Chapter 10—Market Efficiency and Behavioral Finance
MULTIPLE CHOICE
1. Homer recently opened an Internet trading account believing he can capitalize on numerous stock
mispricings now that transactions costs are very low. Since so many novice day traders are involved in
the stock market, Homer will find:
a.
a market in which numerous abnormal return investment opportunities can easily be
identified
b.
a market with serious imperfections due to the similarity of financial assets
c.
a market offering competitive pricing, intense analysis, and decreasing transaction costs
d.
great value in using past stock price changes to forecast future price changes
e.
many opportunities to profit from abnormal excess returns
2. If informational efficiency exists in financial markets:
a.
allocative efficiency must also exist
b.
operational efficiency must also exist
c.
allocative and operational efficiency must also exist
d.
financial assets will reflect recurring patterns in price and expected returns
e.
none of the above
3. If financial markets are semistrong-form efficient, asset prices will incorporate __________; however,
if financial markets are strong-form efficient, asset prices will reflect __________.
a.
all information about price trends or repeating patterns on record; all relevant current and
predictable information
b.
all pertinent historical and current information; all information from public sources
c.
all information available from public sources; all pertinent historical, current and
predictable future information from public and private sources
d.
all information relevant to the level of asset prices; all information regarding both the level
and flow of asset prices
e.
all pertinent historical, current and predictable future information from public and private
sources; all information available from public sources
4. If stock returns follow a random walk, you should:
a.
employ a mean reversion investment trading strategy
b.
base trades on recurring patterns in stock prices
c.
not attempt to find a predictable pattern in stock returns
d.
employ an industry-based momentum trading strategy
e.
all of the above
5. Nathan does not believe that stock markets overreact. Which of the following statements support his
case?
a.
Overreaction trading strategies are very sensitive to the research methodology employed,
and small changes often substantively change the findings.
b.
Empirical evidence shows that the number of stock price overreactions and underreactions
are roughly equal.
c.
When researchers use value-weighted returns, the methodology itself leads to the finding
of overreaction evidence.
d.
a and b
e.
all of the above
6. An examination of gourmet food store stocks and grocery store stocks reveals a 3% premium on a
portfolio of gourmet food store stocks. The differences in beta values for portfolios of gourmet food
stocks and grocery store stocks suggests the gourmet portfolio should earn 1.5% higher returns than
the grocery portfolio. This finding suggests:
a.
an anomaly exists and investors should put all their wealth in gourmet store stocks
b.
the CAPM may overstate the true expected return on grocery store stocks
c.
the CAPM fails to correctly value gourmet stocks but values grocery store stocks correctly
d.
the possibility of market inefficiency or a deficiency of the CAPM
e.
all of the above
7. Event studies are designed to test:
a.
whether stock prices fully and instantaneously reflect new information
b.
whether the volatility in financial markets causes anomalous price returns
c.
whether financial markets react to random noise in returns
d.
whether stock prices change over varying event intervals
e.
whether financial markets contain recurring patterns in stock prices
8. Shawna is interested in mutual fund investments. Over the last ten years, the alphas of three funds that
Shawna is considering were –0.2, 0, and 0.8. According to the EMH:
a.
most mutual funds will beat the market, given a long investment horizon
b.
some mutual funds will beat the market over a given period of time
c.
the performance of a fund will persist over time
d.
most underperformance by mutual funds can be explained by survivorship bias
e.
there is enough persistence in fund performance for investors to earn higher returns than
applying a buy-and-hold strategy
9. According to behaviorists, noise traders affect prices in financial markets by:
a.
trading on beliefs not fully justified by fundamental news
b.
decreasing the risk for rational investors who might otherwise trade against them
c.
creating riskless arbitrage opportunities for more informed traders
d.
seeking to exploit small pricing irregularities when a stock is undervalued or overvalued
e.
assessing true risks and expected returns on all securities
10. In a strong-form efficient market, accounting announcements:
a.
will impact stock price only if it is related to cash flows
b.
will impact stock price if it involves new public information
c.
will impact stock price if it affects a firm’s ability to borrow funds
d.
will not impact stock price
e.
b and c
11. __________ means that markets channel resources to their most productive uses.
a.
