Chapter 11 – The Efficient Market Hypothesis
11–16
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
D. gradually decline for the next several weeks.
E. gradually increase for the next several weeks.
Difficulty: Moderate
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
Difficulty: Moderate
Chapter 11 – The Efficient Market Hypothesis
11–17
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.
Difficulty: Moderate
44. When Maurice Kendall first examined stock price patterns in 1953, he found that
A. certain patterns tended to repeat within the business cycle.
Difficulty: Easy
Chapter 11 – The Efficient Market Hypothesis
11–18
45. If stock prices follow a random walk
A. it implies that investors are irrational.
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.
Difficulty: Moderate
47. Chartists practice
E. psychoanalysis.
Difficulty: Easy
Chapter 11 – The Efficient Market Hypothesis
11–19
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
Difficulty: Moderate
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.
Difficulty: Moderate
Chapter 11 – The Efficient Market Hypothesis
11–20
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
Difficulty: Moderate
51. Google has a beta of 1.0. The annualized market return yesterday was 11%, and the risk-
free 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.
Difficulty: Moderate
Chapter 11 – The Efficient Market Hypothesis
11–21
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
E. interest rates fell yesterday.
Difficulty: Moderate
53. QQAG has a beta of 1.7. The annualized market return yesterday was 13%, and the risk-
free 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.
Difficulty: Moderate
Chapter 11 – The Efficient Market Hypothesis
11–22
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
A. the market is not efficient.
B. QQAG stock will probably rise in value tomorrow.
Difficulty: Moderate
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
A. the market is not efficient.
B. LJP stock will probably rise in value again tomorrow.
Difficulty: Moderate
Chapter 11 – The Efficient Market Hypothesis
11–23
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
A. the market is not efficient.
B. Music Doctors stock will probably rise in value tomorrow.
Difficulty: Moderate
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
A. the market is not efficient.
B. King stock will probably rise in value tomorrow.
Difficulty: Moderate
Chapter 11 – The Efficient Market Hypothesis
11–24
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
Difficulty: Moderate
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
Difficulty: Moderate
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
Difficulty: Moderate
Chapter 11 – The Efficient Market Hypothesis
11–25
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.
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
Difficulty: Moderate
Chapter 11 – The Efficient Market Hypothesis
11–26
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,
Difficulty: Moderate
Chapter 11 – The Efficient Market Hypothesis
11–27
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
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
Difficulty: Moderate
Chapter 11 – The Efficient Market Hypothesis
11–28
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
Difficulty: Moderate
Chapter 11 – The Efficient Market Hypothesis
11–29
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
Difficulty: Moderate