Financial Markets and Institutions, 8e (Mishkin)
Chapter 6 Are Financial Markets Efficient?
6.1 Multiple Choice
1) How expectations are formed is important because expectations influence
A) the demand for assets.
B) bond prices.
C) the risk structure of interest rates.
D) the term structure of interest rates.
E) all of the above.
2) According to the efficient market hypothesis, the current price of a financial security
A) is the discounted net present value of future interest payments.
B) is determined by the highest successful bidder.
C) fully reflects all available relevant information.
D) is a result of none of the above.
3) The efficient market hypothesis
A) is based on the assumption that prices of securities fully reflect all available information.
B) holds that the expected return on a security equals the equilibrium return.
C) both A and B.
D) neither A nor B.
4) If the optimal forecast of the return on a security exceeds the equilibrium return, then
A) the market is inefficient.
B) an unexploited profit opportunity exists.
C) the market is in equilibrium.
D) only A and B of the above are true.
E) only B and C of the above are true.
5) According to the efficient market hypothesis
A) one cannot expect to earn an abnormally high return by purchasing a security.
B) information in newspapers and in the published reports of financial analysts is already
reflected in market prices.
C) unexploited profit opportunities abound, thereby explaining why so many people get rich by
trading securities.
D) all of the above are true.
E) only A and B of the above are true.
6) Another way to state the efficient market condition is that in an efficient market,
A) unexploited profit opportunities will be quickly eliminated.
B) unexploited profit opportunities will never exist.
C) arbitrageurs guarantee that unexploited profit opportunities never exist.
D) both A and C of the above occur.
7) Another way to state the efficient market hypothesis is that in an efficient market,
A) unexploited profit opportunities will never exist as market participants, such as arbitrageurs,
ensure that they are instantaneously dissipated.
B) unexploited profit opportunities will not exist for long, as market participants will act quickly
to eliminate them.
C) every financial market participant must be well informed about securities.
D) only A and C of the above.
8) A situation in which the price of an asset differs from its fundamental market value is called
A) an unexploited profit opportunity.
B) a bubble.
C) a correction.
D) a mean reversion.
9) A situation in which the price of an asset differs from its fundamental market value
A) indicates that unexploited profit opportunities exist.
B) indicates that unexploited profit opportunities do not exist.
C) need not indicate that unexploited profit opportunities exist.
D) indicates that the efficient market hypothesis is fundamentally flawed.
10) Studies of mutual fund performance indicate that mutual funds that outperformed the market
in one time period
A) usually beat the market in the next time period.
B) usually beat the market in the next two subsequent time periods.
C) usually beat the market in the next three subsequent time periods.
D) usually do not beat the market in the next time period.
11) The efficient market hypothesis suggests that allocating your funds in the financial markets
on the advice of a financial analyst
A) will certainly mean higher returns than if you had made selections by throwing darts at the
financial page.
B) will always mean lower returns than if you had made selections by throwing darts at the
financial page.
C) is not likely to prove superior to a strategy of making selections by throwing darts at the
financial page.
D) is good for the economy.
12) Raj Rajaratnam, a successful investor in the 2000s who consistently beat the market, was
able to outperform the market on a consistent basis, indicating that
A) securities markets are not efficient.
B) unexploited profit opportunities were abundant.
C) investors can outperform the market with inside information.
D) only B and C of the above.
13) To say that stock prices follow a “random walk” is to argue that
A) stock prices rise, then fall.
B) stock prices rise, then fall in a predictable fashion.
C) stock prices tend to follow trends.
D) stock prices are, for all practical purposes, unpredictable.
14) To say that stock prices follow a “random walk” is to argue that
A) stock prices rise, then fall, then rise again.
B) stock prices rise, then fall in a predictable fashion.
C) stock prices tend to follow trends.
D) stock prices cannot be predicted based on past trends.
15) Rules used to predict movements in stock prices based on past patterns are, according to the
efficient markets theory,
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.
