CHAPTER 5—EFFICIENT CAPITAL MARKETS
TRUE/FALSE
1. Prices in efficient capital markets fully reflect all available information and rapidly adjust to new
information.
2. An efficient market requires a large number of profit-maximizing investors.
3. If the efficient market hypothesis is true price changes are independent and biased.
4. The random walk hypothesis contends that stock prices occur randomly.
5. In his original article, Fama divided the efficient market hypothesis into two subhypotheses.
6. The weak form of the efficient market hypothesis contends that stock prices fully reflect all public and
private information.
7. The weak form of the efficient market hypothesis contends that technical trading rules are of little
value.
8. Tests have shown that if small filters are used in simulating trading rules, these trading rules have
produced above average returns after transactions costs are factored in.
9. In tests of the semi-strong form EMH, it is not necessary to use risk-adjusted rates of return.
10. Results of initial public offering (IPOs) studies tend to support the semi-strong EMH, because it
appears that prices adjusted rapidly after initial underpricing.
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11. Results from studies on the effects of unexpected world events have consistently indicated that the
price change is so rapid, that it takes place between the close of one day and the opening of the next
day.
12. Studies concerning quarterly earnings reports indicate that information in quarterly statements is of
value and can provide an above-average risk-adjusted return.
13. Results of studies concerning corporate insider trading indicate that corporate insiders generally enjoy
above-average returns.
14. The strong form of the efficient market hypothesis contends that only insiders can earn abnormal
returns.
15. Technical analysis and the efficient market hypothesis have a consistent set of assumptions concerning
stock market behaviour.
16. Even when fees and costs are considered most mutual fund managers outperform the aggregate
market.
17. When considering markets in Europe, it is inappropriate to assume a level of efficiency similar to that
for Canadian markets.
18. The weak-form efficient market hypothesis assumes all publicly available information is reflected in
current stock prices.
19. Studies examining stock splits support the semi-strong form efficient market hypothesis.
20. There is little evidence from studies examining initial public offerings (IPOs) that suggest markets are
semi-strong form efficient.
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MULTIPLE CHOICE
1. Which of the following would be inconsistent with an efficient market?
a.
Information arrives randomly and independently.
b.
Stock prices adjust rapidly to new information.
c.
Price changes are independent.
d.
Price changes are random.
e.
Price adjustments are biased.
2. Fusion investing is the integration of the following elements of investment valuation:
a.
Fundamental value and investor sentiment.
b.
Fads and fashions.
c.
Technical analysis and investor sentiment.
d.
Historical prices and returns.
e.
Transaction costs and fundamental value.
3. The weak form of the efficient market hypothesis states that
a.
Successive price changes are dependent.
b.
Successive price changes are independent.
c.
Successive price changes are biased.
d.
Successive price changes depend on trading volume.
e.
Properly specified trading rules are of value.
4. Which statement is true concerning alternative efficient market hypothesis?
a.
The weak hypothesis encompasses the semi-strong hypothesis.
b.
The weak hypothesis encompasses the strong hypothesis.
c.
The semi-strong hypothesis encompasses the weak hypothesis.
d.
The strong hypothesis relates only to public information.
e.
All of the above statements are false.
5. If statistical tests of stock returns over time support the efficient market hypothesis the resulting
correlations should be
a.
Positive.
b.
Negative.
c.
Zero.
d.
Lagged.
e.
Skewed.
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6. A “runs test” on successive stock price changes which supports the efficient market hypothesis would
show the actual number of runs
a.
Falls into the range expected of a random series.
b.
Falls into the range expected of a dependent series.
c.
Is small.
d.
Is large.
e.
Would approximate N/2.
7. A trading rule which signals purchase of a stock if it rises X percent and sale of a stock if it falls X
percent is known as a
a.
Breakout.
b.
Short sale.
c.
Sieve.
d.
Filter.
e.
Relative strength.
8. Which of the following has not been involved in a direct test of the semi-strong form of the efficient
market hypothesis?
a.
Stock splits
b.
New Issues
c.
Exchange listing
d.
Accounting changes
e.
Specialists’ returns
9. Examples of anomalies providing contrary evidence to the semi-strong efficient market hypothesis
include studies of all of the following except
a.
Quarterly earnings reports.
b.
Price earnings ratios.
c.
