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Chapter 7
Stock Price Behavior and Market Efficiency
Concept Questions
2. Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators
3. The efficient markets paradigm only says, within the bounds of increasingly strong assumptions about
However, that does not mean that a few particular investors cannot outperform the market over a
4. a. If the market is not weak-form efficient, then this information could be acted on and a profit
b. Under 2, if the market is not semistrong-form efficient, then this information could be used to buy
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
d. Despite the fact that this information is obviously less open to the public and a clearer signal of
imminent price gains than is the scenario in part (c), the conclusions remain the same. If the
5. 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
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Education.
6. 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
7. Beating the market during any year is entirely possible. If you are able to consistently beat the market,
8. a. False. Market efficiency implies that prices reflect all available information, but it does not
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-
c. False. Market efficiency implies that market participants are rational. Rational people will
e. True. Competition among investors results in the rapid transmission of new market information.
10. Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all
b. Only scenario (ii) indicates market efficiency. In that case, the price of the stock rises
12. 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
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
13. 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
14. The market is generally considered to be efficient up to the semi-strong form. Therefore, no
systematic profit can be made by trading on publicly-available information. Although illegal, the lead
15. Under the semi-strong form of market efficiency, the stock price should stay the same. The
16. 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
17. You should not agree with your broker. The performance ratings of the small manufacturing firms
b. Possibly. If the rumors were publicly disseminated, the prices would have already adjusted for
20. The statement is false because every investor has a different risk preference. Although the expected
21. At the time of the announcement, the price of the stock should immediately decrease to reflect the
negative information.
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Education.
22. In an efficient market, the cumulative abnormal return (CAR) for Prospectors would rise substantially
at the announcement of a new discovery. The CAR falls slightly on any day when no discovery is
on the other days, leaving CARs that are horizontal over time.
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
Core Questions
1. To find the cumulative abnormal returns, we chart the abnormal returns for the days preceding and
Daily Cumulative
Days from Abnormal Abnormal
Announcement Return Return
-5 -0.1 -0.1
-4 0.1 0.0
-3 -0.1 -0.1
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Education.
-5 -4 -3 -2 -1 0 1 2 3 4 5
-0.5
0.0
0.5
1.0
1.5
2.0
Cumulative Abnormal Returns
Days from announcement
CAR
Given that the battle with the current CEO was acrimonious, it must be assumed that investors felt
2. The diagram does not support the efficient markets hypothesis. The CAR should remain relatively flat
following the announcements. The diagram reveals that the CAR rose in the first month, only to drift
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
CAR prior to an event can easily occur in an efficient capital market. For example, consider a
c. Supports. The CAR does not fluctuate after the announcement at time 0. While the CAR was
d. Supports. The diagram indicates that the information announced at time 0 was of no value.
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
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,
5. To find the cumulative abnormal returns, we chart the abnormal returns for each of the three
companies for the days preceding and following the announcement. The abnormal return is
Abnormal returns ( Ri – R M)
Days from
announcement Ross W’field Jordan Sum
Average
abnormal return
Cumulative
average residual
–4 -0.2 -0.2 0.2 -0.2 -0.1 -0.1
–3 0.2 -0.1 0.6 0.7 0.2 0.2
–2 0.2 -0.2 0.4 0.4 0.1 0.3
-4 -3 -2 -1 0 1 2 3 4
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
Cumulative Abnormal Returns
Days from announcement
CAR
The market reacts favorably to the announcements. Moreover, the market reacts only on the day of the
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
