Part 4 Portfolio and Capital Market Theory
CHAPTER 10
MARKET EFFICIENCY
CHAPTER LEARNING OBJECTIVES
10.1 Explain what market efficiency is and why it is important.
10.2 Differentiate among the different levels of efficiency.
10.3 Discuss the general consensus based on empirical evidence of market
10.4 Differentiate between behavioural finance and the traditional view of finance.
10.5 Explain the implications of market efficiency.
Market Efficiency 10 – 2
MULTIPLE CHOICE QUESTIONS
1. What does operational efficiency refer to?
a) Prices that quickly reflect important information
b) Low transaction costs
c) Sufficient securities to efficiently allocate risk
d) Both A and B are correct.
2. What does informational efficiency refer to?
a) Cheap information costs
b) Prices that quickly reflect important information
c) Low number of transactions
d) Both A and B are correct.
3. The Kumquat Exchange is characterized by high transaction costs and very
infrequent trading. This exchange is likely to have:
a) informational efficiency and operational efficiency.
b) informational inefficiency and operational efficiency.
c) informational efficiency and operational inefficiency.
d) informational inefficiency and operational inefficiency.
4. In many emerging markets, stock exchanges do not have big capitalizations. This
refers to which type of inefficiency?
a) Operational efficiency
b) Allocational efficiency
c) Informational efficiency
d) Liquidity efficiency
5. Which one of the following is NOT an example of market efficiency?
a) Stock price changes after earning announcements.
b) Stock price decreases every third day by 0.5% from the opening price.
c) Stock price has a beta of 1.
d) Stock price decreases when the market goes up.
6. Prices of securities trading on The Grenadines Exchange react rapidly to information;
however, firms listed on the exchange cannot completely hedge their risks. The
Grenadines Exchange is likely to have:
a) informational efficiency and allocational efficiency.
b) informational inefficiency and allocational efficiency.
c) informational efficiency and allocational inefficiency.
d) informational inefficiency and allocational inefficiency.
7. Which of the following is NOT an underlying assumption of the existence of an
efficient market?
a) A large number of rational, profit-maximizing investors exist.
b) Information is costless and widely available to market participants.
c) Information arrives at predetermined times.
d) Investors react quickly and fully to new information.
8. Which of the following is an underlying assumption of the existence of an efficient
market?
a) A few number of rational, profit-maximizing investors exist.
b) Information is costly and not widely available to market participants.
c) Information arrives at predetermined times.
d) Investors don’t react quickly and fully to new information.
e) None of the above
9. Use the following statements to answer the question:
I. Increasing disclosure of information about the firm enhances transparency in the
market.
II. Disclosure enhances the understanding of a firm’s actions, hence it increases the
efficiency of the market.
a) I is incorrect, II is correct.
b) I is correct, II is incorrect.
c) I and II are incorrect.
d) I and II are correct.
10. What does the concept of an efficient market imply?
a) All shares of stock have the same market beta.
b) Selecting stocks by throwing darts at a page of stocks will yield the same return as a
carefully selected portfolio.
c) Prices reflect all available information.
d) Stock prices do not fluctuate.
11. According to John Keynes, what do small investors’ reactions in the financial market
increase?
a) Allocational inefficiency
b) Liquidity constraints
c) Market inefficiency
d) Excessive volatility
12. If markets were strong form efficient, which of the following situations would yield
abnormal returns?
a) Analyzing a company’s earnings report.
b) Identifying a pattern in a company’s stock price
c) Obtaining insider information.
d) None of the above would yield abnormal returns.
13. Which of the following form is classified as market efficiency?
a) Weak form
b) Semi-strong form
c) Strong form
d) All of the above
14. If markets were semi-strong form efficient, which of the following situations would
yield abnormal returns?
a) Analyzing a company’s earnings report.
b) Identifying a pattern in a company’s stock price.
c) Obtaining insider information.
d) None of the above would yield abnormal returns.
