Chapter 7

Forecasting share price movements

True/False questions
1. F Secondary market liquidity means that the demand for and supply of shares has little
relevance to the movement in share prices.
2. F Fundamental analysis comprises two forms; the top-down approach and the bottom-up
approach. Analysts must choose either one or the other of these approaches.
. T !he top-down approach to fundamental analysis considers the impact of forecast chan"es
in a wide ran"e of economic variables on future share -market performance.
#. F !he economic performance of international economies has very little relevance to the
e$pected performance of the ma%ority of local companies listed in the share market.
&. T 'i"h levels of economic "rowth in developin" economies may not be sustainable in the
lon"-term and may well lead to upward wa"es and inflationary pressures.
(. F )han"es in forei"n currency e$chan"e rates principally affect the financial markets and
therefore will have little impact upon the share price of listed corporations.
*. F +ith the top-down approach to fundamental analysis, monetary policy actions of the
central bank are not considered as they are beyond the control of corporations.
-. T +a"e increases that are in e$cess of productivity increases may have a ne"ative impact on
the share market.
.. T !he bottom-up approach to fundamental analysis focuses on the use of financial ratio data
to forecast future company "rowth and profitability.
1/. T +ith the bottom-up approach to fundamental analysis, company ratio analysis should be
compared with companies in the same industry and over a three- to five -year period.
11. T 0ne of the inadequacies of the bottom-up approach to fundamental analysis is that
financial ratios "enerally reflect the past performance of a company.
12. F 1conomic fundamentals measure a corporation2s financial, operational and mana"ement
performance, stren"th and efficiency.
1. F 0ne of the features of the technical analysis approach to share price forecastin" is the
reliance on very sophisticated technical models of the macroeconomic environment.
1#. F 3ovin" -avera"es models are hi"hly fle$ible in that they allow considerable scope for an
analyst2s interpretation of the data and in the "eneration of buy and sell orders.
1&. T !he five-day movin" avera"e for the followin" data collected over a seven-day period is
4*.1/5 6ay 1, 4..2&; day 2, 4-.*&; day , 4-.2&; day #, 4*.&/; day &, 4*.//; day (, 4(.2&; day *,
4(.&/
1(. F Since all chartists are confronted with identical share price data, they should typically
identify identical patterns and "enerate identical buy and sell si"nals from that data.
1*. T 'i"h frequency tradin" uses special al"orithms in hi"h-speed super computers to analyse
data and make instantaneous investment decisions that impact upon share prices.
1-. T !he random walk hypothesis implies that the e$amination of past price movements
provides no useful information on the direction of future price movements.
1.. T +ithin the conte$t of the efficient market hypothesis, share markets are said to be
information -efficient if share prices ad%ust immediately to new information.
2/. F 7nder the stron" form efficiency test of the efficient market hypothesis, a fundamental
analyst should be able to make superior profits in the share market.
Essay questions
!he followin" su""ested answers incorporate the main points that should be reco"nised by a student.
An instructor should advise students of the depth of analysis and discussion that is required for a
particular question. For e$ample, an under"raduate student may only be required to briefly introduce
points, e$plain in their own words and provide an e$ample. 0n the other hand, a post-"raduate
student may be required to provide much "reater depth of analysis and discussion.
1. The top-down approach to fundamental analysis includes an analysis of the local economy in
which a company is situated plus the economies of ma!or trading partner countries and the
glo"al economy more generally. #hy would an investor "e interested in forecasting changes in
these economies$ %&' 7.1(
!he purpose of the top-down approach to fundamental analysis is to forecast the overall
economic environment in which corporations will operate over a ran"e of future plannin"
periods.
)han"es in economic performance may have si"nificant impacts on the performance of industry
sectors.
)han"es in industry sector performance will impact upon the performance of corporations
operatin" within that industry sector.
Forecast chan"es in the economic environment, industry sector performance and company
performance may be either positive or ne"ative.
An investor will consider restructurin" an investment portfolio havin" re"ard to the outcomes of
the top-down approach analysis.
!he top-down approach must include all macro issues that will impact economic performance.
!herefore it is necessary to look at both the local economy and international economies.
8nternational economic performance will have direct and consequential impacts on a local
economy.
). * funds manager is considering investment opportunities in China +ong ,ong and -apan.
