The Efficient Market Hypothesis

Question 1

What is true about stock prices?

a) They follow a systematic pattern
b) To a close approximation they seem to follow a random walk.
c) Only new information will move stock prices, this information is usually positive.

Answer 1

b) To a close approximation they seem to follow a random walk.

Only new information will move stock prices, but this information is equally likely to be good or bad news.

Question 2

Market participants distinguish among three forms of the efficient market hypothesis.

The ______ form, which generally is acknowledged to be extreme, asserts that all information, including insider information, is reflected in prices.
The _______ form asserts that all information to be derived from past trading data already is reflected in stock prices.
The ________ form claims that all publicly available information is already reflected.

a) Efficient
b) Semi-strong
c) Weak
d) strong

Answer 2

The (d) strong form, which generally is acknowledged to be extreme, asserts that all information, including insider information, is reflected in prices.
The (c) weak form asserts that all information to be derived from past trading data already is reflected in stock prices.
The (b) semi strong form claims that all publicly available information is already reflected.

Question 3

True or false

Proponents of the efficient market hypothesis often advocate active as opposed to passive investment strategies

Answer 3

False
Proponents of the efficient market hypothesis often advocate PASSIVE as opposed to ACTIVE investment strategies.
The policy of passive investors is to buy and hold a broad-based market index. They expend resources neither on market research nor on frequent purchase and sale of stocks. Passive strategies may be tailored to meet individual investor requirements.

Question 4

Which of the following describe technical analysis?

a) Focuses on the determinants of the underlying value of the firm, such as current profitability and growth prospects.
b) Passive strategies
c) Active portfolio management
d) Focuses on stock price patterns and on proxies for buy or sell pressure in the market.

Answer 4

d) Focuses on stock price patterns and on proxies for buy or sell pressure in the market.

Technical analysis is essentially the search for recurrent and predictable patterns in stock prices. Whatever the fundamental reason for a change in stock price, if the stock price responds slowly enough, the analysis will be able to identify a trend that can be exploited during the adjustment period.

Question 5

Which of the following describe fundamental analysis?

a) Focuses on the determinants of the underlying value of the firm, such as current profitability and growth prospects.
b) Passive strategies
c) Active portfolio management
d) Focuses on stock price patterns and on proxies for buy or sell pressure in the market.

Answer 5

a) Focuses on the determinants of the underlying value of the firm, such as current profitability and growth prospects.

Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates and risk evaluation of the firm to determine proper stock prices. Ultimately, it represents an attempt to determine the PV of all the payments a stockholder will receive from each share of stock.

Both technical and fundamental analysis are based on public information, therefore, neither should generate excess profits if markets are operating efficiently.

Question 6

How is abnormal return computed?

Answer 6

Abnormal return = Actual return -Expected return given the return on a market index

Question 7

Why should information that could be used to predict stock performance already be reflected in stock prices?

Answer 7

As soon as there is any information indicating that a stock is underpriced, and therefore offers a profit opportunity, investors flock to buy the stock and immediately bid up its price to a fair level, where only ordinary rates (=return commensurate with risk of stock) of return can be expected. At those levels one cannot expect abnormal returns.

Question 8

What does the efficient market hypothesis (EMH) reflect?

a) All information is reflected in the stock price
b) Selected information is reflected in the stock price
c) All available information is reflected in the stock price
d) No information is reflected in the stock price

Answer 8

c) All available information is reflected in the stock price

Question 9

What is true about resistance and support levels?

a) Terms describing price levels
b) These levels are believed to be determined by market psychology.
c) Above these there are difficult for stock prices to rise and below these there are unlikely for stocks to fall.
d) All of the above

Answer 9

d) All of the above

Question 10

What does proponents of the EMH advocate?

a) Active management
b) Passive investment strategy

Why?

Answer 10

b) Passive investment strategy

They believe active management is largely wastes effort and unlikely to justify the expenses incurred. They advocate a passive investment strategy that makes no attempt to outsmart the market. Because EMH indicates that stock prices are at fair levels, given all available information, it makes no sense to buy and sell securities frequently, due to large trading costs without increasing expected performance.

