Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Chapter 10: Market Efficiency
Multiple Choice Questions
1. Section: 10.1 Defining Market Efficiency
Learning Objective: 10.1
Level of difficulty: Basic
2. Section: 10.1 Defining Market Efficiency
Learning Objective: 10.1
Level of difficulty: Basic
3. Section: 10.1 Defining Market Efficiency
Learning Objective: 10.1
Level of difficulty: Basic
4. Section: 10.2 The Efficient Market Hypothesis (EMH)
Learning Objective: 10.2
Level of difficulty: Basic
5. Section: 10.2 The Efficient Market Hypothesis (EMH)
Learning Objective: 10.2
Level of difficulty: Medium
6. Section: 10.5 Implications of Market Efficiency
Learning Objective: 10.5
Level of difficulty: Medium
7. Section: 10.2 The Efficient Market Hypothesis (EMH)
Learning Objective: 10.2
Level of difficulty: Basic
8. Section: 10.2 The Efficient Market Hypothesis (EMH)
Learning Objective: 10.2
Level of difficulty: Medium
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
9. Section: 10.3 Empirical Evidence Regarding Market Efficiency
Learning Objective: 10.3
Step 1: Concept of market efficiency
Level of difficulty: Medium
10. Section: 10.3 Empirical Evidence Regarding Market Efficiency
Learning Objective: 10.3
Level of difficulty: Medium
11. Section: 10.1 Defining Market Efficiency
Learning Objective: 10.1
Level of difficulty: Medium
12. Section 10.2 The Efficient Market Hypothesis (EMH)
Learning Objective: 10.2
13. Section: 10.3 Empirical Evidence Regarding Market Efficiency
Learning Objective: 10.3
Level of difficulty: Medium
14. Section: 10.3 Empirical Evidence Regarding Market Efficiency
Learning Objective: 10.3
15. Section: 10.3 Empirical Evidence Regarding Market Efficiency
Learning Objective: 10.3
Level of difficulty: Medium
16. Section: 10.5 Implications of Market Efficiency
Learning Objective: 10.5
Level of difficulty: Medium
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
17. Section: 10.3 Empirical Evidence Regarding Market Efficiency
Learning Objective: 10.3
Level of difficulty: Difficult
18. Section: 10.3 Empirical Evidence Regarding Market Efficiency
Learning Objective: 10.3
Level of difficulty: Difficult
19. Section: 10.3 Empirical Evidence Regarding Market Efficiency
Learning Objective: 10.3
Level of difficulty: Basic
20. Section: 10.4 Behavioural Finance
Learning Objective: 10.4
Level of difficulty: Medium
21. Section: 10.4 Behavioural Finance
Learning Objective: 10.4
Level of difficulty: Medium
22. Section: 10.3 Empirical Evidence Regarding Market Efficiency
Learning Objective: 10.3
Level of difficulty: Medium
Practice Problems
Basic
23. Section: 10.1 Defining Market Efficiency
Learning Objective: 10.1
Level of difficulty: Basic
Solution:
a. This market is likely to suffer from operational inefficiency due to high transaction costs and
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
24. Section: 10.1 Defining Market Efficiency
Learning Objective: 10.1
Level of difficulty: Basic
Solution:
a. Yes. All I have to do to consistently beat the market is do the opposite of what my broker
advises.
25. Section: 10.3 Empirical Evidence Regarding Market Efficiency
Learning Objective: 10.3
Level of difficulty: Basic
Solution: Statistical significance simply asks whether or not the observations are likely under the
26. Section: 10.1 Defining Market Efficiency
Learning Objective: 10.1
Level of difficulty: Basic
Solution: A sell-side analyst works for the investment banks and brokerage houses who are
27. Section: 10.3 Empirical Evidence Regarding Market Efficiency
Learning Objective: 10.3
Level of difficulty: Basic
Solution: Weak form and semi-strong form efficiency are both well-supported. It is reasonable to
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
28. Section: 10.5 Implications of Market Efficiency
Learning Objective: 10.5
Level of difficulty: Basic
Solution:
For investors, technical and fundamental analysis both tend to be futile since weak form and
Intermediate
29. Section: 10.3 Empirical Evidence Regarding Market Efficiency
Learning Objective: 10.3
Level of difficulty: Intermediate
Solution: To test the weak form, one way is to test if price changes are independent of each other.