.ata indicate the rate of economic growth over the past year as/
China 0.12 per cent
+ong ,ong 1.71 per cent
-apan ).)1 per cent
3ased on these data the funds manager concludes that the significantly stronger economic
growth in China represents much higher potential investment returns in the form of capital
growth on share investments. Critically analyse this conclusion. %&' 7.1(
Firstly, the data is historic, so an investor needs to reco"nise that future performance may be
different.
)hina is a lar"e e$porter to ma%or international economies. !here is a need to consider the impact
of lower economic "rowth in 7SA and 1urope on future e$port "rowth in )hina.
!here is a need to consider the various sources of the economic "rowth in these countries.
8s the "rowth bein" driven by increased consumer demand, or by a sur"e in business investment
in capital equipment9
Stron"er economic "rowth should be e$pected to improve the performance of companies
contributin" to that "rowth; however, there is a need to ascertain whether hi"h economic "rowth
is sustainable.
7nsustainable "rowth over the medium-to-lon"er-term may have si"nificant ne"ative impacts
such as a deterioration on the :0;, inflation, hi"her wa"es and interest rates.
!his could lead to an economic downturn.
!he investor needs to consider the impact of the hi"her economic performance on relative
e$chan"e rates <note5 )hina currently has a mana"ed e$chan"e rate=.
1ssentially the investor needs to know what is drivin" the economic "rowth and is it sustainable.
4. The "oard of directors of 3+5 3illiton &imited is concerned a"out changes in the e6change
rate "etween the *ustralian dollar and the 78 dollar. *nalyse this situation and discuss the
main impacts a change in e6change rates might have on the performance of 3+5 3illiton
&imited and its share price. %&' 7.1(
A corporation, such as :'; :illiton, that is an importer or e$porter of "oods or services will
usually enter into contracts denominated in a forei"n currency; for e$ample, if e$port contracts
are priced in 7S6 the level of profitability could be affected by forei"n e$chan"e risk.
An appreciation of the e$chan"e rate of the local currency a"ainst the 7S6 will result in lower
profits from the contract as the e$porter converts its 7S6 income back into its local currency at
the hi"her e$chan"e rate.
A depreciation of the local currency will increase the profits received on e$istin" contracts.
Also, a depreciation will lower the relative cost of e$ports and thus make them more price
competitive, with the potential for increased sales.
A depreciation in the local currency will, over time, push up the price of imports, and therefore
add to the cost of livin" and put upward pressure on the rate of inflation.
!he flow-on effects of the currency chan"e may result in the workforce seekin" to maintain its
standard of livin" by demandin" relative wa"e increases, thus pushin" up business costs.
!he central bank may attempt to dampen the inflationary impact of the weakenin" currency by
ti"htenin" monetary policy throu"h an increase in short-term interest rates.
8ncreased interest rates, which resulted from e$chan"e rate movements, will slow economic
"rowth.
Future profits would be squee>ed from both increased costs and hi"her interest rates.
9. +E8T* 8uper Fund controls over 411 "illion in investment assets for its :02 222 mem"ers.
+E8T* is currently reviewing the structure of its "alanced fund and analysing forecasts
prepared "y independent e6perts on interest rates the rate of inflation economic growth
the "usiness cycle and the performance of corporations. #ithin the conte6t of the top-down
approach to fundamental analysis +E8T* is particularly concerned a"out the effects of the
relationships "etween these varia"les on the value of the "alanced fund. *nalyse and write a
report for +E8T*. %&' 7.1(
!he ma%ority of businesses borrow funds, therefore a chan"e in interest rates represents a chan"e
in the cost of doin" business; for e$ample, if interest rates rise then the cost of funds will
increase. !his will have a ne"ative impact on cash flows, profitability and the share price.
8n this situation, the hi"her the debt to equity ratio, the "reater the impact.
!he central bank influences interest rates throu"h its monetary policy actions.
!he central bank increases short-term interest rates if it wishes to dampen economic "rowth and
lower inflation <increases in prices=.
!i"htenin" monetary policy <increased interest rates= will slow the business cycle and this will
have a ne"ative impact on future cash flows and earnin"s of a corporation.
)onversely, an easin" <lowerin"= of interest rates will stimulate business investment, economic
"rowth and increase corporate cash flows and earnin"s.
1. Evans and 5artners is an investment advisory firm that provides specialist investment
advice to its private clients. *s part of the investment decision process the senior
investment analysts at the firm apply the "ottom-up approach to the fundamental analysis
of share prices. This approach focuses on the analysis of accounting ratios and other
performance measures. %&' 7.)(
%a(E6plain why Evans and 5artners will use this type of analysis.
Fundamental analysis considers macro and micro fundamentals that impact upon future chan"es
in share prices; includes the bottom-up approach and the top-down approach.
!he bottom-up approach analyses the performance of specific corporations usin" accountin"
ratios and other or"anisation specific information.
Accountin" ratios focus on measures of a company2s financial and mana"ement performance,
stren"th and efficiency over specific periods.
An investor will calculate and compare the ratios of companies in the same industry.
!he investor will consider selectin" the shares of companies with the stron"est ratios for
inclusion in an investment portfolio.
An investor should consider the bottom-up approach within the conte$t of the top-down
approach.
%"( ;dentify and discuss si6 different accounting ratios that should "e included in a "ottom-up
approach model.
)urrent ratio?ratio of current assets to current liabilities
@iquid ratio?ratio of current assets, less inventory, to current liabilities, less bank overdraft
8nterest cover ratio?the number of times a firm2s financial commitments are covered by
earnin"s
1:8! to total funds ratio?the profits of a firm before allowin" for interest e$pense and ta$
payments divided by shareholders2 funds and borrowin"s
1:8! to lon"-term funds ratio?1:8! divided by total funds less short-term debt
Aeturn on equity?net income of a firm as a percenta"e of shareholders2 funds.
%c( ;dentify and discuss three other performance measures that may "e used.
1arnin"s per share ratio?earnin"s attributable to an ordinary share
;rice earnin"s ratio?the current share price divided by the earnin"s per share
;rice to net tan"ible assets ratio?the current share price relative to the firm2s net tan"ible assets.
:. 5erpetual &imited is a large funds manager within *ustralia. 5erpetual is preparing a
presentation to a new client on the investment approaches ta<en "y the company. 'ne
approach used "y 5erpetual is the "ottom-up approach to fundamental analysis. From past
e6perience 5erpetual <nows that the new client will as< a num"er of questions a"out the
"ottom-up approach. *ssume you wor< for 5erpetual and are required to answer these
questions. 5repare an answer relating to the main advantages and disadvantages of the
"ottom-up approach to fundamental analysis. %&' 7.)(
=ote/ points included in question 1 %a( would also "e included in this question
8nvestors are able to adopt the principals of modern portfolio theory and diversify away
unsystematic risk usin" the bottom-up approach to select a ran"e of stocks for a diversified
investment portfolio.
!he top-down approach provides insi"hts into which economies and industry sectors to invest,
while the bottom-up approach provides insi"hts into which stocks to select within the chosen
economies and industry sectors.
!he main problem with the bottom-up approach is that investors typically use historical data to
calculate the accountin" ratios. !his indicates past performance, but an investor really needs to
forecast future performance.
7. *n investor is evaluating the use of the "ottom-up approach and the top-down approach to
fundamental analysis. The investor wants to use the approach that will "est ena"le them to
structure a diversified share portfolio that will achieve specified income returns and capital
gains. #hich approach do you recommend the investor adopt$ %&' 7.1 and 7.)(
Fundamental analysis requires the adoption of both the top-down approach and the bottom-up
approach.
!he top-down approach analyses macro variables includin"5
o the rate of "rowth of ma%or international economies, and their "overnmentsB policy responses
to developments within those economies
o the e$chan"e rate between a domestic currency and the currencies of ma%or tradin" partners
and competitors
o interest rate movements
o the rate of "rowth of the economy
o developments in the current account of the balance of payments
o price rises, as measured by the rate of inflation
o the rate of "rowth in wa"es and productivity
o "overnment policy responses to developments in the above variables.
!he bottom-up approach considers factors that reflect or will impact upon the performance of
individual corporations and their share price, includin"5
o accountin" ratios, typically over the past to & years
o a comparison of the performance indicators with other similar firms in the same industry
o intelli"ence on chan"es in key mana"ement positions
o information on the corporate mission, and planned strate"ic directions of the company into
the future.
!he top-down approach identifies economies and industries that may provide profitable
investment opportunities in the future; the bottom-up approach identifies specific corporations
with the preferred economies and industry sectors that may represent stocks to incorporate in an
investment portfolio.
