Chapter 11 - The Efficient Market HypothesisChapter 11 The Efficient Market Hypothesis Multiple Choice Questions 1. If you believe in the ________ form of the EMH, you believe that stock prices reflect all relevant information including historical stock prices and current public information about the firm, but not information that is available only to insiders. A. semistrong B. strong C. weak D. A, B, and C E. none of the above The semistrong form of EMH maintains that stock prices immediately reflect all historical and current public information, but not inside information. Difficulty: Easy 2. When Maurice Kendall examined the patterns of stock returns in 1953 he concluded that the stock market was __________. Now, these random price movements are believed to be _________. A. inefficient; the effect of a well-functioning market B. efficient; the effect of an inefficient market C. inefficient; the effect of an inefficient market D. efficient; the effect of a well-functioning market E. irrational; even more irrational than before Random price changes were originally thought to be driven by irrationality. Now, financial economists believe random price changes occur because markets are informationally efficient. Difficulty: Easy 11-1 4. A hybrid strategy is one where the investor A. uses both fundamental and technical analysis to select stocks. B. selects the stocks of companies that specialize in alternative fuels. C. selects some actively-managed mutual funds on their own and uses an investment advisor to select other actively-managed funds. D. maintains a passive core and augments the position with an actively managed portfolio. E. none of the above. especially for small investors. A and B E. B and C Believers of market efficiency advocate passive investment strategies.The Efficient Market Hypothesis A hybrid strategy is one where the investor maintains a passive core and augments the position with an actively managed portfolio. zero. 11-3 . D. zero B. B. zero A random walk has an expected price change of zero and a submartingale has a positive expected price change. positive. investing in an index fund. C. an active trading strategy. a passive investment strategy.Chapter 11 . positive E. A. and an investment in an index fund is one of the most practical passive investment strategies. Difficulty: Easy 5. positive. The difference between a random walk and a submartingale is the expected price change in a random walk is ______ and the expected price change for a submartingale is ______. negative D. Proponents of the EMH typically advocate A. Difficulty: Easy 7. zero. positive. positive C. A. D. investing in hedge funds. Difficulty: Easy 9. you believe that stock prices reflect all information that can be derived by examining market trading data such as the history of past stock prices. which is the data set for the weak form of market efficiency. weak D. Proponents of the EMH typically advocate A. a passive investment strategy. trading volume or short interest. If you believe in the _______ form of the EMH. and an investment in an index fund is one of the most practical passive investment strategies. C. A and B E. Difficulty: Easy . strong C. all of the above E. semistrong B. none of the above The information described above is market data. especially for small investors. The strong form includes all public and private information. B and C Believers of market efficiency advocate passive investment strategies. buying individual stocks on margin and trading frequently. B.Difficulty: Easy 8. The semistrong form includes the above plus all other public information. go short. E. you should A. C. none of the above The strong form includes all public and private information. all of the above E. strong C. B. A.Chapter 11 . D. you believe that stock prices reflect all available information. and vice versa. C and D The reversal effect states that stocks that do well in one period tend to perform poorly in the subsequent period. buy stocks this period that performed poorly last period. buy bonds in this period if you held stocks in the last period.The Efficient Market Hypothesis 10. semistrong B. Difficulty: Easy 11. buy stocks in this period if you held bonds in the last period. Difficulty: Easy 11-5 . If you believe in the _________ form of the EMH. If you believe in the reversal effect. weak D. including information that is available only to insiders. Support level is a value D. these prices are termed resistance levels. A. _________ above which it is difficult for the market to rise. Difficulty: Easy 14. __________ focus more on past price movements of a firm's stock than on the underlying