Question 11

Which of the following describe event studies?

a) Focuses on the determinants of the underlying value of the firm, such as current profitability and growth prospects.
b) A technique of empirical financial research that enables an observer to assess the impact of a particular event on a firm’s stock price.
c) Active portfolio management
d) Focuses on stock price patterns and on proxies for buy or sell pressure in the market.

Answer 11

b) A technique of empirical financial research that enables an observer to assess the impact of a particular event on a firm’s stock price.

It quantifies the relationship between dividend changes and stock returns.

Question 12

Which of the following describe the magnitude issue?

a) Under the hypothesis that any stock is fairly priced, given all available information, any bet on a stock is simply a coin toss. Equal likelihood of winning or losing the bet. However, if many investors using a variety of schemes make fair bets, statistically speaking, some of those investors will be lucky and win a great majority of the bets.
b) Annual standard deviation of S&P500 is 20%. Hence a 0,1% annual contribution to a portfolio performance would be swamped by the volatility of the market. A small increase in performance will be hard to detect among all the fluctuations in the index.
c) When you discover a profitable investment scheme you have two options, publish in The Wall Street Journal, or keep it a secret. Only investors who don’t are able to create abnormal returns will report their techniques. Opponents of EMH will therefore always be able to use evidence that various techniques do not provide investment rewards as proof that the techniques that do work simply are not being reported to the public.

Answer 12

b) Annual standard deviation of S&P500 is 20%. Hence a 0,1% annual contribution to a portfolio performance would be swamped by the volatility of the market. A small increase in performance will be hard to detect among all the fluctuations in the index.

Question 13

Which of the following describe the selection bias issue?

a) Under the hypothesis that any stock is fairly priced, given all available information, any bet on a stock is simply a coin toss. Equal likelihood of winning or losing the bet. However, if many investors using a variety of schemes make fair bets, statistically speaking, some of those investors will be lucky and win a great majority of the bets.
b) Annual standard deviation of S&P500 is 20%. Hence a 0,1% annual contribution to a portfolio performance would be swamped by the volatility of the market. A small increase in performance will be hard to detect among all the fluctuations in the index.
c) When you discover a profitable investment scheme you have two options, publish in The Wall Street Journal, or keep it a secret. Only investors who don’t are able to create abnormal returns will report their techniques. Opponents of EMH will therefore always be able to use evidence that various techniques do not provide investment rewards as proof that the techniques that do work simply are not being reported to the public.

Answer 13

c) When you discover a profitable investment scheme you have two options, publish in The Wall Street Journal, or keep it a secret. Only investors who don’t are able to create abnormal returns will report their techniques. Opponents of EMH will therefore always be able to use evidence that various techniques do not provide investment rewards as proof that the techniques that do work simply are not being reported to the public.

Question 14

Which of the following describe the lucky event issue?

a) Under the hypothesis that any stock is fairly priced, given all available information, any bet on a stock is simply a coin toss. Equal likelihood of winning or losing the bet. However, if many investors using a variety of schemes make fair bets, statistically speaking, some of those investors will be lucky and win a great majority of the bets.
b) Annual standard deviation of S&P500 is 20%. Hence a 0,1% annual contribution to a portfolio performance would be swamped by the volatility of the market. A small increase in performance will be hard to detect among all the fluctuations in the index.
c) When you discover a profitable investment scheme you have two options, publish in The Wall Street Journal, or keep it a secret. Only investors who don’t are able to create abnormal returns will report their techniques. Opponents of EMH will therefore always be able to use evidence that various techniques do not provide investment rewards as proof that the techniques that do work simply are not being reported to the public.

Answer 14

a) Under the hypothesis that any stock is fairly priced, given all available information, any bet on a stock is simply a coin toss. Equal likelihood of winning or losing the bet. However, if many investors using a variety of schemes make fair bets, statistically speaking, some of those investors will be lucky and win a great majority of the bets.

Question 15

Several studies have documented the ability of easily observed variables to predict market return – variation in the market risk premium.

Match studies and people.

a) The return on the aggregate stock market tends to be higher when the dividend/ price ratio, the dividend yield, is high.
b) The earnings yield can predict market returns.
c) Bond market data such as the spread between yields on high- and low-grade corporate bonds also help predict broad market returns.

i) Keim and Stambaugh.
ii) Fama and French.
iii) Campbell and Shiller.

Answer 15

a) - ii)
b) - iii)
c) - i)

Question 16

What are efficient market anomalies?

Answer 16

Accessible statistics that seems to predict abnormal risk-adjusted return.

Question 17

Which anomaly describes the following?

Average annual returns are consistently higher on small-firm portfolios, although they tend to be riskier. By even when returns are adjusted for risk using CAPM, there is still a consistent premium for the smaller-sized portfolios.

a) The P/E effect
b) The Neglected-Firm and Liquidity Effect
c) Post-Earnings-Announcement Price Drift
d) The Small-Firm Effect
e) Book-to-Market Ratios

Answer 17

d) The Small-Firm Effect

Question 18

Which anomaly describes the following?

Portfolios of low P/E-ratio stocks have provided higher returns than high P/E portfolios. If two firms have the same expected earnings, the riskier stock will set a lower price and lower P/E ratio. Because of its higher risk, the low P/E stock also will have higher expected returns. I.e., an investor could earn superior returns simply by buying low P/E securities.

a) The P/E effect
b) The Neglected-Firm and Liquidity Effect
c) Post-Earnings-Announcement Price Drift
d) The Small-Firm Effect
e) Book-to-Market Ratios

Answer 18

a) The P/E effect

Question 19

Which anomaly describes the following?

Small firms tend to be neglected by large institutional traders, hence information about smaller firm is less available. The information deficiency makes smaller firms to be riskier investments that command higher returns.

a) The P/E effect
b) The Neglected-Firm and Liquidity Effect
c) Post-Earnings-Announcement Price Drift
d) The Small-Firm Effect
e) Book-to-Market Ratios

Answer 19

b) The Neglected-Firm and Liquidity Effect

Question 20

Which anomaly describes the following?

A powerful predictor of returns across securities in the ratio of the book value of the firm’s equity to the market value of equity. The dramatic dependence of returns on book-to-market ratio is independent of beta, suggesting either that high book-to-market ratio firms are relatively underpriced or that the book-to-market ratio is serving as a proxy for a risk factor that affect equilibrium returns.

a) The P/E effect
b) The Neglected-Firm and Liquidity Effect
c) Post-Earnings-Announcement Price Drift
d) The Small-Firm Effect
e) Book-to-Market Ratios

Answer 20

e) Book-to-Market Ratios

Question 21

Which anomaly describes the following?

Sluggish response of stock’s prices. The ‘news content’ of an earnings announcement can be evaluated by comparing the announcement of actual earnings to the value previously expected by market participants. The difference is the ‘earnings surprise’. One could have earned abnormal profits by simply waiting for earnings announcement and purchasing a stock portfolio of positive-earnings-surprise companies.

a) The P/E effect
b) The Neglected-Firm and Liquidity Effect
c) Post-Earnings-Announcement Price Drift
d) The Small-Firm Effect
e) Book-to-Market Ratios

Answer 21

c) Post-Earnings-Announcement Price Drift

Question 22

True or false.

Negative abnormal returns (declining CARs) after an announcement date is a violation of efficient markets.

Answer 22

True.

If one can predict such a phenomenon, a profit opportunity emerges: Sell (or short sell) the affected stocks on an event date just before their prices are predicted to fall.

Question 23

If markets are efficient, what should be the correlation coefficient between stock returns for two non-overlapping time periods?

a) Positive
b) Negative
c) 0
d) 1

Answer 23

c) 0

If not, one could use returns from one period to predict returns in later periods and make abnormal profits – which should not be possible in an efficient market.

Question 24

“If all securities are fairly priced, all must offer equal expected rates of return.”

a) Yes, fairly priced securities correlate with equal expected rates of return.
b) No, fairly priced means the return reflects the corresponding risk of the individual security.
c) This cannot be determines.
d) Yes, the return incorporates the corresponding risk and this is equal for all securities.

Answer 24

b) No, fairly priced means the return reflects the corresponding risk of the individual security.

Question 25

Steady Growth Industries has never missed a dividend payment in its 94-year history. Does this make it more attractive to you as a possible purchase for your stock portfolio?

Answer 25

No, the value of dividend predictability would be already reflected in the stock price.

Question 26

Which of the following (hypothetical) observations would most contradict the proposition that the stock market is weakly efficient? a) Over 25% of mutual funds outperform the market on average. b) Insiders earn abnormal trading profits. c) Every January, the stock market earns abnormal returns. d) All of the above

Answer 26

c) Every January, the stock market earns abnormal returns. This is the most contradicting observation, since knowing that the stock prices earn abnormal returns every January, even a weakly efficient market would reflect this abnormal return in prices every January. In other words, this is a predictable pattern in returns which should not occur if the weak-form EMH is valid. Explanation: a) Overperformance of competent investors and asset managers is possible given absence of perfectly efficient markets. b) This would contradict strongly efficient markets, since all information (public and non-public) would be immediately reflected in prices.

Question 27

Which of the following sources of market inefficiency would be most easily exploited? a) A stock price drops suddenly due to a large sale by an institution. b) A stock is overpriced because traders are restricted from short sales. c) Stocks are overvalued because investors are exuberant over increased productivity in the economy.

Answer 27

a) A stock price drops suddenly due to a large sale by an institution.

Question 28

Suppose that, after conducting an analysis of past stock prices, you come up with the following observations. Which would appear to contradict the weak form of the efficient market hypothesis? a) The average rate of return is significantly greater than zero. b) The correlation between the return during a given week and the return during the following week is zero. c) One could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall. d) One could have made higher-than-average capital gains by holding stocks with low dividend yields.

Answer 28

c) One could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall. Buying stocks when prices are rising and selling them at lower prices can by definition not result in superior returns. Investors should always try to buy at a lower cost and sell at higher price to make profit.

Question 29

Which of the following statements are true if the efficient market hypothesis holds? a) It implies that future events can be forecast with perfect accuracy. b) It implies that prices reflect all available information. c) It implies that security prices change for no discernible reason. d) It implies that prices do not fluctuate.

Answer 29

b) It implies that prices reflect all available information.

Question 30

Which of the following would be a viable way to earn abnormally high trading profits if markets are semi-strong-form efficient? a) Buy shares in companies with low P/E ratios. b) Buy shares in companies with recent above-average price changes. c) Buy shares in companies with recent below-average price changes. d) Buy shares in companies for which you have advance knowledge of an improvement in the management team.

Answer 30

d) Buy shares in companies for which you have advance knowledge of an improvement in the management team. This is the possibility to achieve abnormal returns in a semi-strong efficient market, since it allows non-public information to be source of excess profits. In a strong form efficient market, insider information would be reflected in the stock price, which means that this source of profit would no longer exist. In a semi strong-form efficient market, it is not possible to earn abnormally high profits by trading on publicly available information. Information about P/E ratios and recent price changes is publicly known. On the other hand, an investor who has advance knowledge of management improvements could earn abnormally high trading profits (unless the market is also strong-form efficient).

Question 31

Is the following consistent or a violation of the EMH? Nearly half of all professionally managed mutual funds are able to outperform the S&P 500 in a typical year

Answer 31

Consistent – simply based on pure luck, half of all managers should be able to beat the market in any year.

Question 32

Is the following consistent or a violation of the EMH? Money managers who outperform the market (on a risk-adjusted basis) in one year are likely to outperform the market in the following year.

Answer 32

Violent – Following the notion of random walk, the outperformance in one year should not result in a likely outperformance of the market in the future. This would be the basis of an ‘easy money’ rule: simply invest with last year’s best manager.

Question 33

Is the following consistent or a violation of the EMH? Stock prices tend to be predictably more volatile in January than in other months.

Answer 33

Consistent – In contrast to predictable returns, predictable volatility does not convey a mean to earn abnormal returns.

Question 34

Is the following consistent or a violation of the EMH? Stock prices of companies that announce increased earnings in January tend to outperform the market in February.

Answer 34

Violent – Under EMH, abnormal performance ought to occur in January when earnings are announced – not later.

Question 35

If you believe that a firm is less bad than what the market believes, should you buy or sell? a) Buy b) Sell Why?

Answer 35

a) Buy In your view, the firm is not as bad as everyone else believes it to be. Therefore, you view the firm as undervalued by the market. You are less pessimistic about the firm’s prospects than the beliefs built into the stock price.

Question 36

Good News, Inc., just announced an increase in its annual earnings, yet its stock price fell. Is there a rational explanation for this phenomenon?

Answer 36

The market may have estimated even greater increase in earnings. Compared to expectations, the announcement may have been a disappointment.