3) If the optimal forecast of the return on a security exceeds the equilibrium return, then
A) the market is inefficient.
B) no unexploited profit opportunities exist.
C) the market is in equilibrium.
D) the market is myopic.
4) Another way to state the efficient markets hypothesis is: in an efficient market
A) unexploited profit opportunities will be quickly eliminated.
B) unexploited profit opportunities will never exist.
C) all prices can be accurately predicted.
D) every financial market participant must be well informed about securities.
5) ________ occurs when market participants observe returns on a security that are larger than
what is justified by the characteristics of that security and take action to quickly eliminate the
unexploited profit opportunity.
A) Arbitrage
B) Mediation
C) Asset capitalization
D) Market intercession
6) The efficient markets hypothesis suggests that if an unexploited profit opportunity arises in an
efficient market
A) it will tend to go unnoticed for some time.
B) it will be quickly eliminated.
C) financial analysts are your best source of this information.
D) all profits will be eliminated through taxation.
7) Financial markets quickly eliminate unexploited profit opportunities through changes in
A) dividend payments.
B) tax laws.
C) asset prices.
D) monetary policy.
8) The elimination of unexploited profit opportunities requires that ________ market participants
be well informed.
A) all
B) a few
C) zero
D) many
9) If future changes in stock prices are unpredictable, then we say that the stock prices follow a
A) random walk.
B) straight and narrow path.
C) meandering path.
D) generalized walk.
10) When we describe stock prices as following a random walk, we mean that future changes in
stock prices are
A) unpredictable.
B) increasing.
C) decreasing.
D) constant.
11) The efficient markets hypothesis implies that future changes in exchange rates should for all
practical purposes be
A) unpredictable.
B) set by each country.
C) increasing.
D) pegged to a standard such as the U.S. dollar or the Euro.
12) According to the efficient markets hypothesis, purchasing the reports of financial analysts
A) is likely to increase one’s returns by an average of 10%.
B) is likely to increase one’s returns by about 3 to 5%.
C) is not likely to be an effective strategy for increasing financial returns.
D) is likely to increase one’s returns by an average of about 2 to 3%.
13) You have observed that the forecasts of an investment advisor consistently outperform the
other reported forecasts. The efficient markets hypothesis says that future forecasts by this
advisor
A) may or may not be better than the other forecasts. Past performance is no guarantee of the
future.
B) will always be the best of the group.
C) will definitely be worse in the future. What goes up must come down.
D) will be worse in the near future, but improve over time.
14) Which of the following types of information most likely allows the exploitation of a profit
opportunity?
A) financial analysts’ published recommendations
B) technical analysis
C) hot tips from a stockbroker
D) insider information
15) Sometimes one observes that the price of a company’s stock falls after the announcement of
favorable earnings. This phenomenon is
A) clearly inconsistent with the efficient markets hypothesis.
B) consistent with the efficient markets hypothesis if the earnings were not as high as
anticipated.
C) consistent with the efficient markets hypothesis if the earnings were not as low as anticipated.
D) consistent with the efficient markets hypothesis if the favorable earnings were expected.
16) You read a story in the newspaper announcing the proposed merger of Dell Computer and
Gateway. The merger is expected to greatly increase Gateway’s profitability. If you decide to
invest in Gateway stock, you can expect to earn
A) above average returns since you will share in the higher profits.
B) above average returns since your stock price will definitely appreciate as higher profits are
earned.
C) below average returns since computer makers have low profit rates.
D) a normal return since stock prices adjust to reflect expected changes in profitability almost
immediately.
17) The efficient markets hypothesis indicates that investors
A) can use the advice of technical analysts to outperform the market.
B) do better on average if they adopt a “buy and hold” strategy.
C) let too many unexploited profit opportunities go by if they adopt a “buy and hold” strategy.
D) do better if they purchase loaded mutual funds.
18) The efficient markets hypothesis suggests that investors
A) should purchase no-load mutual funds which have low management fees.
B) can use the advice of technical analysts to outperform the market.
C) let too many unexploited profit opportunities go by if they adopt a “buy and hold” strategy.
D) act on all “hot tips” they hear.