15. How are abnormal returns defined?
a) Returns in excess of the market return
b) Returns in excess of the risk-free rate
c) Returns in excess of the risk-adjusted expected return
d) Positive return
16. If markets were weak form efficient, which of the following situations would NOT
yield abnormal returns?
a) Analyzing a company’s earnings report
b) Identifying a pattern in a company’s stock price
c) Obtaining insider information
d) All of the above would yield abnormal returns
17. The price of a certain stock rises every Monday and falls every Thursday. Which
form of efficiency is contradicted?
a) Weak form
b) Semi-strong form
c) Strong form
d) No form of efficiency is contradicted.
18. A senior manager can consistently earn excess profits by trading her company’s
stock. Which form of efficiency is contradicted?
a) Weak form
b) Semi-strong form
c) Strong form
d) No form of efficiency is contradicted.
19. An investor can consistently make excess profits by following the advice provided
on the Financial Guru public website. Which form of efficiency is contradicted?
a) Weak form
b) Semi-strong form
c) Strong form
d) No form of efficiency is contradicted.
20. A stock’s price rises 10 percent two days before the announcement of a large long-
term project takes place. Which form of efficiency is contradicted?
a) Weak form
b) Semi-strong form
c) Strong form
d) No form of efficiency is contradicted.
21. The announcement of the sudden accidental death of the CEO and principal
scientist of a corporation is associated with a 12% decrease in the company’s stock
price. Which form of market efficiency is contradicted?
a) Weak form
b) Semi-strong form
c) Strong form
d) No form of efficiency is contradicted.
22. Technical analysis, which is defined as the analysis of historical trends of prices, is
an important field in finance. Which form of efficiency is this field based on?
a) Weak form inefficiency
b) Semi-strong form inefficiency
c) Strong form inefficiency
d) It has nothing to do with efficiency.
23. Which of the following is FALSE? Market efficiency implies:
a) new information disseminates quickly.
b) investors can take advantage of temporary time lags in information dissemination.
c) new information is instantly reflected in share prices.
d) the prices of securities are considered “right” at any time given their risk profile.
24. Which of the following is NOT true about the efficient market hypothesis?
a) Market prices reflect all available information at any given time.
b) Market prices do not fluctuate dramatically.
c) Market prices are considered fair.
d) Investors cannot continuously earn an excess return over and above the risk-
adjusted return.
25. The Andrews Sisters Music Corp has just released its financial statements showing
an unexpectedly high earnings number. We observe that the stock price of the company
does not respond. This observation is consistent with:
a) semi-strong form market efficiency.
b) semi-strong form market inefficiency.
c) strong form market efficiency.
d) strong form market inefficiency.
26. You have observed that every time Toronto Skaters’ Corp. stock falls by 2% in one
week, it rises by 8% the next week. What is this observation consistent with?
a) Semi-strong form market efficiency
b) Semi-strong form market inefficiency
c) Weak form market efficiency
d) Weak form market inefficiency
27. Which of the following statements is a violation of semi-strong form market
efficiency?
I. Executives trade their stock holdings before major announcements.
II. Day traders base their trading decisions on daily, weekly, and monthly trends.
a) I only
b) II only
c) Both I and II
d) Neither of these statements
28. A university professor is researching the impact of non-public information on the
marketplace. She finds that investors who do have access to material, non-public
information are consistently earning above-average risk-adjusted returns, and that the
market price of the targeted securities are partially reflecting the new information. This
is a violation of:
I. Strong form market efficiency
II. Semi-strong market efficiency
III. Weak form market efficiency
a) I only
b) I and II
c) I and III
d) II and III
29. You purchased shares of a company in the automotive industry a year ago. Over
the course of the past year, the economy began to slow down and the company faced
declining sales. As a result, the stock price declined over your holding period. Which of
the following is true?
a) This is a violation of strong form market efficiency.
b) This is a violation of semi-strong form market efficiency.
c) This is a violation of weak form market efficiency.
d) This is not a violation of the efficient market hypothesis.
30. If security markets are efficient, then:
a) the net present value of all securities should be positive.
b) the net present value of all securities should be zero.
c) the net present value of all securities should be negative.
d) there are no implications on the net present value of securities.
Market Efficiency 10 – 12
31. Semi-strong form efficiency suggests:
a) stock prices will adjust instantaneously to public information.
b) stock prices reflect all information.
c) all of the above.
32. The random walk theory suggests that
a) all stocks have an expected return of zero.
b) stock price changes are random.
c) stock prices are random.
d) diversification is pointless.
