Chap 011

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
11-1
3. The stock market follows a __________.

A. random walk
B. submartingale
C. predictable pattern that can be exploited
D. A and C
E. B and C
The stock market follows a sbumartingale.
Difficulty: Easy
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.
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
11-2
6. 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. negative; zero
B. negative; positive
C. zero; 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.
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
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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
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
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
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
11-5
11-6
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
11-7
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
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.
Factors A, B, and C all exist make rigid testing of market efficiency difficult or impossible.
Difficulty: Easy
17. A common strategy for passive management is ____________.

A. creating an index fund
B. creating a small firm fund
C. creating an investment club
D. A and C
E. B and C
The index fund is, by definition, passively managed. The other investment alternatives may or
may not be managed passively.
Difficulty: Easy
11-8
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.
Difficulty: Moderate
19. Researchers have found that most of the small firm effect occurs
A. during the spring months.
B. during the summer months.
C. in December.
D. in January.
E. randomly.
Much of the so-called small firm effect simply may be the tax-effect as investors sell stocks
on which they have losses in December and reinvest the funds in January. As small firms are
especially volatile, these actions affect small firms in a more dramatic fashion.
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.
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.
11-9
11-10
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.
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.
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.
23. Proponents of the EMH think technical analysts

A. should focus on relative strength.
B. should focus on resistance levels.
C. should focus on support levels.
D. should focus on financial statements.
E. are wasting their time.
Technical analysts attempt to predict future stock prices from historic stock prices; proponents
of EMH believe that stock price changes are random variables.
11-11
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.
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.
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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11-13
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.
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.
11-14
29. 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%
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.
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.
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.
11-15
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
32. The weak form of the efficient market hypothesis asserts that
A. stock prices do not rapidly adjust to new information contained in past prices or past data.
B. future changes in stock prices cannot be predicted from past prices.
C. technicians cannot expect to outperform the market.
D. A and B
E. B and C
Stock prices do adjust rapidly to new information.
Difficulty: Easy
33. A support level is the price range at which a technical analyst would expect the
A. supply of a stock to increase dramatically.
B. supply of a stock to decrease substantially.
C. demand for a stock to increase substantially.
D. demand for a stock to decrease substantially.
E. price of a stock to fall.
A support level is considered to be a level below that the price of the stock is unlikely to fall
and is believed to be determined by market psychology.
Difficulty: Easy
11-16
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.
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.
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.
11-17
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.
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.
11-18
38. Studies of mutual fund performance

A. indicate that one should not randomly select a mutual fund.
B. indicate that historical performance is not necessarily indicative of future performance.
C. indicate that the professional management of the fund insures above market returns.
D. A and B.
E. B and C.
Studies show that all funds do not outperform the market and that historical performance is
not necessarily an indicator of future performance.
Difficulty: Easy
39. The likelihood of an investment newsletter's successfully predicting the direction of the
market for three consecutive years by chance should be
A. between 50% and 70%.
B. between 25% and 50%.
C. between 10% and 25%.
D. less than 10%.
E. greater than 70%.
The probability of successful prediction for 3 consecutive years is 23, or 12.5%.
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.
11-19
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.
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.
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.
11-20
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.
44. When Maurice Kendall first examined stock price patterns in 1953, he found that
A. certain patterns tended to repeat within the business cycle.
B. there were no predictable patterns in stock prices.
C. stocks whose prices had increased consistently for one week tended to have a net decrease
the following week.
D. stocks whose prices had increased consistently for one week tended to have a net increase
the following week.
E. the direction of change in stock prices was unpredictable, but the amount of change
followed a distinct pattern.
The first studies in this area were made possible by the development of computer technology.
Kendall's study was the first to indicate that markets were efficient.
Difficulty: Easy
11-21
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.
A random walk means that the changes in prices are random and independent.
Difficulty: Easy
46. The main difference between the three forms of market efficiency is that
A. the definition of efficiency differs.
B. the definition of excess return differs.
C. the definition of prices differs.
D. the definition of information differs.
E. they were discovered by different people.
The main difference is that weak form encompasses historical data, semistrong form
encompasses historical data and current public information, and strong form encompasses
historical data, current public information, and inside information. All of the other definitions
remain the same.
47. Chartists practice

