Chapter 1 - The Efficient Market Hypothesis

Question 1

What does the EMH state?

Answer 1

Market prices contain all relevant information and are therefore efficient.

Question 2

What does it mean for a market to be efficient?

Answer 2

An efficient security market is one in which every security price fully reflects all available information and hence is equal to its ‘true’ investment value at all times.

When new information becomes available, the share prices adjust immediately and without bias i.e it should not under/over react.

Question 3

What is the implication on security markets if they are efficient?

Answer 3

If markets are efficient, then it is not possible to identify under-or over-priced securities, which can then be traded to generate excess risk-adjusted returns.

Question 4

What is the implication on security markets if they are NOT efficient?

Answer 4

if markets are inefficient then investors with better information may be able to generate excess risk-adjusted returns.

Question 5

What are the three forms of the EMH?

Answer 5

• Weak form
• Semi-strong form
• Strong form

Question 6

What does the weak form of EMH imply?

Answer 6

Market prices incorporate all information contained in historical price data. Technical analysis cannot generate excess risk-adjusted returns.

Question 7

What challenge has the Weak form of the EMH had recently?

Answer 7

Recent econometric evidence suggests that stocks tend to exhibit short-run momentum (trending in the same direction) and medium-run mean-reversion (trending in opposite directions). The implication being that historical performance can inform future behaviour in contradiction of the weak form EMH.

Question 8

What does the semi-strong form of EMH imply?

Answer 8

Market prices incorporate all publicly available information. Fundamental analysis (ie analysing accounting statements and other pieces of financial information) cannot generate excess risk-adjusted returns.

Question 9

What are the tests of the Semi-Strong form of the EMH?

Answer 9

• Informational efficiency
• Excessive volatility

Question 10

What does informational efficiency mean?

Answer 10

If the market is semi-strong efficient, it should respond quickly and accurately to new information in the public domain. It should not over- or under-react to new information, as then it is possible for traders to exploit this to their advantage

Question 11

What does over/under reactions tell us about the security market?

Answer 11

They are not efficient.

Question 12

What did Shiller (1981) conclude?

Answer 12

He concluded that the market exhibited more volatility than could be justified by the arrival of new information, which provides evidence against the
semi-strong form EMH.

Question 13

What are the criticisms of Shillers methodology?

Answer 13

• the choice of terminal value for the stock price
• the use of a constant discount rate
• bias in estimates of the variances due to autocorrelation
• possible non-stationarity of the series, ie the series may have stochastic trends that invalidate the measurements obtained for the variance of the stock price.

Question 14

What is volatility in security markets an example of and what does this mean in respect to the EMH?

Answer 14

Volatility in the security markets suggest over-reactions which is not compatible with semi-strong form efficiency.

Question 15

True or False: The EMH states no investor will be able to ‘beat the market’ in the long term.

Answer 15

False:
An investor may be able to ‘beat the market’ purely by chance e.g. buy a share and then good news comes out and share price rises. However, the EMH suggests no investor will be able to systematically beat the market without:
- insider information
- accept higher risks and therefore a higher return

Question 16

What does the strong form of EMH imply?

Answer 16

Market prices incorporate all information, whether publicly available or not. Insider trading cannot generate excess risk-adjusted returns.

Question 17

True or False: If markets are inefficient, investors with better information may be able to generate higher investment returns.

Answer 17

True

Question 18

Fill in the blank: If markets are efficient, then active investment management is difficult to _______.

Answer 18

[justify]

Question 19

True or False: The Efficient Market Hypothesis states security markets are inefficient.

Answer 19

False

Question 20

What is Technical Analysis?

Answer 20

Technical analysis involves analysing charts of prices and spotting patterns

Question 21

What is Fundamental Analysis?

Answer 21

Fundamental analysis involves analysing accounting statements and other pieces of financial information)

Question 22

Define Active Investment Management

Answer 22

Active fund managers attempt to detect exploitable mispricing’s, since they believe that markets are not universally efficient

Question 23

Define Passive Investment Management

Answer 23

Passive fund managers simply aim to diversify across a whole market, perhaps because they do not believe they have the ability to spot mispricings.

Question 24

Why can active management not be justified by the EMH?

Answer 24

According to the Efficient Markets Hypothesis, active investment management cannot be justified because it is impossible to exploit the mispricing of securities in order to generate higher expected returns. Even if price anomalies exist, then the costs of identifying them and then trading will outweigh the benefits arising from the additional investment returns.

Question 25

What are examples of over-reactions to events?

Answer 25

Past performance: past winners tend to be future losers and vice versa. The market appears to over-react to past performance. Hence it might be possible to make excess profits by selling shares in firms that have performed well recently and buying those that have performed badly. This is sometimes referred to as a contra-cyclical investment policy.

Question 26

State an example how we could contradict the semi-strong form of the EMH.

Answer 26

- Over-reaction/Under-reaction - if it takes time for announcements to be reflected within share prices, this contradicts the SS form of EMH as public announcements should have an immediate effect on share prices as the market should respond quickly and accurate to new information.

Question 27

What does the EMH imply about beating the market?

Answer 27

It implies that beating the market it not impossible, since investors could out perform the market by chance or by accepting above average levels of risk. It does imply that it is not possible to consistently achieve excess risk-adjusted returns net of costs.

Question 28

How can investors take advantage of informational efficiency?

Answer 28

Many studies show that the market tends to under/over react to events. The under/over reaction is corrected over a long time period. This gives investors an opportunity to generate excess risk-adjusted returns and efficiency would not hold.

Question 29

How could you test the weak form of the EMH?

Answer 29

You could perform technical analysis (i.e looking at historical share prices and spot trends/patterns) and also randomly select shares to compare whether there is any difference in returns.

Question 30

What makes testing 'Informational Efficiency' difficult?

Answer 30

It is difficult to establish precisely when information arrives. For example, many events are widely rumoured prior to official announcements.

Question 31

True or False: Company A yields an average return on twice of Company B. This contradicts the EMH.

Answer 31

False: The EMH does not state that the market is inefficient if a Company has higher average yield. This could be because Company A shares have greater riskier and therefore requires a higher return for the additional risk taken on compared to Company B. The EMH states it is not possible to generate excess risk-adjusted returns. i.e higher returns for the same risk.