Market Mechanics

50+ essential concepts in market mechanics and portfolio theory

What You'll Learn

Master market mechanics, CAPM, EMH, and portfolio theory with 50+ comprehensive flashcards. Learn alpha, beta, adjusted close prices, order types, survivor bias, systematic vs idiosyncratic risk, and hedge fund vs mutual fund differences.

Key Topics

  • CAPM formula and calculations with alpha and beta
  • Efficient Market Hypothesis (weak, semi-strong, strong forms)
  • Survivor bias and backtesting pitfalls explained
  • Systematic vs idiosyncratic risk and diversification
  • Market orders vs limit orders and price impact
  • Hedge funds vs mutual funds comparison

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How to study this deck

Start with a quick skim of the questions, then launch study mode to flip cards until you can answer each prompt without hesitation. Revisit tricky cards using shuffle or reverse order, and schedule a follow-up review within 48 hours to reinforce retention.

Preview: Market Mechanics

Question

What is the difference between Close and Adjusted Close prices?

Answer

Close is the actual trading price at market close. Adjusted Close is retroactively adjusted for corporate actions (dividends, splits, spin-offs) to ensure accurate return calculations across these events.

Question

When a 2-for-1 stock split occurs, what happens to historical Adjusted Close prices?

Answer

All historical Adjusted Close prices BEFORE the split are divided by 2 (adjusted backward in time). This ensures returns are calculated correctly across the split. The Close price remains unchanged historically.

Question

Why must you use Adjusted Close prices for backtesting trading strategies?

Answer

Adjusted Close accounts for corporate actions (dividends, splits). Without it, a 2-for-1 split would appear as a 50% loss overnight, and dividend payments wouldn't be reflected, making backtest results completely inaccurate.

Question

What does a market order guarantee?

Answer

A market order guarantees EXECUTION (that your order will be filled), but NOT PRICE. You may pay different prices as your order 'walks up' the order book, especially for large orders.

Question

What does a limit order guarantee?

Answer

A limit order guarantees PRICE (you won't pay more than your limit for a buy), but NOT EXECUTION. Your order may not fill if the market price doesn't reach your limit.

Question

What is price impact (slippage)?

Answer

Price impact occurs when a large order moves the market price against you as you consume available liquidity at each price level. Your average execution price differs from the initial quote.

Question

What is front-running in the context of HFT?

Answer

Front-running is when high-frequency traders detect a large incoming order, buy shares ahead of it (anticipating the price will rise), then immediately sell back at higher prices, increasing execution costs for the original buyer.

Question

⭐ What is the CAPM formula? (MEMORIZE THIS)

Answer

Expected Return = Rf + β(Rm - Rf) Where: Rf = risk-free rate, β = beta, Rm = market return Key: Beta multiplies the EXCESS market return (Rm - Rf), NOT the total market return!

Question

⭐ If Rf = 2%, β = 1.5, and Rm = 10%, what is the expected return using CAPM?

Answer

E(R) = 2% + 1.5(10% - 2%) = 2% + 1.5(8%) = 2% + 12% = 14% NOT 15%! Common mistake is to calculate 1.5 × 10% = 15%

Question

⭐ What is alpha and how do you calculate it?

Answer

Alpha = Actual Return - Expected Return (from CAPM) Alpha measures performance beyond what's explained by market exposure (beta). Positive alpha suggests outperformance; negative alpha suggests underperformance.

Question

⭐ If a fund returns 15% when CAPM predicts 14%, what is its alpha?

Answer

Alpha = 15% - 14% = +1% Positive alpha indicates the fund outperformed expectations given its beta (market risk).

Question

What does beta measure?

Answer

Beta measures a stock's sensitivity to EXCESS market returns (market return - risk-free rate). β > 1 means more volatile than market; β < 1 means less volatile; β = 1 means moves with market.

Question

If a stock has β = 1.5 and the market excess return is 8%, what is the stock's expected excess return?

Answer

Expected excess return = β × (market excess return) = 1.5 × 8% = 12% Add risk-free rate to get total expected return.

Question

What are the three forms of the Efficient Market Hypothesis (EMH)?

Answer

Weak form: Prices reflect all past trading info (prices, volume). Semi-strong form: Prices reflect all publicly available info. Strong form: Prices reflect ALL info, including private/insider info.

Question

If weak-form EMH holds, can technical analysis consistently beat the market?

Answer

No. Weak form says all past price and volume data is already incorporated into current prices, so patterns in historical data cannot predict future returns.

Question

If semi-strong EMH holds, can fundamental analysis consistently beat the market?

Answer

No. Semi-strong form says all publicly available information (financial statements, news, earnings) is already reflected in prices, so analyzing public info won't give you an edge.

Question

If semi-strong EMH holds, could insider trading be profitable?

Answer

Yes (theoretically). Semi-strong only covers PUBLIC information. Private/insider information is not yet reflected in prices, so it could provide an edge (though it's illegal).

Question

Does consistent outperformance by some hedge funds prove EMH is false?

Answer

Not necessarily. Could be due to: (1) survivorship bias (we only see survivors), (2) luck (some will outperform by chance), (3) risk-adjusted returns may not beat market, or (4) insufficient sample size.

