Dean's Office Official Model Question Paper

Informational Market Efficiency

An informationally efficient market is one where security prices rapidly and accurately reflect all available relevant information, ensuring current market prices equal the fundamental intrinsic value of securities.

Weak-Form EMH

Weak-form EMH asserts that current stock prices fully reflect all past market trading data (historical prices and volumes). Technical analysis and historical chart patterns cannot be used to consistently achieve risk-adjusted excess abnormal returns.

January Effect

The January Effect is a seasonal calendar anomaly where small-cap stock returns are abnormally higher in the first two weeks of January, historically driven by year-end tax-loss selling in December followed by re-investment in January.

Loss Aversion

Loss aversion refers to the cognitive phenomenon where the psychological pain of losing a sum of money is mentally quantified as roughly twice as intense as the pleasure of gaining an equal sum (losses loom larger than gains).

Herding Behavior

Herding behavior occurs when investors mimic the financial decisions of a crowd or social majority rather than relying on independent fundamental analysis, often driving speculative bubbles and market crashes.

The Three Forms of the Efficient Market Hypothesis (Eugene Fama)

+----------------------------------------------------------------------+
|                     THE THREE FORMS OF EMH                           |
+-------------------+--------------------------------------------------+
| 1. Weak-Form      | Prices reflect ALL historical trading data       |
| 2. Semi-Strong    | Prices reflect all publicly available information|
| 3. Strong-Form    | Prices reflect all public AND private insider info|
+-------------------+--------------------------------------------------+

1. Comparative Breakdown

2. Investment Implications: Active vs. Passive Management

• If markets are semi-strong efficient, active fund managers charging high management fees to analyze annual reports will fail to beat market indexes consistently.
• Investors should adopt Passive Index Investing—holding broad market index funds or ETFs with minimal fees.

Prospect Theory vs. Expected Utility Theory

Developed by Daniel Kahneman and Amos Tversky (1979), Prospect Theory replaced traditional Expected Utility Theory by describing how real humans actually make decisions under risk:

                      Psychological Value V(x)
                                ^
                                |         / (Gains: Concave - Risk Averse)
                                |       /
                                |     /
       -------------------------+-------------------------> Objective Wealth (x)
             (Losses: Convex)  /|
                             /  |
                           /    | (Steeper in Loss Domain - Loss Aversion)
                         /      |
                                v

1. The S-Shaped Value Function

• Reference Dependence: Gains and losses are evaluated relative to a neutral psychological reference point (often the purchase price), rather than absolute total wealth.
• Diminishing Sensitivity:
  • In the Gain Domain: The curve is concave, reflecting risk-averse behavior (preferring a certain gain of Rs. 10,000 over a 50% gamble for Rs. 20,000).
  • In the Loss Domain: The curve is convex, reflecting risk-seeking behavior (preferring a 50% gamble to lose Rs. 20,000 rather than accepting a guaranteed loss of Rs. 10,000).
• Loss Aversion (Steeper Slope): The loss curve is approximately 2.25 times steeper than the gain curve, explaining why losing Rs. 10,000 feels far more painful than winning Rs. 10,000 feels enjoyable.

2. Mental Accounting (Richard Thaler)

• Investors violate the financial principle that money is fungible. They mentally compartmentalize money into separate psychological accounts based on its source (e.g., hard-earned salary vs. speculative “house money” lottery gains), treating them with different risk tolerances.

Financial Market Anomalies

Anomalies are empirical pricing patterns that contradict the Efficient Market Hypothesis and Capital Asset Pricing Model:

1. Calendar Anomalies

• The January Effect: Small-cap stocks consistently outperform large-cap stocks during the first weeks of January.
• The Weekend / Monday Effect: Average returns on Monday mornings are statistically lower or negative compared to Friday trading, historically linked to negative news released over weekends.

2. Cross-Sectional Fundamental Anomalies

• The Size Effect (Banz, 1981): Small-capitalization firms earn statistically higher risk-adjusted returns than large-cap firms, even after adjusting for CAPM Beta.
• The Value Premium (Fama & French): High Book-to-Market (value) stocks consistently outperform low Book-to-Market (growth) stocks over long horizons, suggesting market overreaction to growth glamour stocks.

3. Post-Earnings Announcement Drift (PEAD)

• Under semi-strong EMH, a company’s stock price should adjust instantaneously to earnings surprises.
• In reality, stock prices drift upward for several weeks following positive earnings surprises (and drift downward following negative surprises), demonstrating under-reaction by market participants.

Behavioral Biases and NEPSE Trading Dynamics

Behavioral biases systematically distort investor decision-making, generating speculative market volatility:

1. Core Cognitive and Emotional Biases

• Representativeness Heuristic: The tendency to judge the probability of an uncertain event by how closely it resembles existing stereotypes (e.g., assuming an IPO that shares the name of a successful company will be equally profitable).
• Anchoring and Adjustment: Fixating on an arbitrary initial number (such as the 52-week high of a stock or personal purchase price) and insufficiently adjusting estimates when new fundamental data arrives.
• Overconfidence & Self-Attribution: Investors attribute winning trades to personal investing genius while blaming losing trades on market manipulation or broker delays, trading excessively and racking up high commission fees.
• The Disposition Effect: The tendency of investors to sell winning stocks too early (to lock in the pleasure of a gain) while holding losing stocks too long (to avoid the painful realization of a loss), riding declining stocks to near zero.

