CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
PROBLEM SETS
1. The correlation coefficient between stock returns for two nonoverlapping periods
2. No. Microsoft’s continuing profitability does not imply that stock market investors
who purchased Microsoft shares after its success was already evident would have
5. No, markets can be efficient even if some investors earn returns above the market
average. Consider the Lucky Event issue: Ignoring transaction costs, about 50% of
6. Volatile stock prices could reflect volatile underlying economic conditions as large
amounts of information being incorporated into the price will cause variability in
7. The following effects seem to suggest predictability within equity markets and thus
disprove the efficient market hypothesis. However, consider the following:
11-1
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
a. Multiple studies suggest that “value” stocks (measured often by low P/E
multiples) earn higher returns over time than “growth” stocks (high P/E multiples).
b. The book-to-market effect suggests that an investor can earn excess returns by
investing in companies with high book value (the value of a firm’s assets minus its
liabilities divided by the number of shares outstanding) to market value. A study by
c. Stock price momentum can be positively correlated with past performance (short
to intermediate horizon) or negatively correlated (long horizon). Historical data
seem to imply statistical significance to these patterns. Explanations for this include
d. The small-firm effect states that smaller firms produce better returns than larger
The measure of systematic risk according to Sharpe’s CAPM is the stock’s beta (or
sensitivity of returns of the stock to market returns). If the stock’s beta is the best
explanation of risk, then the small-firm effect does indicate an inefficient market.
1 Fama, Eugene and Kenneth French, “Common Risk Factors in the Returns on Stocks
and Bonds,” Journal of Finance 33:1, pp. 3-56.
2 Ibid
11-2
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
In addition this effect seems to be endpoint and data sensitive. For example, smaller
stocks did not outperform larger stocks from the mid-1980s through the 1990s. In
8. Over the long haul, there is an expected upward drift in stock prices based on their
fair expected rates of return. The fair expected return over any single day is very
10. a. Acute market inefficiencies are temporary in nature and are more easily
13. a. Though stock prices follow a random walk and intraday price changes do
appear to be a random walk, over the long run there is compensation for
b. In an efficient market, any predictable future prospects of a company have
11-3
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
c. While the random nature of dart board selection seems to follow naturally
14. d. In a semistrong-form efficient market, it is not possible to earn abnormally
high profits by trading on publicly available information. Information about
15. Market efficiency implies investors cannot earn excess risk-adjusted profits. If the
stock price run-up occurs when only insiders know of the coming dividend increase,
16. While positive beta stocks respond well to favorable new information about the
economy’s progress through the business cycle, they should not show abnormal
17. a. Consistent. Based on pure luck, half of all managers should beat the market
in any year.
18. The return on the market is 8%. Therefore, the forecast monthly return for Ford is:
Ford’s actual return was 7%, so the abnormal return was –1.9%.
11-4
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
19. a. Based on broad market trends, the CAPM indicates that AmbChaser stock
should have increased by: 1.0% + 2.0 × (1.5% – 1.0%) = 2.0%
b. If the settlement was expected to be $2 million, then the actual settlement was
20. Given market performance, predicted returns on the two stocks would be:
Apex underperformed this prediction; Bpex outperformed the prediction. We
conclude that Bpex won the lawsuit.
Therefore, the expected rate of return is:
b. If rM falls short of your expectation by 2% (that is, 10% – 12%) then you
c. Given a market return of 10%, you would forecast a return for Changing
Fortunes of 7%. The actual return is 10%. Therefore, the surprise due to
Because the firm is initially worth $100 million, the surprise amount of the
11-5
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
23. The market responds positively to new news. If the eventual recovery is anticipated,
then the recovery is already reflected in stock prices. Only a better-than-expected
24. Buy. In your view, the firm is not as bad as everyone else believes it to be.
25. Here we need a two-factor model relating Ford’s return to those of both the broad
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
However, several studies, including Siegel,3 show that successfully timing the
changes have eluded professional investors thus far. Moreover a changing risk
b. As the market risk premium increases during a recession, stocks prices tend to fall.
As the economy recovers, the market risk premium falls, and stock prices tend to
rise. These changes could give investors the impression that markets overreact,
especially if the underlying changes in the market risk premium are small but
CFA PROBLEMS
1. b. Semistrong form efficiency implies that market prices reflect all publicly
3. d. If low P/E stocks tend to have positive abnormal returns, this would represent
4. c. In an efficient market, no securities are consistently overpriced or
underpriced. While some securities will turn out after any investment period
3 Jeremy Siegel, Stocks for the Long Run: The Definitive Guide to Financial Market Returns and
Long-Term Investment Strategies, 2002, New York: McGraw-Hill.
11-7
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
7. a.
8. a. Some empirical evidence that supports the EMH:
(i) Professional money managers do not typically earn higher returns than
comparable risk, passive index strategies.
b. Some evidence that is difficult to reconcile with the EMH concerns simple
portfolio strategies that apparently would have provided high risk-adjusted
returns in the past. Some examples of portfolios with attractive historical
returns:
c. An investor might choose not to index even if markets are efficient because he
9. a. The efficient market hypothesis (EMH) states that a market is efficient if
security prices immediately and fully reflect all available relevant information.
i. The weak form of the EMH asserts that stock prices reflect all the information
that can be derived by examining market trading data such as the history of past
prices and trading volume.
11-8
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
ii. The semistrong form states that a firm’s stock price reflects all publicly
Evidence strongly supports the notion of semistrong efficiency, but occasional
studies (e.g., identifying market anomalies such as the small-firm-in-January or
iii. The strong form of the EMH holds that current market prices reflect all
Empirical evidence suggests that strong-form efficiency does not hold. If this
form were correct, prices would fully reflect all information. Therefore even
b. i. Technical analysis involves the search for recurrent and predictable patterns in
stock prices in order to enhance returns. The EMH implies that technical analysis
ii. Fundamental analysis uses earnings and dividend prospects of the firm,
expectations of future interest rates, and risk evaluation of the firm to determine
In summary, the EMH holds that the market appears to adjust so quickly to
information about both individual stocks and the economy as a whole that no
c. Portfolio managers have several roles and responsibilities even in perfectly
efficient markets. The most important responsibility is to identify the risk/return
objectives for a portfolio given the investor’s constraints. In an efficient market,
11-9
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
10. a. The earnings (and dividend) growth rate of growth stocks may be consistently
overestimated by investors. Investors may extrapolate recent growth too far into
b. In efficient markets, the current prices of stocks already reflect all known relevant
11-10