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Market Efficiency

Professor Beason. This set of notes contains information about: Market...
Course

Investments: Debt, Equity And Derivatives (FIN3144)

11 Documents
Students shared 11 documents in this course
Academic year: 2022/2023
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Virginia Polytechnic Institute and State University

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Market Efficiency

● Market efficiency refers to the extent to which prices reflect all available information about an asset. ● A market is considered efficient if prices reflect all relevant information about an asset and are not influenced by external factors or biases. ● There are three levels of market efficiency: weak form, semi-strong form, and strong form. ○ Weak form efficiency means that past prices and returns on an asset cannot be used to predict future prices and returns. ○ Semi-strong form efficiency means that all publicly available information is reflected in the price of an asset. ○ Strong form efficiency means that all information, including insider information, is reflected in the price of an asset. ● The efficient market hypothesis (EMH) is a theory that proposes that financial markets are efficient, meaning that prices reflect all available information and it is impossible to consistently outperform the market.

Practice Problems:

  1. Which of the following statements is true about market efficiency? ● a. A market is efficient if prices reflect all relevant information about an asset and are not influenced by external factors or biases. ● b. A market is efficient if prices reflect all available information about an asset and are influenced by external factors or biases. ● c. A market is efficient if prices do not reflect all available information about an asset and are not influenced by external factors or biases. ● d. A market is efficient if prices do not reflect all relevant information about an asset and are influenced by external factors or biases.

Answer: a. A market is efficient if prices reflect all relevant information about an asset and are not influenced by external factors or biases.

  1. Which of the following is NOT a level of market efficiency? ● a. Weak form efficiency

● b. Semi-strong form efficiency ● c. Strong form efficiency ● d. Ultra-strong form efficiency

Answer: d. Ultra-strong form efficiency

Behavioral Finance

● Behavioral finance is a field of study that combines psychology and finance in order to understand why people make financial decisions and how those decisions can differ from what is predicted by traditional economic models. ● Behavioral finance helps to explain why people may not always act in their own best interests when it comes to financial decision-making. ● Some of the key concepts in behavioral finance include: ○ Anchoring bias, which refers to the tendency to rely too heavily on the first piece of information encountered when making a decision. ○ framing bias, which refers to the way in which the same information can be presented differently and affect decision-making. ○ overconfidence bias, which refers to an excessive belief in one's own abilities or judgments. ○ loss aversion, which refers to the tendency to strongly prefer avoiding losses over acquiring gains. ○ herding behavior, which refers to the tendency to follow the actions of others without fully considering their own independent judgment.

Practice Problems:

  1. Which of the following is NOT a concept in behavioral finance? ● a. Anchoring bias ● b. framing bias ● c. overconfidence bias ● d. loss aversion ● e. traditional economics

Answer: e. traditional economics

Answer: The expected return of the stock according to the CAPM is 16%. The formula for the CAPM is: expected return = risk-free rate + (beta x (market return - risk-free rate)). Plugging in the values: expected return = 4% + (2 x (12% - 4%)) = 16%. ● Diversification ● Diversification is a risk management strategy that involves investing in a variety of assets in order to spread risk and potentially reduce the impact of negative returns on a portfolio. ● Diversification can be achieved through a variety of means, such as investing in different asset classes (e., stocks, bonds, real estate), investing in different sectors (e., technology, healthcare, energy), or investing in different geographic regions. ● The idea behind diversification is that if one asset in the portfolio underperforms, the other assets may still perform well, which can help to mitigate overall portfolio risk. ● It is important to note that diversification does not guarantee a profit or protect against loss, but it can potentially reduce the overall risk of a portfolio.

Practice Problems:

  1. An investor has a portfolio that consists solely of stocks in the healthcare sector. Which of the following would be an example of diversifying their portfolio? ● a. Adding stocks from the technology sector ● b. Adding stocks from the energy sector ● c. Adding bonds ● d. All of the above

Answer: d. All of the above. Adding stocks from different sectors (such as technology and energy) and adding bonds would both be ways to diversify the portfolio and potentially reduce risk.

  1. An investor has a portfolio that consists of stocks in the healthcare sector and bonds. Which of the following would NOT be an example of further diversifying their portfolio? ● a. Adding stocks from the technology sector ● b. Adding real estate investment trusts (REITs) ● c. Adding stocks from the energy sector

● d. Adding more bonds

Answer: d. Adding more bonds. While adding bonds is a way to diversify a portfolio, the investor already has bonds in their portfolio. Adding stocks from different sectors (such as technology and energy) or adding real estate investment trusts (REITs) would be ways to further diversify the portfolio.

●

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Market Efficiency

Course: Investments: Debt, Equity And Derivatives (FIN3144)

11 Documents
Students shared 11 documents in this course

University: Virginia Polytechnic Institute and State University

Was this document helpful?
Market Efficiency
●Market efficiency refers to the extent to which prices reflect all available
information about an asset.
●A market is considered efficient if prices reflect all relevant information about an
asset and are not influenced by external factors or biases.
●There are three levels of market efficiency: weak form, semi-strong form, and
strong form.
○Weak form efficiency means that past prices and returns on an asset
cannot be used to predict future prices and returns.
○Semi-strong form efficiency means that all publicly available information is
reflected in the price of an asset.
○Strong form efficiency means that all information, including insider
information, is reflected in the price of an asset.
●The efficient market hypothesis (EMH) is a theory that proposes that financial
markets are efficient, meaning that prices reflect all available information and it is
impossible to consistently outperform the market.
Practice Problems:
1. Which of the following statements is true about market efficiency?
●a. A market is efficient if prices reflect all relevant information about an asset and
are not influenced by external factors or biases.
●b. A market is efficient if prices reflect all available information about an asset
and are influenced by external factors or biases.
●c. A market is efficient if prices do not reflect all available information about an
asset and are not influenced by external factors or biases.
●d. A market is efficient if prices do not reflect all relevant information about an
asset and are influenced by external factors or biases.
Answer: a. A market is efficient if prices reflect all relevant information about an asset
and are not influenced by external factors or biases.
2. Which of the following is NOT a level of market efficiency?
●a. Weak form efficiency

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