19) The advantage of a “buy-and-hold strategy” is that
A) net profits will tend to be higher because there will be fewer brokerage commissions.
B) losses will eventually be eliminated.
C) the longer a stock is held, the higher will be its price.
D) profits are guaranteed.
20) For small investors, the best way to pursue a “buy and hold” strategy is to
A) buy and sell individual stocks frequently.
B) buy no-load mutual funds with high management fees.
C) buy no-load mutual funds with low management fees.
D) buy load mutual funds.
21) Does the efficient markets hypothesis imply that the average investor will not earn anything
by purchasing stock?
A) No, the efficient market hypothesis implies that the average investor should not expect to
receive abnormally high returns on a consistent basis.
B) Yes, the efficient markets hypothesis implies that the best that the average investor can do is
break even.
C) No, the efficient market hypothesis implies that the investor will consistently earn abnormally
high returns by purchasing stock.
D) Yes, the efficient markets hypothesis implies that stock purchases are extremely risky and
that the average investor has no hope of recovering any loss.
22) If a corporation announces that it expects quarterly earnings to increase by 25% and it
actually sees an increase of 22%, what should happen to the price of the corporation’s stock if the
efficient markets hypothesis holds, everything else held constant?
23) Your best friend calls and gives you the latest stock market “hot tip” that he heard at the
health club. Should you act on this information? Why or why not?
7.5 Why the Efficient Market Hypothesis Does Not Imply That Financial Markets are Efficient
1) If in an efficient market all prices are correct and reflect market fundamentals, which of the
following is a FALSE statement?
A) A stock that has done poorly in the past is more likely to do well in the future.
B) One investment is as good as any other because the securities’ prices are correct.
C) A security’s price reflects all available information about the intrinsic value of the security.
D) Security prices can be used by managers to assess their cost of capital accurately.
2) The efficient markets hypothesis implies that prices in the stock market
A) follow a definite pattern.
B) are more likely to go up than down.
C) always undervalue the true assets of a corporation.
D) are unpredictable.
3) Stock market crashes lead us to believe that
A) factors other than market fundamentals have an effect on asset prices.
B) unexploited profit opportunities never exist.
C) crashes are always predictable when market participants behave rationally.
D) bubbles are a natural outcome of an efficient market.
7.6 Behavioral Finance
1) ________ is the field of study that applies concepts from social sciences such as psychology
and sociology to help understand the behavior of securities prices.
A) Behavioral finance
B) Strategical finance
C) Methodical finance
D) Procedural finance
2) If a market participant believes that a stock price is irrationally high, they may try to borrow
stock from brokers to sell in the market and then make a profit by buying the stock back again
after the stock falls in price. This practice is called
A) short selling.
B) double dealing.
C) undermining.
D) long marketing.
3) ________ means people are more unhappy when they suffer losses than they are happy when
they achieve gains.
A) Loss fundamentals
B) Loss aversion
C) Loss leader
D) Loss cycle
4) Loss aversion can explain why very little ________ actually takes place in the securities
market.
A) short selling
B) bargaining
C) bartering
D) negotiating
5) Psychologists have found that people tend to be ________ in their own judgments.
A) underconfident
B) overconfident
C) indecisive
D) insecure
6) ________ and ________ may provide an explanation for stock market bubbles.
A) Overconfidence; social contagion
B) Underconfidence; social contagion
C) Overconfidence; social isolationism
D) Underconfidence; social isolationism
7) Investors tend to trade on their beliefs rather than on pure facts. This statement might explain
why securities markets have ________ that the efficient market hypothesis does not predict.
A) such a large trading volume
B) short sales
C) a random walk
D) arbitrage
7.7 Web Appendix: Evidence on the Efficient Market Hypothesis
1) If a mutual fund outperforms the market in one period, evidence suggests that this fund is
A) highly likely to consistently outperform the market in subsequent periods due to its superior
investment strategy.
B) likely to under-perform the market in subsequent periods to average its overall returns.
C) not likely to consistently outperform the market in subsequent periods.
D) not likely to outperform the market in any subsequent period.
2) Studies of mutual fund performance indicate that mutual funds that outperformed the market
in one time period usually
A) beat the market in the next time period.
