Chapter 11 EMH

Chapter 11 - The Efficient Market Hypothesis

Chapter 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

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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.

Chapter 11 - 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. Difficulty: Easy

5. 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 ______. A. positive; zero B. positive; positive C. positive; negative D. zero; positive E. zero; zero

A random walk has an expected price change of zero and a submartingale has a positive expected price change. Difficulty: Easy

7. Proponents of the EMH typically advocate A. an active trading strategy. B. investing in an index fund. C. a passive investment strategy. D. A and B E. B and C

Believers of market efficiency advocate passive investment strategies, and an investment in an index fund is one of the most practical passive investment strategies, especially for small investors.

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Difficulty: Easy

8. Proponents of the EMH typically advocate A. buying individual stocks on margin and trading frequently. B. investing in hedge funds. C. a passive investment strategy. D. A and B E. B and C

Believers of market efficiency advocate passive investment strategies, and an investment in an index fund is one of the most practical passive investment strategies, especially for small investors. Difficulty: Easy

9. If you believe in the _______ form of the EMH, 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, trading volume or short interest. A. semistrong B. strong C. weak D. all of the above E. none of the above

The information described above is market data, which is the data set for the weak form of market efficiency. The semistrong form includes the above plus all other public information. The strong form includes all public and private information. Difficulty: Easy

Chapter 11 - The Efficient Market Hypothesis

10. If you believe in the _________ form of the EMH, you believe that stock prices reflect all available information, including information that is available only to insiders. A. semistrong B. strong C. weak D. all of the above E. none of the above

The strong form includes all public and private information. Difficulty: Easy

11. If you believe in the reversal effect, you should A. buy bonds in this period if you held stocks in the last period. B. buy stocks in this period if you held bonds in the last period. C. buy stocks this period that performed poorly last period. D. go short. E. C and D The reversal effect states that stocks that do well in one period tend to perform poorly in the subsequent period, and vice versa. Difficulty: Easy

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12. __________ focus more on past price movements of a firm's stock than on the underlying determinants of future profitability. A. Credit analysts B. Fundamental analysts C. Systems analysts D. Technical analysts E. All of the above

Technicians attempt to predict future stock prices based on historical stock prices. Difficulty: Easy

13. _________ above which it is difficult for the market to rise. A. Book value is a value B. Resistance level is a value C. Support level is a value D. A and B E. A and C

When stock prices have remained stable for a long period, these prices are termed resistance levels; technicians believe it is difficult for the stock prices to penetrate these resistance levels. Difficulty: Easy

14. _________ below which it is difficult for the market to fall. A. Intrinsic value is a value B. Resistance level is a value C. Support level is a value D. A and B E. B and C

When stock prices have remained stable for a long period, these prices are termed support levels; technicians believe it is difficult for the stock prices to penetrate these support levels. Difficulty: Easy

Chapter 11 - The Efficient Market Hypothesis

15. ___________ the return on a stock beyond what would be predicted from market movements alone. A. An excess economic return is B. An economic return is C. An abnormal return is D. A and B E. A and C

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An economic return is the expected return, based on the perceived level of risk and market factors. When returns exceed these levels, the returns are called abnormal or excess economic returns. Difficulty: Easy

16. The debate over whether markets are efficient will probably never be resolved because of ________. A. the lucky event issue. B. the magnitude issue. C. the selection bias issue. D. all of the above. E. none of the above.

Factors A, B, and C all exist make rigid testing of market efficiency difficult or impossible. Difficulty: Easy

18. Arbel (1985) found that A. the January effect was highest for neglected firms. B. the book-to-market value ratio effect was highest in January C. the liquidity effect was highest for small firms. D. the neglected firm effect was independent of the small firm effect. E. small firms had higher book-to-market value ratios.

Arbel divided firms into highly researched, moderately researched, and neglected groups based on the number of institutions holding the stock.

Chapter 11 - The Efficient Market Hypothesis Difficulty: Moderate

20. Basu (1977, 1983) found that firms with low P/E ratios A. earned higher average returns than firms with high P/E ratios. B. earned the same average returns as firms with high P/E ratios. C. earned lower average returns than firms with high P/E ratios. D. had higher dividend yields than firms with high P/E ratios. E. none of the above.