determinants of future profitability. technicians believe it is difficult for the stock prices to penetrate these resistance levels. Difficulty: Easy . All of the above Technicians attempt to predict future stock prices based on historical stock prices. Fundamental analysts C. Credit analysts B. A and C When stock prices have remained stable for a long period. A and B E. A. Book value is a value B. technicians believe it is difficult for the stock prices to penetrate these support levels. Support level is a value D. A. Difficulty: Easy 13.12. Technical analysts E. A and B E. these prices are termed support levels. B and C When stock prices have remained stable for a long period. Resistance level is a value C. Systems analysts D. _________ below which it is difficult for the market to fall. Intrinsic value is a value B. Resistance level is a value C. A and C 11-7 . An abnormal return is D. An excess economic return is B.Chapter 11 . A and B E. A. ___________ the return on a stock beyond what would be predicted from market movements alone.The Efficient Market Hypothesis 15. An economic return is C. and neglected groups based on the number of institutions holding the stock. and C all exist make rigid testing of market efficiency difficult or impossible. A. small firms had higher book-to-market value ratios. the lucky event issue. the selection bias issue. the neglected firm effect was independent of the small firm effect. E. E. Arbel divided firms into highly researched. B. B. the January effect was highest for neglected firms. . C.An economic return is the expected return. Difficulty: Easy 18. all of the above. Arbel (1985) found that A. Factors A. the book-to-market value ratio effect was highest in January C. moderately researched. When returns exceed these levels. Difficulty: Easy 16. B. the liquidity effect was highest for small firms. The debate over whether markets are efficient will probably never be resolved because of ________. the magnitude issue. D. D. based on the perceived level of risk and market factors. none of the above. the returns are called abnormal or excess economic returns. were lower than the risk-adjusted returns of large firms. B.The Efficient Market Hypothesis Difficulty: Moderate 20. B. However. earned lower average returns than firms with high P/E ratios. Banz (1981) found that. were unrelated to the risk-adjusted returns of large firms. A. Difficulty: Moderate 21. increased D. were the same as the risk-adjusted returns of large firms. C. Difficulty: Moderate 22. earned the same average returns as firms with high P/E ratios. C. Jaffe (1974) found that stock prices _________ after insiders intensively bought shares. earned higher average returns than firms with high P/E ratios. the P/E ratio may capture risk not fully impounded in market betas so this may represent an appropriate risk adjustment rather than a market anomaly. had higher dividend yields than firms with high P/E ratios. the risk-adjusted returns of small firms A. became much less volatile Insider trading may signal private information. were higher than the risk-adjusted returns of large firms. did not change C. E. 11-9 . on average. Basu (1977. became extremely volatile E. none of the above. D. Firms with high P/E ratios already have an inflated price relative to earnings and thus tend to have lower returns than low P/E ratio stocks.Chapter 11 . 1983) found that firms with low P/E ratios A. E. D. decreased B. were negative. Difficulty: Moderate . etc.Banz found A to be true. the neglected firm effect. although subsequent studies have attempted to explain the small firm effect as the January effect. a positive drift in the stock price on the days following the earnings surprise announcement. Studies of positive earnings surprises have shown that there is A. C. reaction studies. a negative drift in the stock price on the days following the earnings surprise announcement. a negative abnormal return on the day negative earnings surprises are announced. E. Studies of stock price reactions to news are called A. a positive drift in the stock price on the days following the earnings surprise announcement. Difficulty: Moderate 26. B. a negative drift in the stock price on the days following the earnings surprise announcement. E. D. resulting in a sustained period of abnormal returns. both A and B are true. D. Difficulty: Moderate 25. B. event studies. both A and B are true. Studies of negative earnings surprises have shown that there is A. 11-11 . The market appears to adjust to earnings information gradually. E. both A and D are true. drift studies. C. C.The Efficient Market Hypothesis 24. D. both A and C are