:oth approaches should be used to"ether.
>. *fter graduating from university you o"tain a position as a !unior !ournalist with a local
newspaper. * num"er of readers have made requests for information a"out technical
analysis. ?ou <now that technical analysis see<s to forecast and e6plain share price and
share-mar<et movements. ;n conceptual terms write a short article for the newspaper that
e6plains how the technical analysis approach to share price forecasting operates. %&' 7.4(
!echnical analysis seeks to e$plain and forecast share price movements on the basis of the past
behaviour of prices.
0ne underlyin" assumption of technical analysis is that markets are dominated at certain times
by a mass psycholo"y, and that over time, re"ular patterns in share price movements are evident.
As a share price pattern be"ins to emer"e, it is assumed that the historic pattern will re-emer"e in
full, as it did in the past.
!he emer"in" share price pattern formation is taken as bein" a pointer to the future path of the
future price series.
)hart patterns may be used to si"nal the timin" of the ad%ustment in stock prices and market
trends.
0ne of the ma%or claims made by some technical analysts is that they can pick the timin" of
market turnin" points.
0. &isted "elow are the close-of-"usiness share prices for the Commonwealth 3an< of
*ustralia &imited over the last 12 trading days/ %&' 7.4(
@1).1)
@11.7:
@97.49
@9).1)
@99.)1
@99.17
@91.>0
@92.27
@91.>0
@9).94
%a( Calculate a five-day moving average and plot on a graph.
.ay 5rice
@
.elete old
day 1
*dd new
day 1
8um of
days 1 - 1
Aoving
average
1 &2.12
2 &1.*(
#*.#
# #2.12
& ##.2& 2*.&. #*.&2
( ##.&* &2.12 ##.&* 2/./# #(./1
* #1.-. &1.*( #1.-. 22/.1* ##./
- #/./* #*.# #/./* 212../ #2.&-
. #1.-. #2.12 #1.-. 212.(* #2.&
1/ #2.# ##.2& #2.# 21/.-& #2.1*
Students should now plot the 3A prices and the actual share prices on a "raph
;lot the days on the C a$is and the share prices on the D a$is
)onsider the buyEsell decision rules
8s there enou"h data to make an informed decision9
%"( #hy might a technical analyst see< to plot moving averages$
!he analyst is creatin" a price series showin" price chan"es over time
!he technical analyst will seek to interpret the information that is evident within a price series
)onstruction of a movin" avera"e seeks to smooth out erratic price movements and reveal clear
price trends in the series
From this data the technical analyst will employ buy or sell decision rules
:uy when the actual price series cuts the 3A from below
:uy when the 3A series is risin" stron"ly and the price series cuts or touches the 3A from
above, but then moves back above the 3A after a few observations
Sell when the 3A flattens or declines after a steady rise, and the price series cuts the 3A from
above
Sell when the 3A series is in decline and the price series cuts or touches the 3A from below,
but then moves back beneath the 3A after a few observations.
%c( Becalculate the moving average using a simple weighted five-day moving average %show
your calculations(. #hat is the purpose and advantage of using this method$
8t may be ar"ued that the most recent data contains more valuable information and therefore
should be "iven a hi"her wei"htin".
.ay 5rice
@
5rice 6 #eight
@
#eighted total
@
#eighted A*
@
1 &2.12 &2.12 $ 1 F &2.12
2 &1.*( &1.*( $ 2 F 1/.&2
#*.# #*.# $ F 1#2./2
# #2.12 #2.12 $ # F 1(-.#-
& ##.2& ##.2& $ & F 221.2& (-*.. #&.-
( ##.&* Aecalculate?delete day 1
and add new last day
(*2.(& ##.-#
* #1.-. Aepeat above (&2./( #.#*
- #/./* Aepeat above (2.2# #2.1&
. #1.-. Aepeat above (2-.*. #1..2
1/ #2.# Aepeat above (2-.2* #1.-.
Gote5 +ei"hted 3A equals wei"hted total divided by total wei"hts <1&=?for e$ample 4(-*.. E 1&
F 4#&.-. +ei"ht is the accumulation of days F 1 H 2 H H # H & F1&
12. * technical analyst has "een charting movements in a share price and notices that the
trend line has "een rising for some time. %&' 7.4(
%a( *s the analyst draw and la"el an uptrend line and a return line on the chart. E6plain how
this is achieved.