16) Tests used to rate the performance of rules developed in technical analysis conclude that
A) technical analysis outperforms the overall market.
B) technical analysis far outperforms the overall market, suggesting that stockbrokers provide
valuable services.
C) technical analysis does not outperform the overall market.
D) technical analysis does not outperform the overall market, suggesting that stockbrokers do not
provide services of any value.
17) Which of the following types of information will most likely enable the exploitation of a
profit opportunity?
A) Financial analysts’ published recommendations
B) Technical analysis
C) Hot tips from a stockbroker
D) Insider information
18) Which of the following types of information will most likely enable the exploitation of a
profit opportunity?
A) Financial analysts’ published recommendations
B) Technical analysis
C) Hot tips from a stockbroker
D) None of the above
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 its price will be.
D) only B and C of the above are true.
20) The efficient market hypothesis suggests that
A) investors should not try to outguess the market by constantly buying and selling securities.
B) investors do better on average if they adopt a “buy and hold” strategy.
C) buying into a mutual fund is a sensible strategy for a small investor.
D) all of the above are sensible strategies.
E) only A and B of the above are sensible strategies.
21) 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 market hypothesis.
B) consistent with the efficient market hypothesis if the earnings were not as high as anticipated.
C) consistent with the efficient market hypothesis if the earnings were not as low as anticipated.
D) the result of none of the above.
22) Important implications of the efficient market hypothesis include which of the following?
A) Future changes in stock prices should, for all practical purposes, be unpredictable.
B) Stock prices will respond to announcements only when the information in these
announcements is new.
C) Sometimes a stock price declines when good news is announced.
D) All of the above.
E) Only A and B of the above.
23) Although the verdict is not yet in, the available evidence indicates that, for many purposes,
the efficient market hypothesis is
A) a good starting point for analyzing expectations.
B) not a good starting point for analyzing expectations.
C) too general to be a useful tool for analyzing expectations.
D) none of the above.
24) The efficient market hypothesis suggests that
A) investors should purchase no-load mutual funds, which have low management fees.
B) investors can use the advice of technical analysts to outperform the market.
C) investors let too many unexploited profit opportunities go by if they adopt a “buy and hold”
strategy.
D) only A and B of the above are sensible strategies.
25) The efficient market hypothesis applies to
A) both the stock market and the foreign exchange market.
B) the stock market but not the foreign exchange market.
C) the foreign exchange market but not the stock market.
D) neither the stock market nor the foreign exchange market.
26) According to the January effect, stock prices
A) experience an abnormal price rise from December to January.
B) experience an abnormal price decline from December to January.
C) follow a random walk during January.
D) set the pattern for the entire year in January.
27) The small-firm effect refers to the observation that small firms’ stocks
A) follow a random walk but large firms’ stocks do not.
B) have earned abnormally low returns given their greater risk.
C) have earned abnormally high returns even taking into account their greater risk.
D) sell for lower prices than do large firms’ stocks.
28) The efficient markets hypothesis is weakened by evidence that
A) stock prices tend to follow a random walk.
B) stock prices are more volatile than fluctuations in their fundamental values can explain.
C) technical analysis does not outperform the overall market.
D) an investment adviser’s past success or failure at picking stocks does not predict his or her
future performance.
29) Mean reversion refers to the observation that
A) stock prices overact to news announcements.
B) stocks prices are more volatile than fluctuations in their fundamental value would predict.
C) stocks with low returns are likely to have high returns in the future.
D) stocks with low returns are likely to have even lower returns in the future.
30) Which of the following does not weaken the efficient markets hypothesis?
A) Mean reversion
B) Success of buy-and-hold strategy
C) January effect
D) Excessive volatility
31) An important lesson from the Black Monday Crash of 1987 and the tech crash of 2000 is that
A) factors other than market fundamentals affect stock prices.
B) the strong version of the efficient market hypothesis, that stock prices reflect the true
fundamental value of securities, is correct.
C) market psychology has little if any effect on stock prices.
D) there is no such thing as a rational bubble.