33. If information does not arrive randomly and the market rapidly and accurately
adjusts to any new information, stock prices will
a) follow a random walk.
b) not follow a random walk.
c) behave in a deterministic manner.
d) behave in a completely random manner.
34. Which one of the following is NOT a market anomaly?
a) Monday effect
b) January effect
c) Internet bubble
d) Unexpected earning spikes
35. Jane Wong has developed a technical trading rule that has consistently made a risk-
adjusted return of 15% per month for the past 10 years. This is evidence of:
a) semi-strong form efficiency.
b) semi-strong form inefficiency.
c) weak form efficiency.
d) weak form inefficiency.
36. Jimmy Khan has developed a trading rule where he buys firms with relatively high
dividend yields. This trading rule has consistently earned a risk-adjusted return of 15%
per month for the past 10 years. This is evidence of:
a) semi-strong form efficiency
b) semi-strong form inefficiency
c) weak-form efficiency
d) weak-form inefficiency
37. Melanie has observed that stocks that have earned high returns over the past year
tend to earn low returns over the next year. She has also observed that stocks that
earned low returns over the past year tended to earn high returns over the next year.
This is an example of:
a) the January effect.
b) mean reversion in stock prices.
c) stock price momentum.
d) size effect.
38. Which of the following observations would provide evidence against the weak form
of market efficiency?
a) Mutual fund managers earn superior returns over the past 3 years.
b) Most pension funds outperformed the market last year.
c) Investors who trade on inside information make superior returns.
d) None of the above.
39. Empirical support for market efficiency is strongest for:
a) weak form.
b) semi-strong form.
c) strong form.
d) no form of market efficiency is supported by the data.
10 – 15 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
40. Michel has developed a trading strategy for the Abitibi-Témiscamingue Market. He
has observed that his strategy earns returns that are statistically significantly greater
than the market. Should Michel start applying his trading strategy?
a) Yes, the tests show that its returns are statistically significantly greater than the
market.
b) Not necessarily; the tests show that its returns are statistically significantly greater
than the market.
c) Yes, the tests show that its returns are economically significantly greater than the
market.
d) Not necessarily; the tests do not show whether the returns are economically
significantly greater than the market.
41. Use the following statements to answer this question:
I. Strong form efficiency is practically impossible to prove.
II. On average, investors can beat the market using technical analysis.
III. Market efficiency is a myth that does not exist in any of its forms.
a) I, II, and III are correct.
b) I, II, and III are incorrect.
c) I and II are correct and III is incorrect.
d) I is correct, II and III are incorrect.
42. If the weak form of market efficiency holds then:
a) fundamental analysis is useless.
b) stock prices reflect insider trading.
c) stock price changes follow a random walk.
d) all of the above.
43. Which of the following is NOT an implication of the efficient market hypothesis for
corporate financial officers?
a) They should ignore dramatic changes in their company’s stock price.
b) There is no point in timing the issue of new securities.
c) It does not make sense to “play” interest rates by rolling over short-term debt until
long-term rates fall.
d) There is no point in timing stock repurchases in an efficient market.
44. If the capital markets are efficient, then the sale or purchase of any security at the
market price is:
a) a negative NPV transaction.
b) a positive NPV transaction.
c) sometimes a zero NPV transaction.
d) None of the above.
10 – 17 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
PRACTICE PROBLEMS
45. Boris, the business reporter on XOP radio, says that market efficiency doesn’t
matter. Provide two reasons why it does matter to investors.
46. During January and February, the stock of Pigeon Couriers was trading at about
$25. On March 1, the stock price began to rise until it hit $35 on March 14. On March
15, the company disclosed that earnings were up an unanticipated 15% compared to
last year, and the stock price did not change. Explain how, in an efficient market, this is
possible.
47. State the semi-strong form of market efficiency and its implications.
48. Explain the implications of having an inefficient market.
49. Liam, the manager of The Snoring Gryphon, your local Irish pub, is very confused.
He has observed that the stock of Gryphon earns higher returns in January than in
March. He expected the stock to do better around St. Patrick’s Day when the pub’s
sales are the highest. Explain these two observations to Liam.
10 – 19 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
Market Efficiency 10 – 20
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