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We have seen that over long periods, stock investments

have tended to substantially outperform bond


investments, However, it is common to observe investors
with long horizons holding entirely bonds. Are such
investors irrational?
No, stocks are riskier. Some investors are highly risk
averse, and the extra possible return doesn't attract them
relative to the extra risk.
Explain why a characteristic of an efficent market is that
investments in the market have zero NPVs.
On average, the only return that is earned is the required
returninvestors buy assets with returns in excess of the
required return (positive NPV), bidding up the price and
thus causing the return to fall to the required return (zero
NPV); investors sell assets with returns less than the
required return (negative NPV), driving the price lower
and thus causing the return to rise to the required return
(zero NPV).
A stock market analyst is able to identify mispriced
stocks by comparing the average price for the last 10 days
to the average price for the last 60 days. If this is true,
what do you know about the market?
The market is not weak form efficient.
If a market is semistrong form efficient, is it also weak
form efficient? Explain.
Yes, historical information is also public information; weak
form efficiency is a subset of semi-strong form efficiency.

What are the implications of the efficient markets


hypothesis for investors who buy and sell stock in an
attempt to "beat the market"?
Ignoring trading costs, on average, such investors merely
earn what the market offers; stock investments all have a
zero NPV. If trading costs exist, then these investors lose by
the amount of the costs.
Rationality imagine all investors rational, when new
information is released in the market place, all investors will
adjust their estimates of stock prices in rational way. For
example, while FCCs price $40, no one would now transact at
that price. Anyone interested in selling would sell only at a price
at least $45 (=$40 + 5). And anyone interested in buying would
now be willing to pay up to $5. in other words, the price would
rise by $5. Thus, perhaps it is too much to ask that all investors
behave rationally, but the market will still be efficient if the
following scenario holds.
Independent Deviations from Rationality due to
emotional resistance, investors could just as easily react to new
information in a pessimistic manner. If investors were primarily
this type, the stock price would likely rise less than market
efficiency would predict. But suppose that about as many
individuals were irrationally optimistic as were irrationally
pessimistic. Prices would likely rise in a manner consistent with
market efficiency, even though most investors would be classified
as less than fully rational. Thus, market efficiency does not
require rational individuals only countervailing irrationalities.
Arbitrage Imagine a world with two types of individuals: the
irrational amateurs and the rational professional. Arbitrage is the
word generates profit from the simultaneous purchase and sale
of different, but substitute, securities. If the arbitrage of
professionals dominates the speculation of amateurs, markets
would still be efficient.

What are stock market anomalies with the context of an


efficient market?
Limits to arbitrage behavioral finance suggest that there
are limits to arbitrage. That is, an investors buying the
overpriced assets and selling the underpriced assets does not
have a sure thing. Deviations from parity could actually increase
in the short run, implying losses for the arbitrageur.
Earnings surprises common sense suggest that prices
should rise when earnings are reported to be higher than
expected and prices should fall when the reverse occurs.
However, market efficiency implies that prices will adjust
immediately to the announcement, while behavioral finance
would predict another pattern. Prices adjust slowly to the earning
announcements, why do prices adjust slowly? Behavioral finance
suggests that investors exhibit conservatism because they are
slow to adjust to the information contained in the
announcements.
Size in 1981, two important papers presented evidence that
in the US, the returns on stocks with small market capitalizations
were greater than the returns on stock with large market
capitalizations over most of the 20th century.
Value versus growth a number of papers have argued that
stocks with high book value to stock price ratios and/or
high earnings to price ratios (generally called value stocks)
outperform stocks with low ratios (growth stock). Value stocks
have outperformed growth stocks in each of market researched,
but further research is needed.
Crashes and bubbles the stock market crash of October 19.
1987. The market dropped between 20% and 25% on Monday
following a weekend. A drop magnitude for no apparent reasons
is not consistent with market efficiency. Perhaps stock market
crashes are evidence consistence with bubble theory of
speculative markets. That is, security prices sometimes move
wildly above their true values. Eventually, prices fall back to their
original level, causing great losses for investors.