32) An investor gains from short selling by ________ and then later ________.
A) buying a stock; selling it at a higher price
B) selling a stock; buying it back at a lower price
C) buying a stock; selling it at a lower price
D) selling a stock; buying it back at a higher price
33) Which of the following is an insight from behavioral finance?
A) The price of securities fully reflects all available information.
B) Investor overconfidence leads to high trading volumes.
C) The optimal forecast of a security’s return equals the security’s equilibrium return.
D) Investment advisers cannot consistently beat the market.
34) Which of the following is empirical evidence indicating that the efficient market hypothesis
may not always be generally applicable?
A) Small-firm effect
B) January effect
C) Market overreaction
D) All of the above
35) An arrangement with a broker to borrow stocks from them and then sell it in the market, with
the hope that they earn a profit by buying the stock back again after it has fallen in price is called
A) behavioral finance.
B) short sales.
C) smart money.
D) random walk.
36) Evidence in favor of market efficiency includes
A) performance of investment analysts and mutual funds.
B) whether stock prices reflect publicly available information.
C) the random-walk behavior of stock prices.
D) all of the above.
37) Evidence against market efficiency does not include
A) the small-firm effect.
B) technical analysis.
C) excessive volatility.
D) mean reversion.
38) Evidence in favor of market efficiency does not include
A) random-walk behavior.
B) technical analysis.
C) performance of investment analysts and mutual funds.
D) the January effect.
39) The elimination of a riskless profit opportunity in a market is called
A) the efficient market hypothesis.
B) random walk.
C) arbitrage.
D) market fundamentals.
40) According to the strong view of the efficient markets hypothesis, security prices reflect
________ and so financial markets are efficient.
A) market fundamentals
B) rational expectations
C) momentum effects
D) current market trends
41) When a market bubble occurs, ________.
A) prices of assets rise well above their fundamental values
B) a “thin layer” of trading masks true market movements
C) market fundamentals and actual security prices converge
D) prices of assets fluctuate rapidly above and below market fundamentals
1) Evidence that stock prices sometimes fall when a firm announces good news contradicts the
efficient market hypothesis.
2) If the security markets are truly efficient, there is no need to pay for help selecting securities.
3) Evidence that a mutual fund has performed extraordinarily well in the past contradicts the
efficient market hypothesis.
4) Technical analysts look at historical prices for information to project future prices.
5) The evidence suggests technical analysts are not superior stock pickers.
6) If the markets are efficient, the optimal investment strategy will be to buy and hold so as to
minimize transaction costs.
7) In an efficient market, abnormal returns are not possible, even using inside information.
8) “Short selling” refers to the practice of buying a stock and holding it for only a short time
before selling it.
9) Loss aversion means the unhappiness a person feels when he or she suffers a monetary loss
exceeds the happiness the same person experiences from receiving a monetary gain of the same
amount.
10) It is probably a good use of an investor’s time to watch as many shows featuring technical
analysts as possible.
11) Having performed well in the past indicates that an investment adviser or a mutual fund will
perform well in the future.
12) Technical analysis is a popular technique used to predict stock prices by studying past stock
price data and searching for patterns such as trends and regular cycles.
13) The efficient market hypothesis does not have to imply that financial markets are efficient.
6.3 Essay
1) Why are expectations important in understanding how financial instruments are valued?
2) How is it possible that a firm can announce a record-breaking loss, yet its stock price rises
when the announcement is made?
3) What is the optimal investment strategy according to the efficient market hypothesis? Why?
4) Explain what the market reaction will be in an efficient market if a firm announces a fully
anticipated filing for bankruptcy.
5) How do loss aversion, overconfidence of investors, and social contagion affect market
efficiency?
6) What is a rational bubble?
7) Give evidence both for and against market efficiency.
8) Does the efficient market hypothesis imply that financial markets are efficient? Explain.
9) Discuss why Black Monday, the day when the DJIA declined more than 20%, is not evidence
against the efficient market hypothesis.