7. Why are the following “effects” considered efficient market anomalies? Are there rational explanations for any of these effects?
a. P/E effect.
P/E effect can be considered as efficient market anomalies that can’t be explained by CAPM. If two firms have the same expected earnings, the riskier stock will sell at a lower price and lower P/E ratio. Thus the low P/E stock will have higher expected returns. P/E acts as a useful additional descriptor of risk, and will be associated with abnormal returns if the CAPM is used to establish benchmark performance.
CAMP does not account for all risks.
b. Book-to-market effect.
The book-to-market ratio is serving as a proxy for a risk factor that affects equilibrium expected returns and can’t be explained by CAMP. The firms with higher book-to-market ratios are riskier than these with lower ratios. Therefore, they have higher expected returns as compensations.
c. Momentum effect.
While the performance of individual stocks is highly unpredictable, portfolios of the bestperforming stocks in the recent past appear to outperform other stocks with enough reliability to offer profit opportunities. Thus, it appears that there is evidence of short- to intermediatehorizon price momentum in both the aggregate market and cross-sectionally. And subsequent correction of the overreaction leads to poor performance following good performance. The corrections mean that a run of positive returns eventually will tend to be followed by negative returns, leading to negative serial correlation over longer horizons. d. Small-firm effect.
The smaller-firm portfolios tend to be riskier. And even when returns are adjusted for risk using the CAPM, there is still a consistent premium for the smaller-sized portfolios. Smaller firms are generally viewed as risky compared to larger firms and perceived risk and return are positively correlated. Also, this may be due to the sample neglect problem. Databases contain stock returns from...
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