B) beat the market in the next two subsequent time periods.
C) beat the market in the next three subsequent time periods.
D) do not beat the market in the next time period.
3) The number and availability of discount brokers has grown rapidly since the mid-1970s. The
efficient markets hypothesis predicts that people who use discount brokers
A) will likely earn lower returns than those who use full-service brokers.
B) will likely earn about the same as those who use full-service brokers, but will net more after
brokerage commissions.
C) are going against evidence suggesting that full-service brokers can help outperform the
market.
D) are likely to outperform the market by a wide margin.
4) When Happy Feet Corporation announces that their fourth quarter earnings are up 10%, their
stock price falls. This is consistent with the efficient markets hypothesis
A) if earnings were not as high as expected.
B) if earnings were not as low as expected.
C) if a merger is anticipated.
D) the company just invented a new bunion product.
5) To say that stock prices follow a “random walk” is to argue that stock prices
A) rise, then fall, then rise again.
B) rise, then fall in a predictable fashion.
C) tend to follow trends.
D) cannot be predicted based on past trends.
6) The efficient markets hypothesis predicts that stock prices follow a “random walk.” The
implication of this hypothesis for investing in stocks is
A) a “churning strategy” of buying and selling often to catch market swings.
B) turning over your stock portfolio each month, selecting stocks by throwing darts at the stock
page.
C) a “buy and hold strategy” of holding stocks to avoid brokerage commissions.
D) following the advice of technical analysts.
7) Rules used to predict movements in stock prices based on past patterns are, according to the
efficient markets hypothesis
A) a waste of time.
B) profitably employed by all financial analysts.
C) the most efficient rules to employ.
D) consistent with the random walk hypothesis.
8) Tests used to rate the performance of rules developed in technical analysis conclude that
technical analysis
A) outperforms the overall market.
B) far outperforms the overall market, suggesting that stockbrokers provide valuable services.
C) does not outperform the overall market.
D) does not outperform the overall market, suggesting that stockbrokers do not provide services
of any value.
9) Which of the following accurately summarize the empirical evidence about technical analysis?
A) Technical analysts fare no better than other financial analysis—on average they do not
outperform the market.
B) Technical analysts tend to outperform other financial analysis, but on average they
nevertheless under-perform the market.
C) Technical analysts fare no better than other financial analysis, and like other financial analysts
they outperform the market.
D) Technical analysts fare no better than other financial analysis, and like other financial
analysts they under-perform the market.
10) The small-firm effect refers to the
A) negative returns earned by small firms.
B) returns equal to large firms earned by small firms.
C) abnormally high returns earned by small firms.
D) low returns after adjusting for risk earned by small firms.
11) The January effect refers to the fact that
A) most stock market crashes have occurred in January.
B) stock prices tend to fall in January.
C) stock prices have historically experienced abnormal price increases in January.
D) the football team winning the Super Bowl accurately predicts the behavior of the stock
market for the next year.
12) When a corporation announces a major decline in earnings, the stock price may initially
decline significantly and then rise back to normal levels over the next few weeks. This impact is
called
A) the January effect.
B) mean reversion.
C) market overreaction.
D) the small-firm effect.
13) A phenomenon closely related to market overreaction is
A) the random walk.
B) the small-firm effect.
C) the January effect.
D) excessive volatility.
14) Excessive volatility refers to the fact that
A) stock returns display mean reversion.
B) stock prices can be slow to react to new information.
C) stock price tend to rise in the month of January.
D) stock prices fluctuate more than is justified by dividend fluctuations.
15) Mean reversion refers to the fact that
A) small firms have higher than average returns.
B) stocks that have had low returns in the past are more likely to do well in the future.
C) stock returns are high during the month of January.
D) stock prices fluctuate more than is justified by fundamentals.
16) Evidence in support of the efficient markets hypothesis includes
A) the failure of technical analysis to outperform the market.
B) the small-firm effect.
C) the January effect.
D) excessive volatility.
17) Evidence against market efficiency includes
A) failure of technical analysis to outperform the market.
B) the random walk behavior of stock prices.
C) the inability of mutual fund managers to consistently beat the market.
D) the January effect.