CHAPTER 13 B – 1
CHAPTER 13
EFFICIENT CAPITAL MARKETS AND
BEHAVIORAL CHALLENGES
Answers to Concept Questions
1. To create value, firms should accept financing proposals with positive net present values. Firms can
create valuable financing opportunities in three ways: 1) Fool investors. A firm can issue a complex
security to receive more than the fair market value. Financial managers attempt to package securities
to receive the greatest value. 2) Reduce costs or increase subsidies. A firm can package securities to
gain from developing unique securities by issuing these securities at premium prices.
2. The three forms of the efficient markets hypothesis are: 1) Weak form. Market prices reflect
information contained in historical prices. Investors are unable to earn abnormal returns using
3. a. False. Market efficiency implies that prices reflect all available information, but it does not imply
perfect forecasting ability.
b. True. Market efficiency exists when prices reflect all available information. To be efficient in the
weak form, the market must incorporate all historical data into prices. Under the semi-strong
available information.
c. False. Market efficiency implies that market participants are rational. Rational people will
d. False. In efficient markets, prices reflect all available information. Thus, prices will fluctuate
e. True. Competition among investors results in the rapid transmission of new market information.
4. On average, the only return that is earned is the required return—investors buy assets with returns in
excess of the required return (positive NPV), bidding up the price and thus causing the return to fall
to the required return (zero NPV); investors sell assets with returns less than the required return
5. The market is not weak form efficient.
6. Yes, historical information is also public information; weak form efficiency is a subset of semi-strong
form efficiency.
7. Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all
have zero NPV. If trading costs exist, then these investors lose by the amount of the costs.
8. Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators
provide liquidity to markets and thus help to promote efficiency.
9. The EMH only says, within the bounds of increasingly strong assumptions about the information
processing of investors, that assets are fairly priced. An implication of this is that, on average, the
typical market participant cannot earn excessive profits from a particular trading strategy. However,
10. a. If the market is not weak form efficient, then this information could be acted on and a profit
earned from following the price trend. Under (2), (3), and (4), this information is fully impounded
in the current price and no abnormal profit opportunity exists.
b. Under (2), if the market is not semi-strong form efficient, then this information could be used to
buy the stock “cheap” before the rest of the market discovers the financial statement anomaly.
Since (2) is stronger than (1), both imply that a profit opportunity exists; under (3) and (4), this
c. Under (3), if the market is not strong form efficient, then this information could be used as a
profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock
is underpriced or that good news is imminent. Since (1) and (2) are weaker than (3), all three
imply that a profit opportunity exists. Note that this assumes the individual who sees the insider
trading is the only one who sees the trading. If the information about the trades made by company
price.
11. A technical analyst would argue that the market is not efficient. Since a technical analyst examines
past prices, the market cannot be weak form efficient for technical analysis to work. If the market is
not weak form efficient, it cannot be efficient under stronger assumptions about the information
12. Investor sentiment captures the mood of the investing public. If investors are bearish in general, it may
be that the market is headed down in the future since investors are less likely to invest. If the sentiment
is bullish, it would be taken as a positive signal to the market. To use investor sentiment in technical
13. Taken at face value, this fact suggests that markets have become more efficient. The increasing ease
with which information is available over the Internet lends strength to this conclusion. On the other
hand, during this particular period, large-capitalization growth stocks were the top performers. Value-
14. It is likely the market has a better estimate of the stock price, assuming it is semistrong form efficient.
However, semistrong form efficiency only states that you cannot easily profit from publicly available
examine the limited public information and make an extra return.
15. a. Aerotech’s stock price should rise immediately after the announcement of the positive news.
b. Only scenario (ii) indicates market efficiency. In that case, the price of the stock rises
16. False. The stock price would have adjusted before the founder’s death only if investors had perfect
forecasting ability. The 12.5 percent increase in the stock price after the founder’s death indicates that
17. The announcement should not deter investors from buying UPC’s stock. If the market is semi-strong
form efficient, the stock price will have already reflected the present value of the payments that UPC
18. The market is often considered to be relatively efficient up to the semi-strong form. If so, no systematic
profit can be made by trading on publicly-available information. Although illegal, the lead engineer
19. Under the semi-strong form of market efficiency, the stock price should stay the same. The accounting
system changes are publicly available information. Investors would identify no changes in either the
20. Because the number of subscribers has increased dramatically, the time it takes for information in the
newsletter to be reflected in prices has shortened. With shorter adjustment periods, it becomes
21. You should not agree with your broker. The performance ratings of the small manufacturing firms
were published and became public information. Prices should adjust immediately to the information,
22. Stock prices should immediately and fully rise to reflect the announcement. Thus, one cannot expect
23. a. No. Earnings information is in the public domain and reflected in the current stock price.
b. Possibly. If the rumors were publicly disseminated, the prices would have already adjusted for
the possibility of a merger. If the rumor is information that you received from an insider, you
c. No. The information is already public, and thus, already reflected in the stock price.
24. Serial correlation occurs when the current value of a variable is related to the future value of the
variable. If the market is efficient, the information about the serial correlation in the macroeconomic
variable and its relationship to net earnings should already be reflected in the stock price. In other
25. The statement is false because every investor has a different risk preference. Although the expected
return from every well-diversified portfolio is the same after adjusting for risk, investors still need to
26. The share price will decrease immediately to reflect the new information. At the time of the
announcement, the price of the stock should immediately decrease to reflect the negative information.
at the announcement of a new discovery. The CAR falls slightly on any day when no discovery is
announced. There is a small positive probability that there will be a discovery on any given day. If
there is no discovery on a particular day, the price should fall slightly because the good event did not
occur. The substantial price increases on the rare days of discovery should balance the small declines
changes in investor sentiment and psychology. These changes can lead to non-random price behavior.
NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.
CHAPTER 13 B – 5
Basic
1. To find the cumulative abnormal returns, we chart the abnormal returns for each of the three airlines
for the days preceding and following the announcement. The abnormal return is calculated by
subtracting the market return from a stock’s return on a particular day, Ri – RM. Group the returns by
the number of days before or after the announcement for each respective airline. Calculate the
cumulative average abnormal return by adding each abnormal return to the previous day’s abnormal
down to lower levels during later months. Such movement violates the semi-strong form of the
efficient markets hypothesis because an investor could earn abnormal profits while the stock price
gradually decreased.
3. a. Supports. The CAR remained constant after the event at Time 0. This result is consistent with
market efficiency, because prices adjust immediately to reflect the new information. Drops in
-0.2
-0.1
-0.1
-0.1
1.7
1.8
1.8
1.7
1.6
-0.5
0
0.5
1
1.5
2
-4 -3 -2 -1 0 1 2 3 4
Days from announcement
CAR
rather than good stock performance, CARs are likely to be negative prior to removal. Because
the firing of the CEO is announced at Time 0, one cannot use this information to trade profitably
before the announcement. Thus, price drops prior to an event are neither consistent nor
inconsistent with the efficient markets hypothesis.
c. Supports. The CAR does not fluctuate after the announcement at Time 0. While the CAR was
rising before the event, insider information would be needed for profitable trading. Thus, the
graph is consistent with the semi-strong form of efficient markets.
d. Supports. The diagram indicates that the information announced at Time 0 was of no value. There
appears to be a slight drop in the CAR prior to the event day. Similar to part a, such movement
at the event date are neither consistent nor inconsistent with the efficient markets hypothesis.
4. Once the verdict is reached, the diagram shows that the CAR continues to decline after the court
decision, allowing investors to earn abnormal returns. The CAR should remain constant on average,