true.Chapter 11 . resulting in a sustained period of abnormal returns. Studies of stock price reactions to news are called event studies. a positive abnormal return on the day positive earnings surprises are announced. both B and D are true. both A and C are true. The market appears to adjust to earnings information gradually. B. Difficulty: Moderate . greater than 1% B. may help explain the small firm effect. less than 1% C. may be related to the neglected firm effect.50 and the retailer stock index was 600. greater than 1%. A. argues that investors will demand a rate of return premium to invest in less liquid stocks. selling C.The Efficient Market Hypothesis 27. On November 25. underperforming. Walmart is _______ the retail industry and technical analysts who follow relative strength would advise _______ the stock. outperforming.20 = 0. E. On November 22. greater than 1%.0658.5% 11-13 . Thus. neither buying nor selling 11/22: $39.0665. 11/25: $40. Difficulty: Moderate 9. A. greater than 1% D.Chapter 11 .50/600. B and C. 2005 the stock price of Walmart was $40. buying D.25 and the retailer stock index was 605.5%. A. Difficulty: Moderate 28.30. however the theory does not explain why the abnormal returns are concentrated in January.25/605.20. selling E. less than 1%. D. Work by Amihud and Mendelson (1986. outperforming. less than 1% E. Lack of liquidity may affect the returns of small and neglected firms. 1991) A. greater than 0. and C. B. C.30 = 0. B. equally performing. Fama and French (1992) found that the stocks of firms within the highest decile of market/book ratios had average monthly returns of _______ while the stocks of firms within the lowest decile of market/book ratios had average monthly returns of ________. Consider the ratio of Walmart to the retailer index on November 22 and November 25. buying B. 2005 the stock price of Walmart was $39. less than 1%. less than 0. K-Mart's relative strength is improving and technicians using this technique would recommend buying. underperforming. D. security analysts will not enable investors to realize superior returns consistently D. none of the above. it is an example of something that would be considered a violation of the EMH. would be. one cannot make money E. A. B. Difficulty: Moderate 30. In an efficient market. and C are true. B. C. it was a clear response to macroeconomic news. E. security prices react quickly to new information B. Difficulty: Moderate 31. This happened on October 19. would not be.This finding suggests either that low market-to-book ratio firms are relatively underpriced. A. it was a clear response to macroeconomic news. or that the market-to-book ratio is serving as a proxy for a risk factor that affects expected equilibrium returns. security prices are seldom far above or below their justified levels C. Although this specific event is not mentioned in this edition of the book. however. it was not a clear response to macroeconomic news. 1987. and C A. A. __________. would be. even in an efficient market one should be able to earn the appropriate risk-adjusted rate of return. B. A market decline of 23% on a day when there is no significant macroeconomic event ______ consistent with the EMH because ________. would not be. it was not a clear response to macroeconomic news. Difficulty: Easy . The weak form of the efficient market hypothesis contradicts A. A finding that _________ would provide evidence against the semistrong form of the efficient market theory. A and B E. rapidly to information and to the actions of insiders. B. E. and thus the work of the fundamentalist more difficult. gradually to new information and liquidity is provided by security dealers. Difficulty: Moderate 35. but is silent on the possibility of successful fundamental analysis. D. rapidly to new information and liquidity is provided by security dealers.Chapter 11 . none of the above. rapidly to new information and market prices are determined by the interaction of supply and demand. fundamental analysis. Fundamentalists use all public information. A. one can consistently outperform the market by adopting the contrarian approach exemplified by the reversals phenomenon D. low P/E stocks tend to have positive abnormal returns B. technical analysis. D. gradually to new information and market prices are determined by the interaction of supply and demand. Two basic assumptions of technical analysis are that security prices adjust A. but supports fundamental analysis as valid. C. both fundamental analysis and technical analysis.The Efficient Market Hypothesis 34. but supports technical analysis as valid. trend analysis is worthless in determining