Chapter 6
Are Financial Markets Efficient?
The Efficient Market Hypothesis
Rationale Behind the Hypothesis
Evidence on the Efficient Market Hypothesis
Evidence in Favor of Market Efficiency
Mini-Case Box: An Exception That Proves the Rule: Raj Rajaratnam and Galleon
Case: Should Foreign Exchange Rates Follow a Random Walk?
Evidence Against Market Efficiency
Overview of the Evidence on the Efficient Market Hypothesis
The Practicing Manager: Practical Guide to Investing in the Stock Market
How Valuable are Published Reports by Investment Advisers?
Mini-Case Box: Should You Hire an Ape as Your Investment Adviser?
Should You Be Skeptical of Hot Tips?
Do Stock Prices Always Rise When There Is Good News?
Efficient Markets Prescription for the Investor
Why the Efficient Market Hypothesis Does Not Imply that Financial Markets are Efficient
Behavioral Finance
Case: What Do Stock Market Crashes Tell Us About the Efficient Market Hypothesis?
◼ Overview and Teaching Tips
To fully understand how asset prices are determined, students need to be exposed to efficient markets
hypothesis which describes how information is reflected in the asset prices. The discussion of the evidence
on the efficient markets illustrates how much controversy there is in this theory. Students also particularly
enjoy the Practicing Manager application which uses efficient markets theory to provide a practical guide
to investing in the stock market. This application captures the attention of even the most disinterested
student because all of us are interested in how to get rich (or, at least, in how to keep from getting poor).
This application also gives students practice using the reasoning that they learned earlier in the chapter.
In addition, the theory is confronted with evidence that shows the student important implications for the
real world.
30 Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition
◼ Answers to End-of-Chapters Questions
2. Although Joe’s expectations are typically quite accurate, they could still be improved by his taking
3. No, because he could improve the accuracy of his forecasts by predicting that tomorrow’s interest
4. True, as an approximation. If large changes in a stock price could be predicted, then the optimal
forecast of the stock return would not equal the equilibrium return for that stock. In this case, there
5. No, you shouldn’t buy stocks because the rise in the money supply is publicly available information
6. No, because this is publicly available information and is already reflected in stock prices. The optimal
7. Probably not. Although your broker has done well in the past, efficient markets theory suggests that
8. No, if the person has no better information than the rest of the market. An expected price rise of 10%
over the next month implies over a 100% annual return on IBM stock, which certainly exceeds its
9. False. All that is required for the market to be efficient so that prices reflect information on the
Chapter 6: Are Financial Markets Efficient? 31
12. True in principle. Foreign exchange rates are a random walk over a short interval such as a week
because changes in the exchange rate are unpredictable. If a change were predictable, large unexploited
13. No, because this expected change in the value of the dollar would imply that there is a huge
14. False. Although human fear may be the source of stock market crashes, that does not imply that there
◼ Quantitative Problems
1. A company has just announced a 3-for-1 stock split, effective immediately. Prior to the split, the
company had a market value of $5 billion with 100 million shares outstanding. Assuming that the
split conveys no new information about the company, what is the value of the company, the number
of shares outstanding, and price per share after the split? If the actual market price immediately
following the split is $17.00/share, what does this tell us about market efficiency?
Solution: Prior to the split, each share was worth $5 billion/100 million, or $50/share. If the split
2. If the public expects a corporation to lose $5 a share this quarter and it actually loses $4, which is still
the largest loss in the history of the company, what does the efficient market hypothesis say will
happen to the price of the stock when the $4 loss is announced?