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. However, 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. Difficulty: Moderate

21. Jaffe (1974) found that stock prices _________ after insiders intensively bought shares. A. decreased B. did not change C. increased D. became extremely volatile E. became much less volatile

Insider trading may signal private information. Difficulty: Moderate

22. Banz (1981) found that, on average, the risk-adjusted returns of small firms A. were higher than the risk-adjusted returns of large firms. B. were the same as the risk-adjusted returns of large firms. C. were lower than the risk-adjusted returns of large firms. D. were unrelated to the risk-adjusted returns of large firms. E. were negative.

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Banz found A to be true, although subsequent studies have attempted to explain the small firm effect as the January effect, the neglected firm effect, etc. Difficulty: Moderate

Chapter 11 - The Efficient Market Hypothesis

24. Studies of positive earnings surprises have shown that there is A. a positive abnormal return on the day positive earnings surprises are announced. B. a positive drift in the stock price on the days following the earnings surprise announcement. C. a negative drift in the stock price on the days following the earnings surprise announcement. D. both A and B are true. E. both A and C are true.

The market appears to adjust to earnings information gradually, resulting in a sustained period of abnormal returns. Difficulty: Moderate

25. Studies of negative earnings surprises have shown that there is A. a negative abnormal return on the day negative earnings surprises are announced. B. a positive drift in the stock price on the days following the earnings surprise announcement. C. a negative drift in the stock price on the days following the earnings surprise announcement. D. both A and B are true. E. both A and C are true.

The market appears to adjust to earnings information gradually, resulting in a sustained period of abnormal returns. Difficulty: Moderate

26. Studies of stock price reactions to news are called A. reaction studies. B. event studies. C. drift studies. D. both A and D are true. E. both B and D are true.

Studies of stock price reactions to news are called event studies.

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Difficulty: Moderate

Chapter 11 - The Efficient Market Hypothesis

27. On November 22, 2005 the stock price of Walmart was $39.50 and the retailer stock index was 600.30. On November 25, 2005 the stock price of Walmart was $40.25 and the retailer stock index was 605.20. Consider the ratio of Walmart to the retailer index on November 22 and November 25. Walmart is _______ the retail industry and technical analysts who follow relative strength would advise _______ the stock. A. outperforming, buying B. outperforming, selling C. underperforming, buying D. underperforming, selling E. equally performing, neither buying nor selling

11/22: $39.50/600.30 = 0.0658; 11/25: $40.25/605.20 = 0.0665; Thus, K-Mart's relative strength is improving and technicians using this technique would recommend buying. Difficulty: Moderate

28. Work by Amihud and Mendelson (1986, 1991) A. argues that investors will demand a rate of return premium to invest in less liquid stocks. B. may help explain the small firm effect. C. may be related to the neglected firm effect. D. B and C. E. A, B, and C.

Lack of liquidity may affect the returns of small and neglected firms; however the theory does not explain why the abnormal returns are concentrated in January. Difficulty: Moderate

9. 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 ________. A. greater than 1%, greater than 1% B. greater than 1%, less than 1% C. less than 1%, greater than 1% D. less than 1%, less than 1% E. less than 0.5%, greater than 0.5%

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This finding suggests either that low market-to-book ratio firms are relatively underpriced, or that the market-to-book ratio is serving as a proxy for a risk factor that affects expected equilibrium returns. Difficulty: Moderate

30. A market decline of 23% on a day when there is no significant macroeconomic event ______ consistent with the EMH because ________. A. would be, it was a clear response to macroeconomic news. B. would be, it was not a clear response to macroeconomic news. C. would not be, it was a clear response to macroeconomic news. D. would not be, it was not a clear response to macroeconomic news. E. none of the above.

This happened on October 19, 1987. Although this specific event is not mentioned in this edition of the book, it is an example of something that would be considered a violation of the EMH. Difficulty: Moderate

31. In an efficient market, __________. A. security prices react quickly to new information B. security prices are seldom far above or below their justified levels C. security analysts will not enable investors to realize superior returns consistently D. one cannot make money E. A, B, and C

A, B, and C are true; however, even in an efficient market one should be able to earn the appropriate risk-adjusted rate of return.