2. Impact on the Nepal Stock Exchange (NEPSE)

• NEPSE displays intense retail Herding Behavior—uninformed retail investors follow rumors on social media (Facebook trading groups, Viber/Telegram pump channels) rather than reading audited balance sheets.
• Driven by the Disposition Effect, Nepalese investors quickly sell fundamentally sound commercial bank stocks that rise by 5%, while stubbornly holding illiquid loss-making hydropower shares for years.

Case Analysis: The Psychology of a NEPSE Bubble and Crash

(a) Behavioral Diagnosis of the NEPSE Bubble & Crash (7 Marks)

+------------------------------------------------------------------------------------------------+
|                           BEHAVIORAL BIAS MATRIX IN THE NEPSE CYCLE                            |
+-------------------+------------------------------------+---------------------------------------+
| Behavioral Theory | Manifestation in NEPSE Bull Run    | Manifestation in NEPSE Crash          |
+-------------------+------------------------------------+---------------------------------------+
| 1. Herding &      | FOMO (Fear of Missing Out);        | Panic contagion; irrational selling   |
|    Social Proof   | retail investors buying speculative| cascades as margined portfolios       |
|                   | hydropower based on Viber/Clubhouse| were forcibly liquidated by brokers.  |
+-------------------+------------------------------------+---------------------------------------+
| 2. Overconfidence | Novice traders attributed bull     | Blaming NRB's 4/12 crore policy rather|
|    & Self-Attr.   | market profits to personal skill;  | than admitting they overpaid for      |
|                   | ignored fundamental P/E ratios.    | loss-making shell companies.          |
+-------------------+------------------------------------+---------------------------------------+
| 3. Disposition    | Selling blue-chip bank stocks for  | Extreme loss aversion; holding wiped- |
|    Effect         | a quick Rs. 20 gain.               | out micro-caps down 70% to avoid loss.|
+-------------------+------------------------------------+---------------------------------------+
| 4. Mental         | Treating margin borrowings as      | Sudden realization that borrowed debt |
|    Accounting     | "easy house money" without risk.   | requires real cash debt repayment.    |
+-------------------+------------------------------------+---------------------------------------+

• Diagnosis: NEPSE was a classic textbook case of Speculative Mania fueled by cognitive heuristics: investors confused market-wide liquidity inflation with personal investment acumen.

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(b) Empirical Evaluation of Market Efficiency in NEPSE (7 Marks)

Extensive empirical literature on NEPSE (e.g., studies testing autocorrelation, run tests, and serial variance ratios) concludes that NEPSE is NOT even Weak-form efficient:

1. Serial Correlation and Predictability:
   • Historical share price changes on NEPSE exhibit statistically significant serial correlation, meaning past price patterns carry predictive information (violating the Random Walk Hypothesis).
2. Information Asymmetry & Insider Leakage:
   • News of bonus share dividends, corporate mergers, or right shares regularly leaks into market circles days before official formal disclosure on the NEPSE website, enabling insiders to accumulate shares in advance.
3. Illiquidity and Market Thinness:
   • The free-float market capitalization is small; market depth is concentrated in a few brokers, allowing syndicates to influence closing benchmark index prices through small block transactions.

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(c) Policy and Surveillance Roadmap for SEBON (6 Marks)

To curb manipulation and protect retail investors, SEBON and NEPSE must execute a structural regulatory overhaul:

Algorithmic Surveillance -> Circuit Breaker Overhaul -> Institutional Investors -> Mandatory Literacy

1. Real-Time Automated Algorithmic Surveillance:
   • Deploy advanced market surveillance software capable of detecting circular trading, order layering/spoofing, and pump-and-dump syndicates in real time, automatically freezing offending broker codes.
2. Enhanced Circuit Breakers & Dynamic Price Bands:
   • Overhaul the index circuit breaker mechanism: introduce 15-minute trading pauses when the index moves by 4% or 5%, and enforce dynamic price bands (maximum 2% fluctuation within 15 minutes for individual volatile stocks).
3. Promote Institutional Investors & Market Makers:
   • License mutual funds, pension institutions, and professional market makers to provide countervailing liquidity and stabilize wild speculative swings driven by retail herding.
4. Public Warning Disclosures & Mandatory Financial Literacy:
   • Mandate that TMS display visual warning badges (e.g., Red Flags) on stocks with negative net worth, negative EPS, or continuous audit qualifications.
   • Require all newly registered MeroShare users to complete a basic online investor risk awareness quiz before unlocking margin trading privileges.