An uptrend line is achieved by connectin" the lower points of a risin" price series.
!he return line is a line drawn parallel to the uptrend line, usin" the hi"her points of the risin"
price series, to create a trend channel.
!he lon"er a trend line has been in force, and the more times it has been tested, the "reater is its
validity.
8f a trend line is of lon" standin" and has withstood three or four tests, and then an indecisive
break is e$perienced, this penetration can be i"nored and the ori"inal trend retained.
8ntra-day trades that break throu"h established trend lines are considered to be unimportant;
however, if the breakout is on hi"h tradin" volumes, it may si"nal a weakenin" trend.
Failure to reach the return line in a well-established trend indicates a deterioration in the trend.
0nce a trend is broken on the downside, prices fall from it and then often make a return move
towards the line. !he pullback frequently retraces appro$imately &/I of the move away from
the trend. !his pullback provides a "ood sell point, if the trader has not already sold at the break
of the trend.
%"( *fter a ma!or shift in a trend line a technical analyst might e6pect a reversal to "ecome
apparent. 'ne reversal pattern is called the head and shoulders pattern. .escri"e the main
characteristics of a head and shoulders pattern that you would e6pect to "ecome evident.
!he head and shoulders pattern is re"arded by chartists as a most reliable pattern
A simple head and shoulders pattern consists of three successive rallies and reactions
!he second rally reachin" a hi"her point than the rallies on either side
!he left shoulder forms on an e$pandin" volume-stron" rally towards the end of an uptrend
!his is followed by a reaction on quite reduced volumes
!he head forms on a stron" second rally, which carries the price hi"her than that for the left
shoulder
!his is followed by a reaction that sees prices movin" back to the vicinity of the previous low
!he formation of the ri"ht shoulder represents the conclusion of the pattern
!he third rally is marked by much reduced volumes and indicates price weakness
)ompletion of the pattern is attained when prices break throu"h the so-called neckline, which is
formed by a line drawn across the lows of the left and ri"ht shoulders
Followin" the breakout of the neckline, prices often move by at least the hei"ht of the head
!here is then often a pullback; this represents the last sellin" position
'ead and shoulders bottoms are similar in form to their tops.
%c( ?ou <now that there are at least five reasona"ly relia"le generalisations that can "e made
when analysing trend lines. 3riefly identify and e6plain these generalisations.
An important focus of attention for the chartist is the determination of when the trend is about to
chan"e. +hen does a penetration of the trend line constitute a si"nal that the trend has chan"ed9 !he
followin" are re"arded as reasonably reliable "eneralisations5
the lon"er a trend line has been in force, and the more times it has been tested, the "reater is its
validity5
o if a trend line is of lon" standin" and has withstood three or four tests, and then an indecisive
break is e$perienced, this penetration can be i"nored and the ori"inal trend retained
o intra-day trades that break throu"h established trend lines are considered to be unimportant;
however, if the breakout is on hi"h tradin" volumes it may si"nal a weakenin" trend
o failure to reach the return line in a well-established trend indicates deterioration in the trend.
0nce a trend is broken on the downside, prices fall from it and then often make a return move
towards the line. !he pullback frequently retraces appro$imately &/ per cent of the move away from
the trend. !his pullback provides a "ood sell point, if the trader has not already sold at the break of
the trend.
11. %a( E6plain why a funds manager might employ the services of "oth a technical analyst and
a fundamental analyst even though each may argue that the otherCs approach to share price
forecasting is not relia"le. %&' 7.1 7.) and 7.4(
Analysts adopt either a technical approach or a fundamental approach; rarely will an individual
analyst adopt a combination of both approaches; however, fund mana"ers and individual
investors take inputs from both approaches.
Some research indicates that it is a combination of both approaches that provides the better
forecasts.
Fundamental analysis has a reasonable forecastin" track record until the share market moves
well above, or below, what the fundamentals would normally support.
At that sta"e it is ar"ued that the technical analysts provide the best forecastin" record; for
e$ample, if the value of shares in a particular industry sector rises well above forecast future cash
earnin"s potential, then share prices may not be e$plained by economic fundamentals and
technical analysis may provide indicators of future share price corrections.
)hart patterns may be used to si"nal the timin" of the ad%ustment.