Question

What is survivor bias in backtesting?

Answer

Survivor bias occurs when you only analyze stocks/funds that currently exist, excluding those that failed or were delisted. This makes historical performance look artificially good because you've excluded the worst performers.

Question

If you backtest using only current S&P 500 constituents over 20 years, what bias do you introduce?

Answer

Survivor bias. You're using companies that survived until today, excluding companies that were in the index 20 years ago but failed, went bankrupt, or were removed. This excludes the worst performers and inflates returns.

Question

⭐ Does Adjusted Close eliminate survivor bias?

Answer

NO. Adjusted Close handles corporate actions (splits, dividends) but does NOT address which stocks are included in your dataset. Survivor bias is a SAMPLE SELECTION problem, not a price adjustment problem.

Question

⭐ What happens to data for delisted/bankrupt stocks on providers like Yahoo Finance?

Answer

The data often STOPS updating or is REMOVED entirely. You may not see the full decline to zero. This creates data-level survivor bias because your backtest can't capture losses from holding stocks that went bankrupt.

Question

How much can survivor bias inflate backtested returns?

Answer

Studies show survivor bias can inflate returns by 2-5% per year or more, which compounds to massive differences over long periods.

Question

What is SPY and why is it a good market benchmark?

Answer

SPY is an ETF that tracks the S&P 500 index. It's a good benchmark because it's liquid, tradeable, and closely tracks the market. However, it slightly underperforms the pure index due to its expense ratio (~0.09% annually).

Question

Why does SPY underperform the S&P 500 index slightly?

Answer

SPY charges an expense ratio (management fee, ~0.09% annually) that's deducted from fund assets. The S&P 500 index is a theoretical calculation with no costs, so SPY returns = Index returns - expense ratio.

Question

⭐ What is systematic risk (market risk)?

Answer

Systematic risk is risk that affects the entire market (recession, interest rates, war). It's measured by beta and CANNOT be eliminated through diversification. Also called non-diversifiable or market risk.

Question

⭐ What is idiosyncratic risk (company-specific risk)?

Answer

Idiosyncratic risk is risk specific to individual companies (CEO resignation, product failure, lawsuit). It CAN be eliminated through diversification by holding multiple uncorrelated stocks. Also called unsystematic or diversifiable risk.

Question

⭐ Which type of risk can be eliminated through diversification?

Answer

IDIOSYNCRATIC (company-specific) risk can be eliminated by holding ~30 diverse stocks. SYSTEMATIC (market) risk CANNOT be eliminated through diversification—it affects all stocks.

Question

⭐ If you hold 30 randomly selected stocks from different industries, what risk remains?

Answer

SYSTEMATIC RISK (market risk) remains. You've eliminated most idiosyncratic risk through diversification, but all stocks still have some correlation with the market, so you can't diversify away systematic risk.

Question

Does diversification reduce expected returns?

Answer

NO! This is the 'free lunch' of finance. Diversification reduces risk (volatility) WITHOUT reducing expected returns (assuming assets aren't perfectly correlated). Expected portfolio return = weighted average of individual expected returns.

Question

What is the 'free lunch' in portfolio theory?

Answer

Diversification. It's one of the few ways to reduce risk WITHOUT reducing expected return. By combining assets with correlation < 1, portfolio volatility decreases while expected return stays the same.

Question

What is the typical fee structure for hedge funds?

Answer

'2 and 20': 2% annual management fee (on assets under management) plus 20% performance fee (on profits). Much higher than mutual fund fees (typically 0.5-2% with no performance fee).

Question

What strategies can hedge funds use that mutual funds typically cannot?

Answer

Hedge funds can: short sell, use high leverage, trade derivatives/options extensively, invest in alternative assets, employ market-neutral strategies. Mutual funds face regulatory restrictions on these strategies.

Question

How are mutual funds more regulated than hedge funds?

Answer

Mutual funds: Must register with SEC, limited leverage/short selling, diversification requirements, daily liquidity, transparent holdings, fair pricing. Hedge funds: Light regulation, fewer restrictions, less transparency, lock-up periods.

Question

What is an accredited investor?

Answer

Individual with $1M+ net worth (excluding primary residence) OR $200K+ annual income ($300K+ with spouse). Institutions with $5M+ assets. Only accredited investors can invest in hedge funds.

Question

Why are hedge funds restricted to accredited investors?

Answer

Because hedge funds use riskier strategies, have less regulatory oversight, charge higher fees, and have lock-up periods. The assumption is wealthy/sophisticated investors can afford losses and understand complex risks without needing retail investor protections.

Question

In a flash crash where prices DROP suddenly, does a limit buy order protect you from inflated prices?

Answer

No—the logic is backward. In a crash, prices DROP (deflate), not rise (inflate). A limit buy order prevents buying ABOVE your limit, which might actually cause you to miss buying at temporarily low crash prices.

Question

What is the Investment Company Act of 1940?

Answer

The primary law regulating mutual funds in the US. It requires registration with the SEC, imposes investment restrictions, mandates transparency, and provides investor protections. Hedge funds typically structure themselves to be exempt from this law.