A. technical analysis.
B. fundamental analysis.
C. regression analysis.
D. insider analysis.
E. psychoanalysis.
Chartist is another name for a technical analyst.
Difficulty: Easy
11-22
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.
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.
11-23
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.
51. Google has a beta of 1.0. The annualized market return yesterday was 11%, and the riskfree rate is currently 5%. You observe that Google had an annualized return yesterday of 14%.
Assuming that markets are efficient, this suggests that
A. bad news about Google was announced yesterday.
B. good news about Google was announced yesterday.
C. no news about Google was announced yesterday.
AR = 14% - (5% + 1.0 (6%)) = +3.0%. A positive abnormal return suggests that there was
firm-specific good news.
11-24
52. Music Doctors has a beta of 2.25. The annualized market return yesterday was 12%, and
the risk-free rate is currently 4%. You observe that Music Doctors had an annualized return
yesterday of 15%. Assuming that markets are efficient, this suggests that
A. bad news about Music Doctors was announced yesterday.
B. good news about Music Doctors was announced yesterday.
C. no news about Music Doctors was announced yesterday.
AR = 15% - (4% + 2.25 (8%)) = -7.0%. A negative abnormal return suggests that there was
firm-specific bad news.
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.
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.
11-25
54. QQAG just announced yesterday that its 4th quarter earnings will be 35% higher than last
year's 4th quarter. You observe that QQAG had an abnormal return of -1.7% yesterday. This
suggests that
B. QQAG 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.
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.
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
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.
The positive abnormal return suggests that investors view the international joint venture as
good news.
11-26
56. Music Doctors just announced yesterday that its 1st quarter sales were 35% higher than
last year's 1st quarter. You observe that Music Doctors had an abnormal return of -2%
yesterday. This suggests that
B. Music Doctors stock will probably rise in value tomorrow.
C. investors expected the sales increase to be larger than what was actually announced.
D. investors expected the sales increase to be smaller than what was actually announced.
The negative abnormal return suggests that investors expected the sales increase to be larger
than what was actually announced.
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
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
The approval was already anticipated by the market
11-27
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
This is an example of selection bias.
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
This is an example of the lucky event issue.
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
11-28
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.
11-29
Short Answer Questions

