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Chapter 08 - The Efficient Market Hypothesis
CHAPTER 08
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
expected rates of return. The fair expected return over any single day is very small (e.g.,
4. No, this is not a violation of the EMH. Microsoft’s continuing large profits do not
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
Chapter 08 - The Efficient Market Hypothesis
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
11. c. This is a predictable pattern of returns, which should not occur if the stock market is
weakly efficient.
12. c. This is a filter rule, a classic technical trading rule, which would appear to contradict
the weak form of the efficient market hypothesis.
15. No, this is not a violation of the EMH. This empirical tendency does not provide
16. 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
17.
a. Consistent. Half of all managers should outperform the market based on pure
luck in any year.
18. 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
19. Implicit in the dollar-cost averaging strategy is the notion that stock prices fluctuate
20. The market responds positively to new news. If the eventual recovery is anticipated,
21. You should buy the stock. The firm’s management is not as bad as everyone else
23. This is not a violation of EMH. A possible explanation might be that the market index,
24. The negative abnormal returns (downward drift in CAR) just prior to stock purchases
suggest that insiders deferred their purchases until after bad news was released to the
25.
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
predictable; thus it is not actually a violation of EMH. That being said, such a shift
Chapter 08 - The Efficient Market Hypothesis
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
CFA 1
CFA 2
Answer: a.
The information should be absorbed instantly.
CFA 3
CFA 4 Answer: c.
positive alpha.
CFA 5 Answer: c.
A random walk reflects no other information and is thus random.
CFA 6 Answer: d.
Unexpected results are by definition an anomaly.
CFA 7
Chapter 08 - The Efficient Market Hypothesis
CFA 8 Answer:
a. The grandson is recommending taking advantage of (i) the small firm anomaly and
CFA 9 a. The efficient market hypothesis (EMH) states that a market is efficient if security
Chapter 08 - The Efficient Market Hypothesis
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
The strong form of the EMH holds that current market prices reflect all information
(whether publicly available or privately held) that can be relevant to the valuation of
the firm.
Empirical evidence suggests that strong-form efficiency does not hold. If this form
were correct, prices would fully reflect all information. Therefore even insiders
could not earn excess returns. But the evidence is that corporate officers do have
access to pertinent information long enough before public release to enable them to
profit from trading on this information.
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
Chapter 08 - The Efficient Market Hypothesis
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
b. In efficient markets, the current prices of stocks already reflect all known,
relevant information. In this situation, growth stocks and value stocks provide
the same risk-adjusted expected return.
CFA 11 a. Some empirical evidence that supports the EMH is:
(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:
(i) low P/E stocks;
c. An investor might choose not to index even if markets are efficient because he or she
