric risk preferences. Conservatism is the behavioral bias whereby investors react slowly to new information and is unlikely to cause overreaction.

hinsafdar

An investor who is more risk averse with respect to potential negative outcomes than potential positive outcomes most likely exhibits:

A) gambler’s fallacy.

B) mental accounting.

C) loss aversion.

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Loss aversion is exhibited by an investor who dislikes a loss more than he likes an equal gain. That is, the investor’s risk preferences are asymmetric. Gambler’s fallacy is the belief that recent past outcomes affect the probability of future outcomes. Mental accounting refers to mentally classifying investments in separate accounts rather than considering them from a portfolio perspective.

hinsafdar

If the momentum effect persists over time, it would provide evidence against which of the following forms of market efficiency?

A) Weak form only.

B) Semistrong form only.

C) Both weak form and semistrong form.

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The momentum effect suggests it is possible to earn abnormal returns using market data. All three forms of market efficiency (weak form, semistrong form, and strong form) assume that market prices fully reflect market data.

hinsafdar

Which of the following statements best describes the overreaction effect?

A) High returns over a one-year period are followed by high returns over the following year.

B) Low returns over a three-year period are followed by high returns over the following three years.

C) High returns over a one-year period are followed by low returns over the following three years.

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The overreaction effect refers to stocks with poor returns over three to five-year periods that had higher subsequent performance than stocks with high returns in the prior period. The result is attributed to overreaction in stock prices that reverses over longer periods of time. Stocks with high previous short-term returns that have high subsequent returns show a momentum effect.

hinsafdar

Which of the following would provide evidence against the semistrong form of the efficient market theory?

A) Low P/E stocks tend to have positive abnormal returns over the long run.

B) Trend analysis is worthless in determining stock prices.

C) All investors have learned to exploit signals related to future performance.

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P/E information is publicly available information and therefore this test relates to the semistrong-form EMH. Trend analysis is based on historical information and therefore relates to the weak-form EMH. In an efficient market one would expect 50% of pension fund managers to do better than average and 50% of pension fund managers to do worse than average. If all investors exploit the same information no excess returns are possible.

hinsafdar

The opportunity to take advantage of the downward pressure on stock prices that result from end-of-the-year tax selling is known as the:

A) end-of-the-year effect.

B) January anomaly.

C) end-of-the-year anomaly.

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The January Anomaly is most likely the result of tax induced trading at year end. An investor can profit by buying stocks in December and selling them during the first week in January.

hinsafdar

David Farrington is an analyst at Farrington Capital Management. He is aware that many people believe that the capital markets are fully efficient. However, he is not convinced and would like to disprove this claim. Which of the following statements would support Farrington in his effort to demonstrate the limitations to fully efficient markets?

A) Stock prices adjust to their new efficient levels within hours of the release of new information.

B) Technical analysis has been rendered useless by many academics who have shown that analyzing market trends, past volume and trading data will not lead to abnormal returns.

C) Processing new information entails costs and takes at least some time, so security prices are not always immediately affected.

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If market prices are efficient there are no returns to the time and effort spent on fundamental analysis. But if no time and effort is spent on fundamental analysis there is no process for making market prices efficient. To resolve this apparent conundrum one can look to the time lag between the release of new value-relevant information and the adjustment of market prices to their new efficient levels. Processing new information entails costs and takes at least some time, which is a limitation of fully efficient markets.