Total market value.
d.
Stocks ranked by Canadian Bond Rating Service.
e.
The January effect.
10. The opportunity to take advantage of the downward pressure on stock prices that result from
end-of-the-year tax selling is known as
a.
The End-of-the-Year Effect.
b.
The December Anomaly.
c.
The End-of-the-Year Anomaly.
d.
The January Anomaly.
e.
The New Years Anomaly.
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11. Banz and Reinganum found that small firms consistently outperformed large firms. This anomaly is
referred to as the
a.
Large firm effect.
b.
Size effect.
c.
Small firm effect.
d.
PIE effect.
e.
None of the above.
12. The performance of four major groups of investors has been studied in connection with tests of the
strong-form of the efficient market hypothesis. These include all of the following except
a.
Professional money managers.
b.
Stock exchange specialists.
c.
Securities Exchange officers.
d.
Security analysts.
e.
Corporate insiders.
13. Abnormal returns associated with rankings by a major advisory service are associated with
a.
The P/E effect.
b.
The Value-Line Enigma.
c.
The Value-Line Effect.
d.
The Standard and Poor’s Anomaly.
e.
The rankings anomaly.
14. The implication of efficient capital markets and a lack of superior analysts have led to the introduction
of
a.
Balanced funds.
b.
Naive funds.
c.
January funds.
d.
Index funds.
e.
Futures options.
15. Superior analysts are encouraged to concentrate their efforts in “middle tier” stocks. This is
recommended because
a.
it works to minimize taxes for the client.
b.
only individuals deal in the middle tier stocks.
c.
prices may not adjust quite as rapidly for middle tier stocks as they do in the top tier;
therefore, the chances of temporarily undervalued securities are greater.
d.
it includes companies too small to be considered by institutions.
e.
Technical analysts never look at “middle tier” stocks.
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16. A portfolio manager without superior analytical skills should
a.
Determine and quantify the risk preferences of a client.
b.
Minimize transaction costs.
c.
Maintain the specified risk level.
d.
Ensure that the portfolio is completely diversified.
e.
All of the above.
17. Which is not an implication of the EMH?
a.
To do superior industry or company analysis you must understand the variables that affect
returns and do a superior job of estimating these variables.
b.
Aggregate market analysis that involves very detailed analysis of reliable historical
economic data should outperform a simple buy-and-hold policy.
c.
A superior analyst is one who can consistently select stocks that provide positive abnormal
returns on a risk-adjusted basis.
d.
If a portfolio manager does not have any superior analysts, he/she should consider
investing funds in an index fund.
e.
If a portfolio manager has some superior analytical skills, they should be encouraged to
concentrate in second tier stocks which have liquidity, but may be neglected.
18. Some studies have attempted to determine whether it is possible to predict future returns for a stock
based on publicly available quarterly earnings reports. The results of these studies indicate
a.
Stock prices adjust to reflect quarterly earnings reports.
b.
Stock prices do not adjust to reflect quarterly earnings reports.
c.
Support for the semi-strong EMH.
d.
Stock prices adjust if earnings reports are released in January.
e.
Stock prices do not adjust if earnings reports are released in January.
19. The results of studies that have looked at the relationship between PEG ratios and subsequent stock
returns
a.
Find an inverse relationship, with annual rebalancing.
b.
Find no relationship, with monthly or quarterly rebalancing.
c.
Find an inverse relationship, with monthly or quarterly rebalancing.
d.
Find a direct relationship, with monthly or quarterly rebalancing.
e.
Find an direct relationship with annual rebalancing
20. The strongest explanations for the size anomaly are
a.
risk measurements
b.
higher transaction costs
c.
P/E ratio
d.
Choices a and b.
e.
Choices b and c.
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21. Fama and French examined the relationship between the Book Value to Market Value ratio and
average stock returns and found
a.
No evidence of a relationship for Canadian stocks.
b.
Evidence of a negative relationship in Canadian stocks only.
c.
Evidence of a positive relationship for Japanese stocks only.
d.
Evidence of a negative relationship for Canadian and Japanese stocks.
e.
Evidence of a positive relationship for U.S. and Japanese stocks.
22. Investigators have tested the strong form EMH by examining the performance of the following type of
investor
a.
Corporate insiders.
b.