stock prices C. 11-15 . Difficulty: Moderate 36. technical analysis. A and C Both A and C are inconsistent with the semistrong form of the EMH. C. Technicians follow market data--price changes and volume of trading (as indicator of supply and demand) believing that they can identify price trends as security prices adjust gradually. The process of fundamental analysis makes the market more efficient. The data set for the weak form of the EMH is market data. E. which is the only data used exclusively by technicians. B. B. are cumulated over the period prior to the firm-specific event. during the peak of the citrus harvest. . zero. E. B. Difficulty: Moderate 40. In an efficient market there should be no serial correlation between returns from nonoverlapping periods. C. are better measures of security returns due to firm-specific events than are abnormal returns (AR). The weather report says that a devastating and unexpected freeze is expected to hit Florida tonight. are used in event studies. E. C. negative and large. A and B.Difficulty: Moderate 37. drop immediately. E. A and C. B. positive and small. As leakage of information occurs. gradually decline for the next several weeks. Cumulative abnormal returns (CAR) A. In an efficient market the correlation coefficient between stock returns for two nonoverlapping time periods should be A. remain unchanged. increase immediately. positive and large. Difficulty: Moderate 41. C. negative and small. gradually increase for the next several weeks. the accumulated abnormal returns that are abnormal returns summed over the period of interest (around the event date) are better measures of the effect of firm-specific events. D. In an efficient market one would expect the price of Florida Orange's stock to A. D. D. The annualized market return yesterday was 13%. C. that is. good news about Matthews was announced yesterday.4%. the market is not efficient.2% yesterday. interest rates fell yesterday. Difficulty: Moderate 43. B.2. You observe that Nicholas had an abnormal return of -1. investors expected the earnings increase to be larger than what was actually announced. and the risk-free rate is currently 5%. B. D. Matthews Corporation has a beta of 1. bad news about Matthews was announced yesterday. Assuming that markets are efficient. no news about Matthews was announced yesterday.Chapter 11 . the price may once again adjust quickly to the new information. the increase was less than anticipated. Nicholas' stock will probably rise in value tomorrow. This suggests that A. C. investors expected the earnings increase to be smaller than what was actually announced. Difficulty: Moderate 11-17 . A positive abnormal return suggests that there was firm-specific good news.2 (8%)) = +2. Nicholas Manufacturing just announced yesterday that its 4th quarter earnings will be 10% higher than last year's 4th quarter. this suggests that A. Anticipated earnings changes are impounded into a security's price as soon as expectations are formed. interest rates rose yesterday. Difficulty: Moderate 42. Therefore a negative market response indicates that the earnings surprise was negative. AR = 17% . earnings are expected to decrease next quarter. If later news changes the perceived impact to Florida Orange. A gradual change is a violation of the EMH. E. You observe that Matthews had an annualized return yesterday of 17%.(5% + 1.The Efficient Market Hypothesis In an efficient market the price of the stock should drop immediately when the bad news is announced. E. D. price levels are not random. C. it implies that investors are irrational. price movements are predictable. If stock prices follow a random walk A. . it means that the market cannot be efficient. B. D. E. price changes are random.45. II. D. and V B. 11-19 . E. I. III. B. perform fundamental analysis. and V E. Difficulty: Easy 48. I.The Efficient Market Hypothesis A random walk means that the changes in prices are random and independent. Individual investors tend to have relatively small portfolios and are usually unable to realize economies of size. Technical analysts use trendlines and resistance levels. IV. invest in derivative securities. Which of the following are used by fundamental analysts to determine proper stock prices? I) trendlines II) earnings III) dividend prospects IV) expectations of future interest rates V) resistance levels A. C. invest in mutual funds. Analysts look at fundamental factors such as earnings. the best strategy for a small investor with a portfolio worth $40. and risk of the firm. expectation of future interest rates. II. and IV D.Chapter 11 . The information is used to determine the present value of future cash flows to stockholders. The best strategy is to pool funds with other small investors and allow professional managers to invest the funds. All of the items are used by fundamental analysts. Difficulty: Moderate 49.000 is probably to A. dividend prospects. exploit market anomalies. and III C. IV. II. According to proponents of the efficient market hypothesis. invest in Treasury securities. B.7.