Chapter 4

Question 1

What is an efficient securities market?

Answer 1

A market where security prices fully reflect all available information

Question 2

Why is market efficiency important?

Answer 2

It ensures that scarce capital is allocated to the most productive investments

Question 3

How does financial reporting contribute to market efficiency

Answer 3

By converting inside information into publicly available information

Question 4

What are the three forms of market efficiency?

Answer 4

Weak-form efficiency
Semi-strong form efficiency
Strong-form efficiency

Question 5

What is weak-form efficiency?

Answer 5

Prices reflect past prices and volume only

Question 6

What is semi-strong form efficiency?

Answer 6

Prices reflect all publicly available information

Question 7

What is strong-form efficiency?

Answer 7

Prices reflect all public and private (inside) information

Question 8

What form or efficiency is the most widely accepted?

Answer 8

Semi-strong form efficiency

Question 9

What does semi-strong form efficiency imply for financial reporting?

Answer 9

New financial disclosures immediately affect stock prices

Question 10

What is the main assumption behind market efficiency?

Answer 10

Investors rationally process information and adjust prices accordingly

Question 11

What happens when a company releases good news under semi-strong efficiency?

Answer 11

The stock price increases immediately

Question 12

What happens when a company releases bad news under semi-strong efficiency?

Answer 12

The stock price decreases immediately

Question 13

Why is it impossible to consistently beat the market under semi-strong efficiency?

Answer 13

Because all public information is already incorporated into stock prices

Question 14

What is the efficient market hypothesis (EMH)?

Answer 14

The idea that stock prices fully reflect all available information

Question 15

What does the efficient market hypothesis (EMH) suggest about technical analysis?

Answer 15

It is useless because past price patterns cannot predict future returns

Question 16

What doe the efficient market hypothesis (EMH) suggest about fundamental analysis?

Answer 16

It may be useless in semi-strong and strong-form markets, as stock prices already reflect all public information

Question 17

What is the role of financial statements in an efficient market?

Answer 17

To provide timely and relevant information for investors

Question 18

Why do financial statements matter if markets are efficient?

Answer 18

They ensure that all investors have equal access to public information

Question 19

What happens if a company’s financial statements lack transparency?

Answer 19

It may create information asymmetry, leading to mispriced securities

Question 20

What is information asymmetry?

Answer 20

A situation where some investors have more information than others

Question 21

What are the two types of information asymmetry?

Answer 21

Adverse selection
Moral hazard

Question 22

What is adverse selection?

Answer 22

Some investors have better access to information

Question 23

What is moral hazard?

Answer 23

Managers may take actions that investors cannot observe

Question 24

How does financial reporting help reduce adverse selection?

Answer 24

By ensuring that all investors have access to the same public information

Question 25

How does corporate governance reduce moral hazard?

Answer 25

By ensuring managers act in shareholders best interests

Question 26

Why do two similar firms with equal net income sometimes experience different stock price reactions?

Answer 26

Because the market considered more than just reported net income, such as: Future growth potential Industry trends Management credibility Quality of earnings

Question 27

Why do stock prices reach differently to the same financial information?

Answer 27

Investors interpret financial data differently based on expectations and external factors

Question 28

How does the financial press influence market reactions?

Answer 28

By shaping investor perceptions of financial information

Question 29

Can investors consistently earn above-average returns in an efficient market?

Answer 29

No, unless they take on more risk

Question 30

What is the best investment strategy in an efficient market?

Answer 30

Passive investing (index funds) since stock prices already reflect all available information

Question 31

Why might active fund managers struggle to outperform the market?

Answer 31

Because stock prices already incorporate all known information

Question 32

What is the relationship between risk and return in an efficient market?

Answer 32

Investors can only earn higher returns by taking on more risk

Question 33

What happens to firm-specific risk in a diversified portfolio?

Answer 33

It is eliminated, leaving only systematic (market-wide) risk

Question 34

Why do investors not get compensated for firm-specific risk?

Answer 34

Because it can be diversified away

Question 35

How does market efficiency affect the choice of accounting policies?

Answer 35

As long as policies are fully disclosed, markets adjust for differences

Question 36

Why does lack of comparability in accounting policies not necessarily affect share prices?

Answer 36

Investors can adjust for accounting differences if information is transparent

Question 37

Why does full disclosure matter in an efficient market?

Answer 37

Because investors need complete and unbiased information to make decisions

Question 38

What happens when insiders trade based on private information?

Answer 38

It creates information asymmetry, making the market less efficient

Question 39

Why is insider trading illegal?

Answer 39

Because it gives certain investors an unfair advantage over others

Question 40

What efficiency is it if only historical share prices are included?

Answer 40

Weak efficiency

Question 41

What efficiency is it if all information is included, including inside information

Answer 41

Strong efficiency

Question 42

What efficiency is it if all publicly available information is included?

Answer 42

Semi-strong efficiency

Question 43

Is share price a reflection of what the company is worth?

Answer 43

No, it could include information that is incorrect or misleading when investors are calculating the share value, we don't really know

Question 44

Can you diversify away firm specific risk?

Answer 44

Yes, as long as you know what it is

Question 45

Can you diversify away market risk?

Answer 45

No

Question 46

What are examples of firm specific risk?

Answer 46

Currency risk, interest rate risk