Stock exchange specialists.
c.
Security analysts.
d.
Professional money managers.
e.
All of the above.
23. Escalation bias refers to the situation where
a.
Investors have a propensity to sell winners too soon and hang on to losers too long.
b.
Investors ignore bad news and overemphasize good news.
c.
Investors tend to follow the herd.
d.
Investors put more money into a failure rather than into a success.
e.
Investors are all noise traders.
24. Confirmation bias refers to the situation where
a.
Investors have a propensity to sell winners too soon and hang on to losers too long.
b.
Investors ignore bad news and overemphasize good news.
c.
Investors tend to follow the herd.
d.
Investors put more money into a failure rather than into a success.
e.
Investors are all noise traders.
25. According to prospect theory
a.
Investors have a propensity to sell winners too soon and hang on to losers too long.
b.
Investors ignore bad news and overemphasize good news.
c.
Investors tend to follow the herd.
d.
Investors put more money into a failure rather than into a success.
e.
Investors are all noise traders.
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26. Behavioural finance differs from the standard model of finance because behavioural finance
a.
Precludes the impact of investor psychology.
b.
Includes the impact of investor psychology.
c.
Accepts the Efficient Markets Hypothesis.
d.
Rejects the idea of market anomalies.
e.
None of the above.
27. Studies of the relationship between P/E ratios and stock returns have found that
a.
Low P/E stocks of large cap stocks outperformed low P/E stocks of small cap stocks.
b.
Low P/E stocks of small cap stocks outperformed high P/E stocks of large cap stocks.
c.
High P/E stocks of large cap stocks outperformed low P/E stocks of small cap stocks.
d.
High P/E stocks of large cap stocks outperformed high P/E stocks of small cap stocks.
e.
None of the above.
28. The January anomaly refers to the phenomenon where stock prices
a.
Decline in December.
b.
Decline in January.
c.
Rise in January.
d.
Decline in December and rise in January.
e.
Rise in December and decline in January.
29. Researchers have found a positive relationship between default spread and stock returns in the long run
because a large default spread implies
a.
a high risk premium and higher expected returns.
b.
a high risk premium and lower expected returns.
c.
a low risk premium and higher expected returns.
d.
a low risk premium and lower expected returns.
e.
None of the above.
30. The results of return prediction studies have found
a.
Limited success predicting short-horizon returns.
b.
Limited success predicting long-horizon returns.
c.
Good success predicting long-horizon returns.
d.
Choices a and b.
e.
Choices a and c.
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31. In tests of the semi-strong form efficient market hypothesis, an adjustment for market effects is carried
out by
a.
Calculating the historical return.
b.
Calculating the market rate of return.
c.
Calculating the abnormal rate of return.
d.
Calculating the cross-sectional return.
e.
None of the above.
32. In an event study the objective is to
a.
Whether it is possible to predict stock prices.
b.
How fast stock prices adjust to news.
c.
Examine the cross-sectional distributions of returns.
d.
Conduct a time series analysis of returns.
e.
Determine normal P/E ratios.
33. In order to confirm the weak-form efficient market hypothesis you could develop trading rules that
consider,
a.
Advance-decline ratios.
b.
Short sales.
c.
Specialist activities.
d.
Any of the above.
e.
None of the above.
34. In order to confirm the weak-form efficient market hypothesis, an examination of stock price runs over
time would reveal that stock price changes over time were
a.
Highly positively correlated.
b.
Moderately positively correlated.
c.
Highly negatively correlated.
d.
Moderately negatively correlated.
e.
None of the above.
35. According to the strong-form efficient market hypothesis, stock prices fully reflect
a.
All security market information only.
b.
All public information only.
c.
All public and private information only.
d.
All of the above.
e.
None of the above.
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36. According to the semi-strong form efficient market hypothesis, which of the following types of
information are fully reflected in stock prices?
a.
Rates of return, trading volume, and news about the economy.
b.
Dividend and earnings announcements.
c.
Rates of return, trading volume, and block trades.
d.
Earnings announcements and rates of return.
e.
All of the above.
37. According to the weak-form efficient market hypothesis, which of the following types of information
are fully reflected in stock prices?
a.
Rates of return, trading volume, and news about the economy.
b.
Dividend and earnings announcements.
c.