Operational efficiency
b.
Funding
c.
Allocative efficiency
d.
Semistrong-form efficiency
e.
None of the above
12. __________ determines whether markets produce outputs at the lowest possible cost.
a.
Operational efficiency
b.
Funding
c.
Allocative efficiency
d.
Semistrong-form efficiency
e.
None of the above
13. In markets characterized by __________, asset prices reflect all information, public and private.
a.
weak-form efficiency
b.
semistrong-form efficiency
c.
strong-form efficiency
d.
random walk
e.
behavioral finance
14. Fama classified empirical tests of market efficiency with __________.
a.
tests for private information
b.
event studies
c.
test for return predictability
d.
test for rapid price adjustment
e.
all of the above
15. __________ uses insights from psychological research.
a.
Behavioral finance
b.
The efficient markets hypothesis
c.
Technical analysis
d.
Informational efficiency
e.
A noise trader
16. Test for __________ examine whether an investor can construct a consistently profitable trading
strategy based on observed trends in very recent stock returns.
a.
the usefulness of technical analysis
b.
simple trading rules
c.
short-horizon return predictability
d.
long-horizon return predictability
e.
long-term overreaction
17. The January effect is very sensitive to the choice of __________ used in the test.
a.
filter rules
b.
event study
c.
selectivity
d.
stock index
e.
hedge fund
18. Underreaction tests suggest that an investor could follow a profitable trading rule of buying the stocks
of firms announcing __________.
a.
stock splits
b.
dividend increases
c.
share repurchases
d.
spin-offs
e.
all of the above
19. Moe’s has a current stock price of $p. The company announced a new product at 11:00 am Wednesday
which the market had no knowledge of prior to the announcement. If the NPV per share of the project
is $npv and the market agrees with this, what will the price be at 11:01 am Wednesday, if this is an
efficient market?
a.
$w1
b.
$p
c.
$ans
d.
$w2
20. The finance literature suggests that market overreactions to corporate announcements can be explained
by a psychological bias called __________.
a.
biased self-attribution
b.
overconfidence
c.
inferiority
d.
superiority
21. The finance literature suggests that market underreactions to corporate announcements can be
explained by a psychological bias called __________.
a.
self-attribution
b.
overconfidence
c.
inferiority
d.
superiority
22. Assume that markets are semi-strong form efficient. Suppose, then, that during a trading day,
important new information is released for the first time concerning a certain company. This
information indicates that one of the firm’s oil fields, previously thought to be very promising, just
came up dry. How would you expect the price of a share of stock to react to this information?
a.
The value of a share will fall over an extended period of time as investors begin to sell
shares in the company
b.
The value of a share will drop immediately to a price that reflects the value of the new
information.
c.
The value of a share will fall below what is considered appropriate because of the
decreased demand for the shares, but eventually the price will rise to the correct level.
d.
The stock price will not change, since this type of information has no impact in markets
that are semi-strong form efficient.
23. You have discovered from looking at charts of past stock prices that if you buy just after a stock price
has declined for three consecutive days, you make money every time! Which form of market
efficiency is violated?
a.
weak form efficiency
b.
semi-strong form efficiency
c.
strong form efficiency
d.
this does not violate market efficiency
24. For technical analysis, based on patterns of historical prices, to have value, ______ form of market
efficiency must be violated.
a.
Weak
b.
Semi-weak
c.
Strong
d.
Semi-strong
25. According to empirical studies, firms tend to split their shares ________ earning above market returns
and investors who buy firms after stocks split earn _______ market returns
a.
After; average
b.
After; above
c.
Before; above
d.
Before; average
26. Which of the following countries tend to have the lowest mutual fund fees
a.
Countries with high investor protection
b.
Countries with high inside information
c.
Countries with poorly developed capital markets
d.
Countries geographically close to the United States
27. Empirical studies find that mimicking insider trading _______ earn an outside investor abnormal
returns
a.
