Reading 38: market efficiency

Question 1

In an informationally efficient capital market:
active managers can generate abnormal profits.
security prices quickly reflect new information.
investors react to all information releases rapidly.

Answer 1

In informationally efficient capital markets, new information is quickly reflected in security prices. Investors react only to unexpected information releases because information releases that are expected will already be reflected in securities prices. Active strategies will underperform in an efficient market because they have greater transactions and management costs than passive strategies and will not consistently create positive abnormal returns after adjusting for risk. (LOS 38.a)

Question 2

The intrinsic value of an asset:
changes through time as new information is released.
is the price at which the asset can be bought or sold at a given point in time.
can be easily determined with a financial calculator, given investor risk preferences.

Answer 2

Intrinsic value changes as new information arrives in the marketplace. It cannot be known with certainty and can only be estimated. The price of an asset at a given point in time is its market value, which will differ from its intrinsic value if markets are not fully efficient. (LOS 38.b)

Question 3

In terms of market efficiency, short selling most likely:
leads to excess volatility, which reduces market efficiency.
promotes market efficiency by making assets less likely to become overvalued.
has little effect on market efficiency because short sellers face the risk of unlimited losses.

Answer 3

Short selling promotes market efficiency because the sales pressure from short selling can reduce the prices of assets that have become overvalued. (LOS 38.c)

Question 4

The weak-form EMH asserts that stock prices fully reflect which of the following types of information?
Market only.
Market and public.
Public and private.

Answer 4

Weak-form EMH states that stock prices fully reflect all market (i.e., price and volume) information. (LOS 38.d)

Question 5

Research has revealed that the performance of professional money managers tends to be:
equal to the performance of a passive investment strategy.
inferior to the performance of a passive investment strategy.
superior to the performance of a passive investment strategy.

Answer 5

Tests indicate that mutual fund performance has been inferior to that of a passive index strategy. (LOS 38.e)

Question 6

Which of the following best describes the majority of the evidence regarding anomalies in stock returns?
Weak-form market efficiency holds, but semi-strong form efficiency does not.
Neither weak-form nor semi-strong form market efficiency holds.
Reported anomalies are not violations of market efficiency but are the result of research methodologies.

Answer 6

The majority of evidence is that anomalies are not violations of market efficiency but are due to the research methodologies used. Portfolio management based on anomalies will likely be unprofitable after transactions costs are considered. (LOS 38.f)

Question 7

Investors who exhibit loss aversion most likely:
have symmetric risk preferences.
are highly risk averse.
dislike losses more than they like equal gains.

Answer 7

Loss aversion refers to the tendency of investors to be more risk averse when faced with potential losses and less risk averse when faced with potential gains. That is, they dislike losses more than they like gains of an equal amount. Their risk preferences are asymmetric. (LOS 38.g)