63. Discuss the various forms of market efficiency. Include in your discussion the information
sets involved in each form and the relationships across information sets and across forms of
market efficiency. Also discuss the implications for the various forms of market efficiency for
the various types of securities' analysts.
The weak form of the efficient markets hypothesis (EMH) states that stock prices immediately
reflect market data. Market data refers to stock prices and trading volume. Technicians
attempt to predict future stock prices based on historic stock price movements. Thus, if the
weak form of the EMH holds, the work of the technician is of no value.
The semistrong form of the EMH states that stock prices include all public information. This
public information includes market data and all other publicly available information, such as
financial statements, and all information reported in the press relevant to the firm. Thus,
market information is a subset of all public information. As a result, if the semistrong form of
the EMH holds, the weak form must hold also. If the semistrong form holds, then the
fundamentalist, who attempts to identify undervalued securities by analyzing public
information, is unlikely to do so consistently over time. In fact, the work of the fundamentalist
may make the markets even more efficient!
The strong form of the EMH states that all information (public and private) is immediately
reflected in stock prices. Public information is a subset of all information, thus if the strong
form of the EMH holds, the semistrong form must hold also. The strong form of EMH states
that even with inside (legal or illegal) information, one cannot expect to outperform the
market consistently over time.
Studies have shown the weak form to hold, when transactions costs are considered. Studies
have shown the semistrong form to hold in general, although some anomalies have been
observed. Studies have shown that some insiders (specialists, major shareholders, major
corporate officers) do outperform the market.
Feedback: The purpose of this question is to assure that the student understands the
interrelationships across different forms of the EMH, across the information sets, and the
implications of each form for different types of analysts.
11-30
64. What is an event study? It is a test of what form of market efficiency? Discuss the process
of conducting an event study, including the best variable(s) to observe as tests of market
efficiency.
A event study is an empirical test which allows the researcher to assess the impact of a
particular event on a firm's stock price. To do so, one often uses the index model and
estimates et, the residual term which measures the firm-specific component of the stock's
return. This variable is the difference between the return the stock would ordinarily earn for a
given level of market performance and the actual rate of return on the stock. This measure is
often referred to as the abnormal return of the stock. However, it is very difficult to identify
the exact point in time that an event becomes public information; thus, the better measure is
the cumulative abnormal return, which is the sum of abnormal returns over a period of time (a
window around the event date).
This technique may be used to study the effect of any public event on a firm's stock price;
thus, this technique is a test of the semistrong form of the EMH.
Feedback: The rationale for this question is to ascertain if the student understands the
methodology most commonly used as a test of the semistrong form of market efficiency.
Difficulty: Difficult
65. Discuss the small firm effect, the neglected firm effect, and the January effect, the tax
effect and how the four effects may be related.
Studies have shown that small firms earn a risk-adjusted rate of return greater than that of
larger firms. Additional studies have shown that firms that are not followed by analysts
(neglected firms) also have a risk-adjusted return greater than that of larger firms. However,
the neglected firms tend to be small firms; thus, the neglected firm effect may be a
manifestation of the small firm effect. Finally, studies have shown that returns in January tend
to be higher than in other months of the year. This effect has been shown to persist
consistently over the years. However, the January effect may be the tax effect, as investors
may have sold stocks with losses in December for tax purposes and reinvested in January.
Small firms (and neglected firms) would tend to be more affected by this increased buying
than larger firms, as small firms tend to sell for lower prices.
Feedback: The purpose of this question is to reinforce the interrelationships, that "effects"
may not always be independent and thus readily identifiable. Also these effects are widely
discussed in the financial press, and the January effect appears to be quite persistent.
11-31
66. Why might the degree of market efficiency differ across various markets? State three
reasons why this might occur and explain each reason briefly.
1. Market efficiency depends on information being essentially free and costless to market
participants. In the U.S. markets this is the case to a large extent. The U.S. markets are well
developed and professional analysts often follow securities. Information is available on
television, in the press, and on the Internet. The opposite may be true in other markets, such as
those of developing countries, where there are fewer or no analysts and few market
participants with these resources. 2. Accounting disclosure requirements are different across
markets. In the U.S. firms must meet SEC requirements to be publicly traded. In other
countries the requirements may be different or nonexistent. This has implications about the
ease with which analysts can evaluate the company to determine its proper value. 3. Markets
for "neglected" stocks may be less efficient than markets for stocks that are heavily followed
by analysts. If analysts feel that it is not worthwhile to give their attention to particular stocks
then ample information about these stocks will not be readily available to investors.
Feedback: This question leads the student to look at some of the fundamental reasons for
market efficiency and why there may be differences among markets with regard to the
reasons. Alternative answers are possible.
11-32
67. With regard to market efficiency, what is meant by the term "anomaly"? Give three
examples of market anomalies and explain why each is considered to be an anomaly.
Anomalies are patterns that should not exist if the market is truly efficient. Investors might be
able to make abnormal profits by exploiting the anomalies, which doesn't make sense in an
efficient market.
Possible examples include, but are not limited to, the following.
the small-firm effect - average annual returns are consistently higher for small-firm
portfolios, even when adjusted for risk by using the CAPM.
the January effect - the small-firm effect occurs virtually entirely in January.
the neglected-firm effect - small firms tend to be ignored by large institutional traders and
stock analysts. This lack of monitoring makes them riskier and they earn higher risk-adjusted
returns. The January effect is largest for neglected firms.
the liquidity effect - investors demand a return premium to invest in less-liquid stocks. This is
related to the small-firm effect and the neglected-firm effect. These stocks tend to earn high
risk-adjusted rates of return.
book-to-market ratios - firms with the higher book-to-market-value ratios have higher riskadjusted returns, suggesting that they are underpriced. When combined with the firm-size
factor, this ratio explained returns better than systematic risk as measured by beta.
the reversal effect - stocks that have performed best in the recent past seem to underperform
the rest of the market in the following periods, and vice versa. Other studies indicated that this
effect might be an illusion. These studies used portfolios formed mid-year rather than in
December and considered the liquidity effect.
Investors should not be able to earn excess returns by taking advantage of any of these. The
market should adjust prices to their proper levels. But these things have been documented to
occur repeatedly.
Feedback: This question tests whether the student grasps the basic concept of anomalies and
allows some choice in explaining some of them.
11-33

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Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

3. The stock market follows a __________.

4. A hybrid strategy is one where the investor

Chapter 11 - The Efficient Market Hypothesis

7. Proponents of the EMH typically advocate

8. Proponents of the EMH typically advocate

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

11. If you believe in the reversal effect, you should

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

13. _________ above which it is difficult for the market to rise.

14. _________ below which it is difficult for the market to fall.

Chapter 11 - The Efficient Market Hypothesis

17. A common strategy for passive management is ____________.

Chapter 11 - The Efficient Market Hypothesis

18. Arbel (1985) found that

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

23. Proponents of the EMH think technical analysts

Chapter 11 - The Efficient Market Hypothesis

24. Studies of positive earnings surprises have shown that there is

25. Studies of negative earnings surprises have shown that there is

26. Studies of stock price reactions to news are called

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

28. Work by Amihud and Mendelson (1986,1991)

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

31. In an efficient market, __________.

Chapter 11 - The Efficient Market Hypothesis

35. The weak form of the efficient market hypothesis contradicts

Chapter 11 - The Efficient Market Hypothesis

37. Cumulative abnormal returns (CAR)

Chapter 11 - The Efficient Market Hypothesis

38. Studies of mutual fund performance

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

45. If stock prices follow a random walk

47. Chartists practice

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

61. If you believe in the reversal effect, you should

Chapter 11 - The Efficient Market Hypothesis

Short Answer Questions

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

Chapter 11 - The Efficient Market Hypothesis

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