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Chapter 08 - The Efficient Market Hypothesis
CHAPTER 08
8-1
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 08 - The Efficient Market Hypothesis
THE EFFICIENT MARKET HYPOTHESIS
1. The correlation coefficient should be zero. If it were not zero, then one could use
2. The phrase would be correct if it were modified to say “expected risk adjusted returns.”
3. Over the long haul, there is an expected upward drift in stock prices based on their fair
4. No, this is not a violation of the EMH. Microsoft’s continuing large profits do not imply
5. No. The notion of random walk naturally expects there to be some people who beat the
6. b. This is the definition of an efficient market.
7. d. It is not possible to offer a higher risk-return trade off if markets are efficient.
8. Strong-form efficiency includes all information: historical, public, and private.
9. Incorrect. In the short term, markets reflect a random pattern. Information is constantly
10. c. If the stocks are overvalued, without regulative restrictions or other constraints on the
c. This is a predictable pattern of returns, which should not occur if the stock market is
11. c. This is a filter rule, a classic technical trading rule, which would appear to contradict
8-2
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 08 - The Efficient Market Hypothesis
12. c. The P/E ratio is public information so this observation would provide evidence
13. No, it is not more attractive as a possible purchase. Any value associated with dividend
14. No, this is not a violation of the EMH. This empirical tendency does not provide
investors with a tool that will enable them to earn abnormal returns; in other words, it
does not suggest that investors are failing to use all available information. An investor
15. While positive beta stocks respond well to favorable new information about the
economy’s progress through the business cycle, the stock’s returns should be
16.
a. Consistent. Half of all managers should outperform the market based on pure
b. Violation. This would be the basis for an "easy money" rule: Simply invest with
c. Consistent. Predictable volatility does not convey a means to earn abnormal
d. Violation. The abnormal performance ought to occur in January, when the
e. Violation. Reversals offer a means to earn easy money: Simply buy last week's
17. An anomaly is considered an EMH exception because there are historical data to
substantiate a claim that says anomalies have produced excess risk-adjusted abnormal
returns in the past. Several anomalies regarding fundamental analysis have been
uncovered. These include the P/E effect, the momentum effect, the
18. Implicit in the dollar-cost averaging strategy is the notion that stock prices fluctuate
around a “normal” level. Otherwise, there is no meaning to statements such as “when
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© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 08 - The Efficient Market Hypothesis
19. The market responds positively to new news. If the eventual recovery is anticipated,
20. You should buy the stock. The firm’s management is not as bad as everyone else
21. The market may have anticipated even greater earnings. Compared to prior
22. This is not a violation of EMH. A possible explanation might be that the market index,
23. The negative abnormal returns (downward drift in CAR) just prior to stock purchases
24.
a. If a shift were actually predictable, it would be a violation of EMH. Such shifts
would be expected to occur as a result of a recession, but the recession is not
b. The reason this is perceived as an overreaction is because there are two events
occurring. First, recessions lead to reduced profits, impacting the numerator in a
fundamental analysis. This reduced cash flow represses stock prices.
Answer: b.
Public information constitutes semi-string efficiency, while the addition of private
CFA 2
Answer: a.
CFA 3
Answer: b.
CFA 4
Answer: c.
CFA 5
Answer: c.
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© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 08 - The Efficient Market Hypothesis
CFA 6
Answer: d.
CFA 7
Answer:
CFA 8
Answer:
a. The grandson is recommending taking advantage of (i) the small firm anomaly and
(ii) the January anomaly. In fact, this seems to be one anomaly: the
small-firm-in-January anomaly.
(i) Concentration of one’s portfolio in stocks having very similar attributes may
(ii) Even if the study results are correct as described, each such study covers a
(iii) After the results of the studies became publicly known, investment decisions
CFA 9
a. The efficient market hypothesis (EMH) states that a market is efficient if security
prices immediately and fully reflect all available relevant information. If the market
fully reflects information, the knowledge of that information would not allow an
investor to profit from the information because stock prices already incorporate the
information.
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© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 08 - The Efficient Market Hypothesis
b.
(i) Technical analysis involves the search for recurrent and predictable patterns in
(ii) Fundamental analysis uses earnings and dividend prospects of the firm,
expectations of future interest rates, and risk evaluation of the firm to determine
c. Portfolio managers have several roles and responsibilities even in perfectly efficient
markets. The most important responsibility is to identify the risk/return objectives
CFA 10
a. The earnings (and dividend) growth rates of growth stocks may be consistently
overestimated by investors. Investors may extrapolate recent earnings (and
b. In efficient markets, the current prices of stocks already reflect all known,
CFA 11
a. Some empirical evidence that supports the EMH is:
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© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 08 - The Efficient Market Hypothesis
(i) professional money managers do not typically earn higher returns than
(ii) event studies typically show that stocks respond immediately to the public
(iii) most tests of technical analysis find that it is difficult to identify price trends
that can be exploited to earn superior risk-adjusted investment returns.
b. Some evidence that is difficult to reconcile with the EMH concerns simple portfolio
(i) low P/E stocks;
(ii) high book-to-market ratio stocks;
(iii) small firms in January;
(iv) firms with very poor stock price performance in the last few months.
c. An investor might choose not to index even if markets are efficient because he or she
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© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