Can
b.
Cannot
c.
None of the above, the studies have mixed results
28. If inside information has value, the _______ form of market effecdiency is violated
a.
Weak
b.
Semi-weak
c.
Strong
d.
Semi-strong
MATCHING
Match the following terms to the best description:
a.
stock-price momentum
b.
insider trading
c.
selectivity
d.
timing
e.
event studies
1. trading on private information
2. getting into the market before an upturn
3. examine whether stock prices fully and instantaneously incorporate new information into their price
4. stock performance continues in subsequent periods
5. stock-picking ability
SHORT ANSWER
1. Discuss the joint hypothesis problem as it relates to tests of capital market efficiency. Carefully
explain why a better asset pricing model will not solve this potential problem.
2. Advocates of behavioral finance argue that the stock market sometimes overreacts and sometimes
underreacts. What is the basis for this argument, and how do believers in market efficiency counter the
argument?
3. Discuss how the recognition and elimination of an anomaly is consistent with the semi-strong form of
market efficiency.
4. Assume the market is only semi strong-form efficient. You observe a corporation that decides to issue
new stock at existing market prices. What does this suggest about existing market prices?
5. People often speak of buying a “great company, bad stock” (or vice versa). Explain how this statement
is inconsistent with market efficiency.
6. Clarify the following statement: One of the big difficulties in mutual fund management is that by the
time we identify a superior manager, her investment management career is over. Does this inference
problem extend to other areas in this chapter?
7. What is meant when stock prices follow a random walk?
8. What categories did Fama use to classify empirical tests of market efficiency?
9. Do sophisticated filter rules work for stock investment?
10. Given the following returns on two stocks over seven consecutive days, what can you conclude about
financial market efficiency?
2
3
4
5
6
7
Stock x
–1%
+3%
–2%
+4%
-3%
+5%
Stock y
+2%
–1%
–3%
–1%
+5%
–1%
11. If you notice a group of stocks that goes up in price when the market price of the stock divided by its
book value is below 0.75 and the price goes down when the ratio reaches 1.35, what can you say about
market efficiency?
12. How useful is technical analysis in identifying recurring patterns that generate investment profits?
13. Identify and discuss underreaction tests.
14. How do you test for rapid stock price adjustment?
15. What does research suggest about the historical performance of mutual fund managers?
16. Identify some practical problems with using performance measures to evaluate mutual fund managers.
1.
The evaluation is historical and may not predict the future performance.
2.
Difficulty in identifying a benchmark portfolio (index or market) for comparison.
3.
There are more than two components (selectivity and timing) to a mutual fund manager’s job.
17. Why do behaviorists reject EMH as a defensible model of investor behavior and security market
performance?
18. What could behavioral finance do to provide a stronger argument against EMH?
19. Determine if the managers of funds X, Y, and Z created value for investors using Jensen’s model for
assessing mutual fund performance.
Fund
Portfolio Beta
Return
Management Fee
X
xb
xr%
xmf%
Y
yb
yr%
ymf%
Z
zb
zr%
zmf%
The risk-free rate is rf% and the return on the S & P 500 Index was spi%.
20. Under what two conditions would investors ignore an accounting policy change?
21. What should be the presumed reaction of investors to corporate financing announcements if managers
on average announce new seasoned equity issues after a period during which their firm’s stock prices
have experienced unusually large increases in value?
ESSAY
1. Your father-in–law calls to request your advice regarding some changes he plans on making to his
portfolio. In general, he has been disappointed with the performance of his investments. He has found
three mutual funds that have done very well in the last year, and would like to allocate a large sum of
money to these funds. Typically, your father-in-law sells every mutual fund he purchases within a two-
year period, just to be sure he always gets the best available fund management. Write your father-in–
law a letter offering any advice that you believe is warranted.
2. Describe the term technical analysis, and explain how it differs from fundamental analysis. What kind
of information does one need to try to trade stocks based on technical analysis?
3. Identify and explain the three forms of EMH for securities.