Rates of return, trading volume, and block trades.
d.
Earnings announcements and rates of return.
e.
All of the above.
38. Which of the following assumptions imply capital markets will be efficient?
a.
A large number of independent profit-maximizing participants analyze securities.
b.
New information regarding securities comes to the market in a random fashion.
c.
Investors adjust security prices rapidly to reflect the effect of new information.
d.
Both b and c only.
e.
All of the above are assumptions that imply a market will be efficient.
39. Autocorrelation and runs tests are used to test the
a.
Weak-form efficient market hypothesis (EMH).
b.
Semistrong-form efficient market hypothesis (EMH).
c.
Strong-form efficient market hypothesis (EMH).
d.
Choices a and b.
e.
All of the above.
40. Event studies are used to test the
a.
Weak-form efficient market hypothesis (EMH).
b.
Semistrong-form efficient market hypothesis (EMH).
c.
Strong-form efficient market hypothesis (EMH).
d.
Choices b and c.
e.
All of the above.
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41. Evidence supporting the strong form efficient market hypothesis (EMH) resulted from examining
a.
Value Line rankings.
b.
Corporate insiders.
c.
Stock exchange specialists.
d.
Choices b and c.
e.
All of the above.
42. Which of the following behaviours is consistent with escalation bias?
a.
Buying more of a stock as it increases in value.
b.
Buying more of a stock as it decreases in value.
c.
Selling a stock as it decreases in value.
d.
Selling a stock as it increases in value.
e.
Buying or selling a stock as it increases in value.
43. Fusion investing refers to the combination of
a.
Technical analysis and fundamental analysis.
b.
Behavioural analysis and technical analysis.
c.
Fundamental analysis and investor sentiment.
d.
Technical analysis and investor sentiment.
e.
All of the above.
Exhibit 5-1
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Stock
Rit
Rmt
ai
Beta
C
12
10
0
0.8
E
10
8.0
0
1.1
Rit = return for stock i during period t
Rmt = return for the aggregate market during period t
44. Refer to Exhibit 5-1. What is the abnormal rate of return for Stock C during period t using only the
aggregate market return (ignore differential systematic risk)?
a.
4.0%
b.
1.2%
c.
−1.05%
d.
2.0%
e.
−8.50
12
45. Refer to Exhibit 5-1. What is the abnormal rate of return for Stock E during period t using only the
aggregate market return (ignore differential systematic risk)?
a.
4.0%
b.
2.0%
c.
1.2%
d.
−1.05%
e.
−8.5%
46. Refer to Exhibit 5-1. What is the abnormal rate of return for Stock C when you consider its systematic
risk measure (beta)?
a.
4.0%
b.
1.2%
c.
2.0%
d.
−1.05%
e.
−8.5%
47. Refer to Exhibit 5-1. What is the abnormal rate of return for Stock E when you consider its systematic
risk measure (beta)?
a.
2.0%
b.
1.2%
c.
4.0%
d.
−1.05%
e.
−8.5%
13
Exhibit 5-2
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Stock
Rit
Rmt
ai
Beta
ABC
11.5
13.0
0
0.7
XYZ
9.0
7.0
0
1.1
Rit = return for stock i during period t
Rmt = return for the aggregate market during period t
48. Refer to Exhibit 5-2. What is the abnormal rate of return for Stock ABC during period t using only the
aggregate market return (ignore differential systematic risk)?
a.
3.2%
b.
2.4%
c.
1.3%
d.
−1.5%
e.
2.0%
49. Refer to Exhibit 5-2. What is the abnormal rate of return for Stock XYZ during period t using only the
aggregate market return (ignore differential systematic risk)?
a.
−3.2%
b.
2.4%
c.
2.0%
d.
1.3%
e.
−1.5%
50. Refer to Exhibit 5-2. What is the abnormal rate of return for Stock ABC when you consider its
systematic risk measure (beta)?
a.
2.4%
b.
1.5%
c.
−1.5%
d.
2.0%
e.
−3.2%
14
51. Refer to Exhibit 5-2. What is the abnormal rate of return for Stock XYZ when you consider its
systematic risk measure (beta)?
a.
2.0%
b.
−1.5%
c.
2.4%
d.
1.3%
e.