One common test is the serial correlations test, which measures the correlation between
30. Section: 10.1 Defining Market Efficiency
Learning Objective: 10.1
Level of difficulty: Intermediate
Solution:
Assumption #1: A large number of rational, profit-maximizing investors exist who actively
31. Section: 10.3 Empirical Evidence Regarding Market Efficiency
Learning Objective: 10.3
Level of difficulty: Intermediate
Solution: The momentum effect refers to the fact that stocks that have experienced high returns
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
32. Section: 10.5 Implications of Market Efficiency
Learning Objective: 10.5
Level of difficulty: Intermediate
Solution:
The evidence may suggest that on average pharmaceutical company stocks do better in the
33. Section: 10.5 Implications of Market Efficiency
Learning Objective: 10.5
Level of difficulty: Intermediate
Solution: Not necessarily. The Board should consider what other information or rumours are
34. Section: 10.5 Implications of Market Efficiency
Learning Objective: 10.5
Level of difficulty: Intermediate
Solution:
First, if the project is really secret (i.e., no one outside the company knows anything about it),
35. Section: 10.5 Implications of Market Efficiency
Learning Objective: 10.5
Level of difficulty: Intermediate
The efficiency of the market is based upon the continuing services of the analysts and portfolio
36. Section: 10.4 Behavioural Finance
Learning Objective: 10.4
Level of difficulty: Intermediate
Loss aversion refers to investors’ unwillingness to place “fair bets.” It implies that investors may
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Challenging
37. Section: 10.5 Implications of Market Efficiency
Learning Objective: 10.5
Level of difficulty: Challenging
Solution:
a. The markets are full of investors who are constantly analyzing a firm’s prospects (i.e., growth
38. Section: 10.5 Implications of Market Efficiency
Learning Objective: 10.5
Level of difficulty: Challenging
Solution:
(N.B. If you purchase the dividend on or after the ex–dividend date, you are no longer entitled to
the dividend.)
39. Section: 10.5 Implications of Market Efficiency
Learning Objective: 10.5
Level of difficulty: Challenging
Solution:
a. The announcement is bad news that the market did not anticipate and therefore the market has
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
40. Section: 10.4 Behavioural Finance
Learning Objective: 10.4
Level of difficulty: Challenging
Solution:
a. This is an example where human emotions, more than fundamentals of finance, are at play in
the market. At the time the incorrect news hit the market, the atmosphere was already volatile
41. Section: 10.4 Behavioural Finance
Learning Objective: 10.4
Level of difficulty: Challenging
Solution:
Investors are more likely to be overconfident when the economy is booming. Overconfidence
42. Section: 10.4 Behavioural Finance
Learning Objective: 10.4
Level of difficulty: Challenging
Solution:
Investors tend to become more overconfident as they accumulate more information and develop
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Answers to Concept Review Questions
10.1 The Defining Market Efficiency
Concept Review Questions
1. Define market efficiency in terms of information.
2. Discuss the reasonableness of the assumptions underlying market efficiency.
10.2 The Efficient Market Hypothesis (EMH)
Concept Review Questions
1. Explain the efficient market hypothesis (EMH).
2. Describe the various forms of EMH.
Weak form EMH: the theory that security prices fully reflect all market data, which refers to all
10.3 Empirical Evidence Regarding Market Efficiency
Concept Review Questions
1. Is the weak form EMH well supported by empirical evidence? Discuss any exceptions.
The weak form EMH is well supported by empirical evidence. Statistics tests, like serial
2. Is the semi-strong form EMH well supported by empirical evidence? Discuss any exceptions.
Most studies support the semi-strong EMH; however, some do not. One approach to test it is
event studies, which supports it with the exception of post-earnings-announcement drift. A
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
3. Is the strong form EMH well supported by empirical evidence? Discuss any exceptions.
10.4 Behavioural Finance
Concept Review Questions
1. Contrast behavioural finance with the traditional view.
Many of the theories and activities in finance are based on what is sometimes called “the
traditional view of finance.” This view suggests that investors:
i. Consider all available information;
2. Explain why behavioural flaws could result in investors holding portfolios that are not as
predicted by modern portfolio theory.
Traditional finance suggests that investors should make their decisions based on their perceived
investing needs and their beliefs regarding the appropriateness of market prices. Traditional
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
3. Explain why behavioural traits can cause asset price bubbles.
Herding Effect: it is indeed difficult to sit and watch as others make fantastic gains on their
investments, without feeling you are missing out on a “sure thing.”
Snake Bitten Effect: loss-averse investors are reluctant to invest in anything but the safest
investments and are slow to re-enter stock markets.
10.5 Implications of Market Efficiency
Concept Review Question
1. What are the main implications of the EMH for investors? For corporate officers?
Some of the implications for investors include the following:
Two of the most important implications for corporate officers are the following:
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita