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Chapter 08 - The Efficient Market Hypothesis

CHAPTER 08

THE EFFICIENT MARKET HYPOTHESIS

1. The correlation coefficient should be zero. If it were not zero, then one could use returns from one period to predict returns in later periods and therefore earn abnormal profits.

2. The phrase would be correct if it were modified to say “expected risk adjusted returns.” Securities all have the same risk adjusted expected return, however, actual results can and do vary. Unknown events cause certain securities to outperform others. This is not known in advance so expectations are set by known information.

3. Over the long haul, there is an expected upward drift in stock prices based on their fair expected rates of return. The fair expected return over any single day is very small (e.g., 12% per year is only about 0.03% per day), so that on any day the price is virtually equally likely to rise or fall. However, over longer periods, the small expected daily returns cumulate, and upward moves are indeed more likely than downward ones.

4. No, this is not a violation of the EMH. Microsoft’s continuing large profits do not imply that stock market investors who purchased Microsoft shares after its success already was evident would have earned a high return on their investments.

5. No. Random walk theory naturally expects there to be some people who beat the market and some people who do not. The information provided, however, fails to

consider the risk of the investment. Higher risk investments should have higher returns. As presented, it is possible to believe him without violating the EMH.

6. b. This is the definition of an efficient market.

7. d. It is not possible to offer a higher risk risk-return trade off if markets are efficient.

8. Strong firm efficiency includes all information; historical, public and private.

9. Incorrect. In the short term, markets reflect a random pattern. Information is constantly flowing in the economy and investors each have different expectations that vary constantly. A fluctuating market accurately reflects this logic. Furthermore, while

increased variability may be the result of an increase in unknown variables, this merely increases risk and the price is adjusted downward as a result. 10. c

This is a predictable pattern in returns, which should not occur if the stock market is weakly efficient.

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Chapter 08 - The Efficient Market Hypothesis

11. c

This is a classic filter rule, which would appear to contradict the weak form of the efficient market hypothesis.

12. c

The P/E ratio is public information so this observation would provide evidence against the semi-strong form of the efficient market theory.

13. No, it is not more attractive as a possible purchase. Any value associated with dividend predictability is already reflected in the stock price.

14. No, this is not a violation of the EMH. This empirical tendency does not provide investors with a tool that will enable them to earn abnormal returns; in other words, it does not suggest that investors are failing to use all available information. An investor could not use this phenomenon to choose undervalued stocks today. The phenomenon instead reflects the fact that dividends occur as a response to good performance. After the fact, the stocks that happen to have performed the best will pay higher dividends, but this does not imply that you can identify the best performers early enough to earn abnormal returns.

15. While positive beta stocks respond well to favorable new information about the economy’s progress through the business cycle, these should not show abnormal returns around already anticipated events. If a recovery, for example, is already

anticipated, the actual recovery is not news. The stock price should already reflect the coming recovery. 16.

b. Consistent. Half of all managers should outperform the market based on pure

luck in any year.

c. Violation. This would be the basis for an \

last year's best managers.

d. Consistent. Predictable volatility does not convey a means to earn abnormal

returns.

e. Violation. The abnormal performance ought to occur in January, when the

increased earnings are announced.

f. Violation. Reversals offer a means to earn easy money: simply buy last week's

losers.

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Chapter 08 - The Efficient Market Hypothesis

17. An anomaly is considered an EMH exception because there is historical data to

substantiated a claim that said anomalies have produced excess risk adjusted abnormal returns in the past. Several anomalies regarding fundamental analysis have been uncovered. These include the P/E effect, the small-firm-in-January effect, the

neglected- firm effect, post–earnings-announcement price drift, and the book-to-market effect. Whether these anomalies represent market inefficiency or poorly understood risk premiums is still a matter of debate. There are rational explanations for each, but not everyone agrees on the explanation. One dominant explanation is that many of these firms are also neglected firms, due to low trading volume, thus they are not part of an efficient market or offer more risk as a result of their reduced liquidity.

18. Implicit in the dollar-cost averaging strategy is the notion that stock prices fluctuate around a “normal” level. Otherwise, there is no meaning to statements such as: “when the price is high.” How do we know, for example, whether a price of $25 today will be viewed as high or low compared to the stock price in six months from now?

19. The market responds positively to new news. If the eventual recovery is anticipated, then the recovery is already reflected in stock prices. Only a better-than-expected recovery (or a worse-than-expected recovery) should affect stock prices.

20. You should buy the stock. In your view, the firm’s management 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.

21. The market may have anticipated even greater earnings. Compared to prior expectations, the announcement was a disappointment.

22. The negative abnormal returns (downward drift in CAR) just prior to stock purchases suggest that insiders deferred their purchases until after bad news was released to the public. This is evidence of valuable inside information. The positive abnormal returns after purchase suggest insider purchases in anticipation of good news. The analysis is symmetric for insider sales.

23. The negative abnormal returns (downward drift in CAR) just prior to stock purchases suggest that insiders deferred their purchases until after bad news was released to the public. This is evidence of valuable inside information. The positive abnormal returns after purchase suggest insider purchases in anticipation of good news. The analysis is symmetric for insider sales.

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