Difficulty: Easy

Chapter 11 - The Efficient Market Hypothesis

34. A finding that _________ would provide evidence against the semistrong form of the efficient market theory. A. low P/E stocks tend to have positive abnormal returns B. trend analysis is worthless in determining stock prices C. one can consistently outperform the market by adopting the contrarian approach exemplified by the reversals phenomenon D. A and B E. A and C

Both A and C are inconsistent with the semistrong form of the EMH. Difficulty: Moderate

35. The weak form of the efficient market hypothesis contradicts A. technical analysis, but supports fundamental analysis as valid. B. fundamental analysis, but supports technical analysis as valid. C. both fundamental analysis and technical analysis. D. technical analysis, but is silent on the possibility of successful fundamental analysis. E. none of the above.

The process of fundamental analysis makes the market more efficient, and thus the work of the fundamentalist more difficult. The data set for the weak form of the EMH is market data, which is the only data used exclusively by technicians. Fundamentalists use all public information. Difficulty: Moderate

36. Two basic assumptions of technical analysis are that security prices adjust A. rapidly to new information and market prices are determined by the interaction of supply and demand. B. rapidly to new information and liquidity is provided by security dealers. C. gradually to new information and market prices are determined by the interaction of supply and demand. D. gradually to new information and liquidity is provided by security dealers. E. rapidly to information and to the actions of insiders.

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.

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Difficulty: Moderate

37. Cumulative abnormal returns (CAR) A. are used in event studies. B. are better measures of security returns due to firm-specific events than are abnormal returns (AR). C. are cumulated over the period prior to the firm-specific event. D. A and B. E. A and C.

As leakage of information occurs, 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. Difficulty: Moderate

40. In an efficient market the correlation coefficient between stock returns for two nonoverlapping time periods should be A. positive and large. B. positive and small. C. zero. D. negative and small. E. negative and large.

In an efficient market there should be no serial correlation between returns from nonoverlapping periods. Difficulty: Moderate

41. The weather report says that a devastating and unexpected freeze is expected to hit Florida tonight, during the peak of the citrus harvest. In an efficient market one would expect the price of Florida Orange's stock to A. drop immediately. B. remain unchanged. C. increase immediately. D. gradually decline for the next several weeks. E. gradually increase for the next several weeks.

Chapter 11 - The Efficient Market Hypothesis

In an efficient market the price of the stock should drop immediately when the bad news is announced. If later news changes the perceived impact to Florida Orange, the price may once again adjust quickly to the new information. A gradual change is a violation of the EMH. Difficulty: Moderate

42. Matthews Corporation has a beta of 1.2. The annualized market return yesterday was 13%, and the risk-free rate is currently 5%. You observe that Matthews had an annualized return yesterday of 17%. Assuming that markets are efficient, this suggests that A. bad news about Matthews was announced yesterday. B. good news about Matthews was announced yesterday. C. no news about Matthews was announced yesterday. D. interest rates rose yesterday. E. interest rates fell yesterday.

AR = 17% - (5% + 1.2 (8%)) = +2.4%. A positive abnormal return suggests that there was firm-specific good news. Difficulty: Moderate

43. Nicholas Manufacturing just announced yesterday that its 4th quarter earnings will be 10% higher than last year's 4th quarter. You observe that Nicholas had an abnormal return of -1.2% yesterday. This suggests that A. the market is not efficient. B. Nicholas' stock will probably rise in value tomorrow. C. investors expected the earnings increase to be larger than what was actually announced. D. investors expected the earnings increase to be smaller than what was actually announced. E. earnings are expected to decrease next quarter.

Anticipated earnings changes are impounded into a security's price as soon as expectations are formed. Therefore a negative market response indicates that the earnings surprise was negative, that is, the increase was less than anticipated. Difficulty: Moderate

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45. If stock prices follow a random walk A. it implies that investors are irrational. B. it means that the market cannot be efficient. C. price levels are not random. D. price changes are random. E. price movements are predictable.

Chapter 11 - The Efficient Market Hypothesis

A random walk means that the changes in prices are random and independent. Difficulty: Easy

48. 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. I, IV, and V B. I, II, and III C. II, III, and IV D. II, IV, and V E. All of the items are used by fundamental analysts.

Analysts look at fundamental factors such as earnings, dividend prospects, expectation of future interest rates, and risk of the firm. The information is used to determine the present value of future cash flows to stockholders. Technical analysts use trendlines and resistance levels. Difficulty: Moderate

49. According to proponents of the efficient market hypothesis, the best strategy for a small investor with a portfolio worth $40,000 is probably to A. perform fundamental analysis. B. exploit market anomalies. C. invest in Treasury securities. D. invest in derivative securities. E. invest in mutual funds.

Individual investors tend to have relatively small portfolios and are usually unable to realize economies of size. The best strategy is to pool funds with other small investors and allow professional managers to invest the funds.

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Difficulty: Moderate

50. 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. I, III, and IV B. II, III, and IV C. I and III D. III and IV E. I, III, IV, and V

Warren Buffet manages Berkshire Hathaway and Peter Lynch managed Fidelity's Magellan Fund. Phoebe Buffet is a character on NBC's "Friends" and Jimmy Buffet is "Wasting Away in Margaritaville". Merrill Lynch isn't a person. Difficulty: Moderate

53. QQAG has a beta of 1.7. The annualized market return yesterday was 13%, and the riskfree rate is currently 3%. You observe that QQAG had an annualized return yesterday of 20%. Assuming that markets are efficient, this suggests that A. bad news about QQAG was announced yesterday. B. good news about QQAG was announced yesterday. C. no significant news about QQAG was announced yesterday. D. interest rates rose yesterday. E. interest rates fell yesterday.

AR = 20% - (3% + 1.7 (10%)) = 0.0%. 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. Difficulty: Moderate

Chapter 11 - The Efficient Market Hypothesis

55. LJP Corporation just announced yesterday that it would undertake an international joint venture. You observe that LJP had an abnormal return of 3% yesterday. This suggests that A. the market is not efficient. B. LJP stock will probably rise in value again tomorrow. C. investors view the international joint venture as bad news. D. investors view the international joint venture as good news. E. earnings are expected to decrease next quarter. The positive abnormal return suggests that investors view the international joint venture as good news. Difficulty: Moderate

57. The Food and Drug Administration (FDA) just announced yesterday that they would approve a new cancer-fighting drug from King. You observe that King had an abnormal return of 0% yesterday. This suggests that A. the market is not efficient. B. King stock will probably rise in value tomorrow. C. King stock will probably fall in value tomorrow. D. the approval was already anticipated by the market E. none of the above.

The approval was already anticipated by the market Difficulty: Moderate

58. Your professor finds a stock-trading rule that generates excess risk-adjusted returns. Instead of publishing the results, she keeps the trading rule to herself. This is most closely associated with ________. A. regret avoidance B. selection bias C. framing D. insider trading E. none of the above

This is an example of selection bias.

Difficulty: Moderate

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59. At freshman orientation, 1,500 students are asked to flip a coin 20 times. One student is crowned the winner (tossed 20 heads). This is most closely associated with ________. A. regret avoidance B. selection bias C. overconfidence D. the lucky event issue E. none of the above

This is an example of the lucky event issue. Difficulty: Moderate

60. Sehun (1986) finds that the practice of monitoring insider trade disclosures, and trading on that information, would be ________. A. extremely profitable for long-term traders B. extremely profitable for short-term traders C. marginally profitable for long-term traders D. marginally profitable for short-term traders E. not sufficiently profitable to cover trading costs

Answer E; not sufficiently profitable to cover trading costs Difficulty: Moderate

Chapter 11 - The Efficient Market Hypothesis

61. If you believe in the reversal effect, you should A. sell bonds in this period if you held stocks in the last period. B. sell stocks in this period if you held bonds in the last period. C. sell stocks this period that performed well last period. D. go long. E. C and D

The reversal effect states that stocks that do well in one period tend to perform poorly in the subsequent period, and vice versa. Difficulty: Easy

62. Patell and Woflson (1984) report that most of the stock price response to corporate dividend or earnings announcements occurs within ____________ of the announcement. A. 10 minutes B. 45 minutes C. 2 hours D. 4 hours E. 2 trading days

the correct answer is 2 hours. Difficulty: Moderate

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