Q1 Explain the Efficient Market Theory in and what are major misconceptions about this theory?
Answer:
The EMH theory is concerned with speed with which information effects the prices of securities. As per the study carried out technical analyst it was observed that information is slowly incorporated in the price and it provides an opportunity to earn excess profit. However, once the information is incorporated then investor can not earn this excess profit.
Level of Market Efficiency: That price reflects all available information, the highest order of market efficiency. According to FAMA, there exist three levels of market efficiency:-
✓ Weak form efficiency– Price reflect all information found in the record of past prices and volumes.
✓ Semi – Strong efficiency – Price reflect not only all information found in the record of past prices and volumes but also all other publicly available information.
✓ Strong form efficiency – Price reflect all available information public as well as private.
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Q2 Explain the different challenges to Efficient Market Theory.
Answer:
Information inadequacy – Information is neither freely available nor rapidly transmitted to all participants in the stock market. There is a calculated attempt by many companies to circulate misinformation. Other challenges are as follows:
(a) Limited information processing capabilities –
✓ Human information processing capabilities are sharply limited.
✓ According to Herbert Simon every human organism lives in an environment which generates millions of new bits of information every second but the bottle necks of the perceptual apparatus does not admit more than thousand bits per second sand possibly much less.
✓ David Dreman maintained that under conditions of anxiety and uncertainty, with a vast interacting information grid, the market can become a giant.
(b) Irrational Behavior –
✓ It is generally believed that investors’ rationality will ensure a close correspondence between market prices and intrinsic values. But in practice this is not true.
✓ J. M. Keynes argued that all sorts of consideration enter into the market valuation which is in no way relevant to the prospective yield.
✓ This was confirmed by L. C. Gupta who found that the market evaluation processes work haphazardly almost like a blind man firinga gun.
✓ The market seems to function largely on hit or miss tactics rather than on the basis of informed beliefs about the long term prospects of individual enterprises.
(c) Monopolistic Influence –
✓ A market is regarded as highly competitive. No single buyer or seller is supposed to have undue influence over prices.
✓ In practice, powerful institutions and big operators wield great influence over the market.
✓ The monopolistic power enjoyed by them diminishes the competitiveness of the market.
Q3 Explain the Empirical Evidence of Weak form Efficient Market Theory:
Answer:
Three types of tests have been employed to empirically verify the weak form of Efficient Market Theory- Serial Correlation Test, Run Test and Filter Rule Test.
(a) Serial Correlation Test: To test for randomness in stock price changes, one has to look at serial correlation. For this purpose, price change in one period has to be correlated with price change in some other period. Price changes are considered to be serially independent. Serial correlation studies employing different stocks, different time lags and different time period have been conducted to detect serial correlation but no significant serial correlation could be discovered. These studies were carried on short term trends viz. daily, weekly, fortnightly and monthly and not in long term trends in stock prices as in such cases. Stock prices tend to move upwards.
(b) Run Test: Given a series of stock price changes each price change is designated + if it represents an increase and – if it represents a decrease. The resulting series may be
- ,+, - , -, - , +, +. A run occurs when there is no difference between the sign of two changes. When the sign of change differs, the run ends and new run begins.
To test a series of price change for independence, the number of runs in that series is compared with a number of runs in a purely random series of the size and in the process determines whether it is statistically different. By and large, the result of these studies strongly supports the Random Walk Model.
(c) Filter Rules Test: If the price of stock increases by at least N% buy and hold it until its price decreases by at least N% from a subsequent high. When the price decreases at least N% or more, sell it. If the behavior of stock price changes is random, filter rules should not apply in such a buy and hold strategy. By and large, studies suggest that filter rules do not out perform a single buy and hold strategy particular after considering commission on transaction.
Q3 Explain in detail the Dow Jones Theory?
Answer:
Dow Jones Theory is the Bible for traders, who want to trade in stock market. Dow Jones Theory has been established by Charles Dow.
This most popular theory is regarding the behavior of stock market prices according to Charles Dow
“The market is always considered as having three movements, all going at the same time.
1) Daily Fluctuations – This is the narrow movement from day to day.
2) Secondary movement– This is the short swing running from two weeks to a month or more and
3) Primary movement – This is the main movement, covering at least 4 years in its duration.
1. Primary Movements:
They reflect the trend of the stock market from last one year to four years or sometime seven more. On study of the long range behavior of market prices, it has been empirically observed that share prices go though definite phases, Where the prices are either consistently rising or falling. These phases are popularly known as bull and bear phases. So long as each successive rally or price advance reaches a higher level than the one before it, and each secondary reaction, or price decline, stops at a higher level that the previous one, primary trend is up. This is called a “Bull Market”. When each intermediate decline carries prices to successively lower levels and each intervening rally fails to bring them back up to the top level of the preceding rally, the trend is down. This is called a “Bear Market”. Popularly Bull market is known by formation of “Higher Tops and Higher Bottoms”, and Bear Market is known by formation of “Lower Tops and Lower Bottoms”.
2. Secondary Movements:
The secondary trends are intermediates declines or “corrective phase”, which occur in bull market and intermediate rallies which occur in bear markets. Normally they last from 4 weeks to 13 weeks. Generally it retraces 33.33% or 66.66% of primary movements. It is imperative to note here that secondary movements are always in opposite direction of the primary movements.