−3.2%
Exhibit 5-3
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Stock
Rit
Rmt
ai
Beta
Elliot
9.9
15.0
0
0.8
Hemlick
9.1
8.0
0
1.1
Rit = return for stock i during period t
Rmt = return for the aggregate market during period t
52. Refer to Exhibit 5-3. What is the abnormal rate of return for Elliot during period t using only the
aggregate market return (ignore differential systematic risk)?
a.
1.50
b.
1.10
c.
−1.50
d.
−5.10
e.
−8.00
15
53. Refer to Exhibit 5-3. What is the abnormal rate of return for Hemlick during period t using only the
aggregate market return (ignore differential systematic risk)?
a.
0.11
b.
1.10
c.
−1.80
d.
−1.80
e.
−4.60
54. Refer to Exhibit 5-3. What is the abnormal rate of return for Elliot when you consider its systematic
risk measure (beta)?
a.
−2.10%
b.
−2.00%
c.
5.20%
d.
14.10%
e.
None of the above
55. Refer to Exhibit 5-3. What is the abnormal rate of return for Hemlick when you consider its systematic
risk measure (beta)?
a.
0.1%
b.
0.3%
c.
0.5%
d.
1.5%
e.
3.0%
16
Exhibit 5-4
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Stock
Rit
Rmt
ai
Beta
A
10.3
12
0
0.6
B
9.4
9.0
0
1.2
Rit = return for stock i during period t
Rmt = return for the aggregate market during period t
56. Refer to Exhibit 5-4. What is the abnormal rate of return for Stock A during period t using only the
aggregate market return (ignore differential systematic risk)?
a.
3.34
b.
1.75
c.
−1.75
d.
−3.70
e.
−1.70
57. Refer to Exhibit 5-4. What is the abnormal rate of return for Stock B during period t using only the
aggregate market return (ignore differential systematic risk)?
a.
0.40
b.
1.40
c.
−1.10
d.
−4.40
e.
−6.40
58. Refer to Exhibit 5-4. What is the abnormal rate of return for Stock A when you consider its systematic
risk measure (beta)?
a.
2.30%
b.
2.10%
c.
3.10%
d.
12.40%
e.
None of the above
17
59. Refer to Exhibit 5-4. What is the abnormal rate of return for Stock B when you consider its systematic
risk measure (beta)?
a.
0.1%
b.
−1.4%
c.
0.5%
d.
1.5%
e.
2.0%
Exhibit 5-5
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Stock
Rit
Rmt
ai
Beta
A
10.6
15
0
0.8
Z
9.8
8.0
0
1.1
Rit = return for stock i during period t
Rmt = return for the aggregate market during period t
60. Refer to Exhibit 5-5. What is the abnormal rate of return for Stock A during period t using only the
aggregate market return (ignore differential systematic risk)?
a.
3.40
b.
4.40
c.
−1.86
d.
−4.40
e.
−1.70
18
61. Refer to Exhibit 5-5. What is the abnormal rate of return for Stock Z during period t using only the
aggregate market return (ignore differential systematic risk)?
a.
1.80
b.
1.40
c.
−1.80
d.
−4.80
e.
−8.80
62. Refer to Exhibit 5-5. What is the abnormal rate of return for Stock A when you consider its systematic
risk measure (beta)?
a.
1.40%
b.
−1.40%
c.
2.80%
d.
−2.80%
e.
None of the above
63. Refer to Exhibit 5-5. What is the abnormal rate of return for Stock Z when you consider its systematic
risk measure (beta)?
a.
0.1%
b.
1.0%
c.
0.5%
d.
−1.0%
e.
−2.0%
19
64. Refer to Exhibit 5-6. What is the abnormal rate of return for Stock A during period t using only the
aggregate market return (ignore differential systematic risk)?
a.
−2.3%
b.
−0.3%
c.
0.3%
d.
2.3%
e.
3.0%
65. Refer to Exhibit 5-6. What is the abnormal rate of return for Stock A when you consider its systematic
risk measure (beta)?
a.
−2.3%
b.
−0.3%
c.
0.3%
d.
2.3%
e.
3.0%
66. Refer to Exhibit 5-6. What is the abnormal rate of return for Stock B when you consider its systematic
risk measure (beta)?
a.
−0.8%
b.
−1.2%
c.
1.3%
d.
2.4%
e.
6.6%