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Finance Essay

2010 words - 9 pages

"Given some reasonable assumptions about the random behaviour of stock returns, a lognormal distribution is implied." Discuss the relevance of those assumptions and their implications.A popular model which examines the evolution of stock prices in continuous time and one that has received wide coverage in the finance and statistics literature is the lognormal distribution. It largely results from the effects of a large number of independent but multiplicative sources of variation. It is upward skewed, with a mean larger than its mode [Black, 1997, p.277]. Although it is possible to establish upper and lower bounds for option prices using general arbitrage arguments, "precise" option pricing ...view middle of the document...

The assertion is that it is impossible to consistently beat the market with a trading strategy based on past returns/price data. This is often used to refute the predictions of chartists and technical analysts.However, to many, randomness is an intrinsically difficult idea that seems to clash with powerful facts or intuitions, with instances of clear casualty, economic rationality and perhaps even free will. The colossal number of empirical studies dedicated to disproving Fama's Efficient Market Hypothesis (EMH) evidences this. Indeed, predictability in asset returns is a very broad and active research topic, and it is impossible to provide a complete survey of this vast literature in just a few paragraphs. Therefore, I focus exclusively on what I consider to be the most important findings.DeBondt & Thaler (1985) strongly make the case for mean reversion in stock prices. Mean reversion refers to the fact that in a chance process, very extreme observations are likely to be followed by less extreme observations and such a process returns to some fundamental value over time. DeBondt & Thaler (1985) were the first to usr the contrarian idea of "buy losers/sell winners" in finance. They advocate the ranking of all traded stocks by abnormal return over a portfolio formation period, followed by the formation of performance deciles. They suggest the purchase of 35 stocks from the bottom decile (losers) and sale of 35 stocks from the top decile (winners). This strategy is recommended for repetition over each portfolio formation period.They find that returns from both winners and losers are mean reverting; that price reversals for losers are much more pronounced than for winners; and that most of the excess returns for losers occur in January [DeBondt & Thaler, 1985, p.798]. DeBondt (1993) further advocates that subjects find patterns even in random data, and that expected price change in a bull market greatly exceeds that in bear markets, contrary to EMH.Hew et al (1996) test for the presence of Post-Earnings Announcement Drift (PAD) on the UK stock market. The PAD phenomenon may be defined as the tendency of share prices to fully react to earnings news, only after a considerable lag. They find that share price performance following earnings announcements depends on whether "good" news or "bad" news is announced. The results suggest a significant drift over the half-year period following earnings announcement.Basu (1977) suggests that firms with low P/E ratios earn above-normal returns ("price-ratio hypothesis"). Such firms are only temporarily undervalued, however, because the market gets inappropriately pessimistic about current or future earnings. Price corrections invariably follow. A similar result is provided by Lakonishok et al (1994) who argue that ratios involving stock prices proxy for past performance.An extremely interesting discussion is by Mandelbrot (1997), who argues that a price that follows a stationary random walk would...

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