3. Daily Movements:
They are irregular fluctuations, which occur every day in the market. These fluctuations are without any definite trend. Thus if the daily share market price index for a few months is plotted on the graph it will show both upward and downward fluctuations. These fluctuations are on account of speculative factors.
The theory advocates behavior of stock price is 90% psychological and 10% logical. The behavior is contingent upon the mood of the investors at large and this behavior can fairly estimated by analysing various price movements and volume of transactions.
Q4 Explain Elliot Wave Theory of Technical Analysis?
Answer:
The Elliott Wave Theory is named after Ralph Nelson Elliott. Inspired by the Dow Theory and by observations found throughout nature, Elliott concluded that the movement of the stock market could be predicted by observing and identifying a repetitive pattern of waves. In fact, Elliott believed that all of man's activities, not just the stock market, were influenced by these identifiable series of waves.
Simplifying Elliott Wave Analysis
Elliott Wave analysis is a collection of complex techniques. Approximately 60 percent of these techniques are clear and easy to use. The other 40 are difficult to identify, especially for the beginner. The practical and conservative approach is to use the 60 percent that are clear.
When the analysis is not clear, why not find another market conforming to an Elliott Wave pattern that is easier to identify?
From years of fighting this battle, we have come up with the following practical approach to using Elliott Wave principles in trading.
The whole theory of Elliott Wave can be classified into two parts:
• Impulse patterns
• Corrective patterns
Q5 Mention the various types of techniques used in economic analysis.
Answer:
Some of the techniques used for economic analysis are:
✓ Anticipatory Surveys: They help investors to form an opinion about the future state of the economy. It incorporates expert opinion on construction activities, expenditure on plant and machinery, levels of inventory– all having a definite bearing on economic activities. Also future spending habits of consumers are taken into account.
✓ Barometer/Indicator Approach: Various indicators are used to find out how the economy shall perform in the future. The indicators have been classified as under:
o Leading Indicators: They lead the economic activity in terms of their outcome. They relate to the time series data of the variables that reach high/low points in advance of economic activity.
o Roughly Coincidental Indicators: They reach their peaks and troughs at approximately the same in the economy.
o Lagging Indicators: They are time series data of variables that lag behind in their consequences vis-a- vis the economy. They reach their turning points after the economy has reached its own already.
o All these approaches suggest direction of change in the aggregate economic activity but nothing about its magnitude.
✓ Economic Model Building Approach: In this approach, a precise and clear relationship between dependent and independent variables is determined. GNP model building or sectoral analysis is
used in practice through the use of national accounting framework.
Q6 Mention the factors affecting Economic Analysis
Answer:
Some of the economy wide factors are as under:
(a) Growth Rates of National Income and Related Measures
(b) Growth Rates of Industrial Sector
(c) Inflation
(d) Monsoon
a. Correlation & Regression Analysis: Simple regression is used when inter relationship covers two variables. For more than two variables, multiple regression analysis is followed.
Answer:
(a) Product Life-Cycle;
(b) Demand Supply Gap;
(c) Barriers to Entry;
(d) Government Attitude;
(e) State of Competition in the Industry;
(f) Cost Conditions and Profitability and
(g) Technology and Research.
Q6 Mention the various types of techniques used in company analysis.
Answer:
a. Correlation & Regression Analysis: Simple regression is used when inter relationship covers two variables. For more than two variables, multiple regression analysis is followed.
b. Trend Analysis: The relationship of one variable is tested over time using regression analysis. It gives an insight to the historical behavior of the variable.
c. Decision Tree Analysis: In decision tree analysis, the decision is taken sequentially with probabilities attached to each sequence. To obtain the probability of final outcome, various sequential decisions are given along with probabilities, then probabilities of each sequence is to be multiplied and then summed up.
Q7 Explain Various types of Charts
Solution:
(i) Bar Chart : In a bar chart, a vertical line (bar) represents the lowest to the highest price, with a short horizontal line protruding from the bar representing the closing price for the period.
(ii) Line Chart: In a line chart, lines are used to connect successive day’s prices. The closing price for each period is plotted as a point. These points are joined by a line to form the chart. The period may be a day, a week or a month.
(iii) Point and Figure Chart: Point and Figure charts are more complex than line or bar charts. They are used to detect reversals in a trend.
Q8 What is Odd Lot Theory
Solution:
✓ This theory is a contrary- opinion theory.
✓ It assumes that the average person is usually wrong and that a wise course of action is to pursue strategies contrary to popular opinion.
✓ The odd-lot theory is used primarily to predict tops in bull markets, but also to predict revers alsin individual securities.
Q9 Discuss the Buy and Sell Signals provided by the moving averages
Solution:
1. Buy Signal
(i) Stock price line rise through the moving average line when graph of the moving average line is flattering out.
(ii) Stock price line falls below moving average line which is rising.
(iii) Stock price line which is above moving average line falls but begins to rise again before reaching the moving average line
2. Sell Signal
(i) Stock price line falls through moving average line when graph of the moving average line is flattering out.
(ii) Stock price line rises above moving average line which is falling.
(iii) Stock price line which is slow moving average line rises but begins to fall again before reaching the moving average line.
Corporate actions.
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