Review_session_for_Prelim1_Cen

Review_session_for_Prelim1_Cen - Review session for First...

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Review session for First Prelim AEM 4280
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Rational Market Theory: • prices are always right (price = value) • investors are rational • arbitrageurs correct mispricing Behavioral Finance: • prices are sometimes wrong • this is often due to investor irrationality – people make systematic errors • there is limit to arbitrage Price = Value
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Components in Course so far Market Efficiency 3 forms of market efficiency Limits to Arbitrage Short selling constraint Mechanics of Valuation Models Free Cash Flow Models Residual Income Models Discount Dividend Models Pro Forma Statements & Financial Ratios
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Three Forms Of Market Efficiency   Weak Form Financial asset (stock) prices incorporate  all  historical information  into current prices. Past stock price changes cannot help you  predict future price changes.   Semi-strong  Form Stock prices incorporate  all publicly available   information (historical and current). Information in an SEC filing is incorporated into  a stock price as soon as it is made public.   Strong Form Stock prices incorporate   all  information,  private as well as public. Prices react as soon as new information is  generated.
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Implications Of Semi-Strong Form Efficiency 500, even before taking account of expenses. “Superstar” investors (Warren Buffett, Peter Lynch) are the exception rather than the norm. Other tests show prices react efficiently to new  information. Studies also find that purely accounting rule  changes that do not affect cash flow have no  impact on stock prices.
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Evidence Against Semi- strong Form Efficiency Small firm  effect Small firms out-perform large especially in  January (January effect). Temporal  anomalies January effect (all firms), Monday effect   Value versus  glamour  stocks High book-to-market (value) stocks out- perform low book-to-market (glamour)  stocks. Many people feel that “bubbles” form quite frequently in  financial asset prices: Japanese stock prices late 1980s, NASDAQ prices through March 2000.
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Law of One Price The Law of One Price (LOOP) states that identical securities – i.e., securities with identical cash flows - must have identical prices Corollary : a security with higher future cash flows should have a higher price • It is a fundamental law in modern finance theory – If it is violated, arbitraguers are supposed to profit from the mispricing – It doesn’t depend on models of cash flow or discount rate
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Switch Trade IF price is right, then market value of Royal Dutch should always equal 1.5 times the market value of Shell. Identical securities must sell at the same
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Review_session_for_Prelim1_Cen - Review session for First...

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