(3% + 1. AR = 20% . III. Merrill Lynch isn't a person. III. I and III D. Phoebe Buffet is a character on NBC's "Friends" and Jimmy Buffet is "Wasting Away in Margaritaville". this suggests that A. Which of the following are investment superstars who have consistently shown superior performance? I) Warren Buffet II) Phoebe Buffet III) Peter Lynch IV) Merrill Lynch V) Jimmy Buffet A. You observe that QQAG had an annualized return yesterday of 20%. D. and V Warren Buffet manages Berkshire Hathaway and Peter Lynch managed Fidelity's Magellan Fund. Assuming that markets are efficient. A positive abnormal return suggests that there was firm-specific good news and a negative abnormal return suggests that there was firm-specific bad news. I. Difficulty: Moderate . good news about QQAG was announced yesterday. bad news about QQAG was announced yesterday. III. and IV C. III and IV E. interest rates fell yesterday.0%. C.7 (10%)) = 0. QQAG has a beta of 1. Difficulty: Moderate 53. no significant news about QQAG was announced yesterday.Difficulty: Moderate 50. and the riskfree rate is currently 3%. IV. E. interest rates rose yesterday. II. I. The annualized market return yesterday was 13%. and IV B. Difficulty: Moderate 11-21 .The Efficient Market Hypothesis 55. the market is not efficient. E. she keeps the trading rule to herself. You observe that King had an abnormal return of 0% yesterday. A. Difficulty: Moderate 57. investors view the international joint venture as bad news. none of the above. This suggests that A. selection bias C. D. regret avoidance B. The positive abnormal return suggests that investors view the international joint venture as good news. You observe that LJP had an abnormal return of 3% yesterday. B. This is most closely associated with ________. framing D. the approval was already anticipated by the market E. LJP stock will probably rise in value again tomorrow. C. The approval was already anticipated by the market Difficulty: Moderate 58. D.Chapter 11 . none of the above This is an example of selection bias. B. Instead of publishing the results. The Food and Drug Administration (FDA) just announced yesterday that they would approve a new cancer-fighting drug from King. King stock will probably fall in value tomorrow. Your professor finds a stock-trading rule that generates excess risk-adjusted returns. investors view the international joint venture as good news. insider trading E. the market is not efficient. C. earnings are expected to decrease next quarter. This suggests that A. King stock will probably rise in value tomorrow. LJP Corporation just announced yesterday that it would undertake an international joint venture. marginally profitable for long-term traders D. would be ________. selection bias C. none of the above This is an example of the lucky event issue. 1. extremely profitable for short-term traders C. not sufficiently profitable to cover trading costs Difficulty: Moderate . This is most closely associated with ________. Difficulty: Moderate 60. At freshman orientation.59. Sehun (1986) finds that the practice of monitoring insider trade disclosures. overconfidence D. One student is crowned the winner (tossed 20 heads). extremely profitable for long-term traders B.500 students are asked to flip a coin 20 times. A. marginally profitable for short-term traders E. regret avoidance B. not sufficiently profitable to cover trading costs Answer E. and trading on that information. A. the lucky event issue E. A. C and D The reversal effect states that stocks that do well in one period tend to perform poorly in the subsequent period. sell stocks in this period if you held bonds in the last period. sell stocks this period that performed well last period. 2 hours D. If you believe in the reversal effect. C. 4 hours E. 45 minutes C. you should A. B. Patell and Woflson (1984) report that most of the stock price response to corporate dividend or earnings announcements occurs within ____________ of the announcement. Difficulty: Easy 62. go long.Chapter 11 . Difficulty: Moderate 11-23 . 2 trading days the correct answer is 2 hours. D. sell bonds in this period if you held stocks in the last period.The Efficient Market Hypothesis 61. 10 minutes B. E. and vice versa.