A limitation of fundamental analysis is that forecastin" only says that the market is overvalued
and is due for a correction; it does not forecast the timin" of a downturn.
8n that situation the alternative technical analysis approach is considered in order to try and
forecast the timin" of market turnin" points.
%"( +aving regard to your understanding of the fundamentals of price movements in the share
mar<et including fundamental and technical analysis identify any intangi"le issues that an
investor might need to consider.
!he price of a share is essentially a function of supply and demand. 8f the performance and profit
pro%ections for a company are forecast to improve then the demand for that stock will increase,
pushin" up the share price.
!wo principal techniques have been developed to forecast future share price movements.
Fundamental analysis combines two approaches; the bottom-up approach <analysin" company
specific information=, and the top-down approach <analysin" the impact of economic
fundamentals industry sector performance=. !echnical analysis seeks to e$plain and forecast
share price movements on the basis of the past behaviour of prices.
An important question is whether these two techniques incorporate all factors that may, from
time to time, influence movements in share prices.
8t may be ar"ued that while fundamental and technical analyses both provide pricin" messa"es to
the market, other issues also need to be considered, includin"5
o market perception and sentiment?how will the market actually interpret information and
what will be its collective response9
o political chan"es?is there an election imminent; how will the market respond prior to, and
subsequent to, the election; will previous political stability be retained9
o re"ulatory chan"es?will the "overnment introduce new le"islation and re"ulation that will
impact upon the overall performance of the economy, or industry sectors within the
economy; for e$ample, increase in ta$ation, removal of tariffs, new industrial relations
le"islation
o chan"es in key mana"ement positions within a company?this may be within the board of
directors, or within the senior mana"ement of the company
o chan"es in the corporate mission?have the ob%ectives and policies of the company chan"ed;
what is the future business direction of the company9
o competition?are there new competitors enterin" the market; how will the company respond9
o products?product life cycle; are there new products comin" on stream; is e$penditure
occurrin" on research and development9
o technolo"y?what will the impact of new technolo"y have on the operational efficiency of
the company, its products, and its competitors9
1). 8toc<-mar<et regulators endeavour to maintain confidence in the mar<ets "y
esta"lishing regulation that ensures efficiency transparency and fairness for all mar<et
participants. #ithin this conte6t "riefly discuss the impacts of high frequency trading
flash trading and dar< pools. %&' 7.9(
'i"h-frequency tradin" <'F!= is the application of hi"h-speed supercomputers that are controlled
by al"orithms that analyse data, identify investment opportunities, and influence stock order flows
and therefore share prices in the market.
Flash tradin" is a situation where certain privile"ed institutional investors, typically 'F! firms,
receive <are flashed= information from a stock e$chan"e of incomin" stock orders a fraction of a
second before this information is sent to the e$chan"es tradin" system.
6ark pools is a dedicated tradin" system that operates within an e$chan"e that allows certain
institutional investors to place lar"e buy or sell orders without havin" to disclose the trade to the
entire market.
'i"h frequency tradin", flash tradin" and dark pools all have an impact on share prices. 8t may be
ar"ued that these tradin" arran"ements provide a distortion in the market in that 'F! "ain an
advanta"e over other market participants and that some of their tradin" method is desi"ned to
influence directional movements in share prices.
14. * tutor of a university financial mar<ets class has "een as<ed "y a student to e6plain
the random wal< hypothesis. %&' 7.1(
%a( E6plain the main propositions of the random wal< hypothesis.
!he random walk hypothesis contends that each observation in a time series such as share prices
is independent of the previous observation.
8f a share price rises in period one, there is an equal probability that in period two the price will
rise, fall or remain unchan"ed.
0nce the result for period two is observed, a"ain there is an equal probability that in period three
the price will rise, fall or remain unchan"ed.
1ach share is assumed to have an intrinsic value that is based on investorsB e$pectations about the
present value of the firmBs future net cash flows.
!he price of the share is based on the latest information available and relevant to the companyBs
current state and its future prospects.
Jariations in the price of the share throu"h time should only be in response to chan"es in the
relevant information that comes to the attention of the market concernin" the company.
%"( #ould the o"servation of increasing prices on a particular share over a series of
consecutive months violate the random wal< hypothesis$ E6plain your response.
An increasin" price trend, as "iven in the question, does not violate the hypothesis.
8t is possible that new information relevant to the company is predominantly "ood.
!ypically, over time, the news will not have a particular trend. 8t is likely to be randomly
distributed.
19. %a( 3riefly outline the main contentions of the efficient mar<et hypothesis. ;n your answer
discuss the contentions of the efficient mar<et hypothesis within the conte6t of technical
analysis and fundamental analysis.
1fficient market hypothesis contends that markets are information-efficient and that share prices
reflect all available information.
8f this is the case e$tra profits cannot be made from superior information.
!his su""ests that the two fundamental analysis approaches will not achieve hi"her results.
'owever, there is a need to consider the ability of market participants to understand, evaluate
and interpret that information.
!he efficient market hypothesis also ar"ues that technical analysis is of no value as it relies the
repetition of past price patterns.
Share markets are "enerally information-efficient and prices "enerally follow the random walk
process and reflect the current available information.
Above-normal profits are unlikely to be made by usin" current information since it is likely to
already be reflected in the price of the share.
Gevertheless, for some skilled analysts, and for those able to uncover not-yet-public information,
above-avera"e rates of return may be available.
%"( +ow can the hypothesis "e tested$ ;n your response distinguish "etween the wea< semi-
strong and strong forms of efficiency. %&' 7.1(
!he stren"th of the efficient market hypothesis is related to the level of efficiency of the markets;
that is, how quickly is information absorbed by the market and reflected in the share price
!here are three measures or levels of efficiency
+eak form efficiency?share prices chan"es are independent and not based on historic data
Semi-stron" form efficiency?all publicly available information is fully reflected in a share price
Stron" form efficiency?all publicly available information and private research is fully reflected
in a share price.
11. 3ehavioural finance see<s to e6tend our understanding of the investment decision
process.
%a( #hat is the conceptual foundation of the "ehavioural finance hypothesis$
:ehavioural finance attempts to e$tend our understandin" of investor behaviour, based on
psycholo"ical principles of decision makin".
!he focus of behavioural finance is to identify and reco"nise the importance of co"nitive factors
that impin"e on the rational behaviour contentions of the efficient market hypothesis.
;roponents of behavioural finance ar"ue that it hi"hli"hts inefficiencies in the markets, that is,
action or inaction result in swin"s in market prices that are not rationally supported by economic
fundamentals.
!hese effects will influence markets trends, which over time, may well result in an asset class
bubble, and potentially a market crash. For e$ample, an environment of low interest rates and
easy credit may drive the residential property market prices to unsustainable levels. 8f interest
rates in the future rise si"nificantly, the asset price bubble may burst, resultin" in a rapid fall in
property prices and possibly an increase in mort"a"e loan defaults.
%"( 7sing e6amples discuss four underlying reason for the so-called irrational "ehaviour
considered in "ehavioural finance.
1. An investor is more likely to be upset by a less than e$pected return on an investment than the
investor will be pleased at a hi"her than e$pected return on an investment. 8n other words, the
investor is more affected by ne"ative news than by positive news.
2. An investor may be inclined towards over-confidence in a risin" market and over-pessimism in a
fallin" market. 8nvestor actions and reactions to over-confidence and over-pessimism can push
prices beyond their fundamentals, in both directions.
. An investor may be drawn into a herdin" instinct where the instinct is to follow other investors
into certain investment opportunities. 8f most investors are followers in the herd, then economic
fundamentals become less important as the basis of any market price chan"e.
#. An investor may be distracted by tradin" noise. !his includes carryin" out transactions in an
overreaction to daily information flows that flood the market. 8n reality hard economic fundamentals
are swamped by daily chatter in the markets.
%c( ;dentify and e6plain three categories of investor "ehaviour that have "een formalised
within the "ehavioural finance hypothesis.
1. 'euristic behaviour?where investors do not seek to ma$imise returns on investment, but are
quite willin" to accept a lesser outcome or return. 'euristic behaviour may be influenced by a
wide ran"e of co"nitive and emotional factors, such as ethical issue, environmental issues and
security issues.
2. Framin" behaviour?where an investor is influenced by the manner in which an investment
opportunity is presented. For e$ample the same investment may be marketed at bein" either
speculative or prospective which will influence an investor2s view of the investment.
. 3arket inefficiencies?where other factors create mis-pricin" that cannot be supported or
e$plained by rational efficient market e$pectations. !hese may relate to "overnment policy
chan"es, ta$ incentives and performance bonuses.