Chapter 11 – The Efficient Market Hypothesis
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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
4. No. The value of dividend predictability would be already reflected in the
stock price.
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
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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).
This could suggest a strategy for earning higher returns over time. However,
another rational argument may be that traditional forms of CAPM (such as Sharpe’s
model) do not fully account for all risk factors that affect a firm’s price level. A
firm viewed as riskier may have a lower price and thus P/E multiple.
b. The book-to-market effect suggests that an investor can earn excess returns by
c. Stock price momentum can be positively correlated with past performance (short
to intermediate horizon) or negatively correlated (long horizon). Historical data
d. The small-firm effect states that smaller firms produce better returns than larger
firms. Since 1926, returns from small firms outpace large firm stock returns by
about 1% per year. Do small cap investors earn excess risk-adjusted returns?
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
Chapter 11 – The Efficient Market Hypothesis
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
9. c. This is a predictable pattern in returns that should not occur if the weak-form
EMH is valid.
10. a. Acute market inefficiencies are temporary in nature and are more easily
12. b. This is the definition of an efficient market.
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
bearing market risk and for the time value of money. Investing differs from a
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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
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.
b. Inconsistent. This would be the basis of an “easy money” rule: simply invest
18. The return on the market is 8%. Therefore, the forecast monthly return for Ford is:
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%
Chapter 11 – The Efficient Market Hypothesis
20. Given market performance, predicted returns on the two stocks would be:
21. a. E(rM ) = 12%, rf = 4% and β = 0.5
Therefore, the expected rate of return is:
4% + 0.5 × (12% – 4%) = 8%
If the stock is fairly priced, then E(r) = 8%.
22. Implicit in the dollar-cost averaging strategy is the notion that stock prices
23. The market responds positively to new news. If the eventual recovery is anticipated,
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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
market and the auto industry. If we call rI the industry return, then we would first
26. The market may have anticipated even greater earnings. Compared to prior
expectations, the announcement was a disappointment.
27. Thinly traded stocks will not have a considerable amount of market research
performed on the companies they represent. This neglected-firm effect implies a
28. The negative abnormal returns (downward drift in CAR) just prior to stock
purchases suggest that insiders deferred their purchases until after bad news was
29. a. The market risk premium moves countercyclical to the economy, peaking in
recessions. A violation of the efficient market hypothesis would imply that
investors could take advantage of this predictability and earn excess risk adjusted
Chapter 11 – The Efficient Market Hypothesis
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,
CFA PROBLEMS
1. b. Semistrong form efficiency implies that market prices reflect all publicly
available information concerning past trading history as well as fundamental
aspects of the firm.
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
5. c. A random walk implies that stock price changes are unpredictable, using past
price changes or any other data.
7. a.
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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
or she may want to tailor a portfolio to specific tax considerations or to specific
risk management issues, for example, the need to hedge (or at least not add to)
exposure to a particular source of risk (e.g., industry exposure).
9. a. The efficient market hypothesis (EMH) states that a market is efficient if
security prices immediately and fully reflect all available relevant information.
If the market fully reflects information, the knowledge of that information
would not allow an investor to profit from the information because stock
prices already incorporate the information.
ii. The semistrong form states that a firm’s stock price reflects all publicly
available information about a firm’s prospects. Examples of publicly available
information are company annual reports and investment advisory data.
Chapter 11 – The Efficient Market Hypothesis
iii. 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.
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
is without value. If past prices contain no useful information for predicting future
prices, there is no point in following any technical trading rule.
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 for a portfolio given the investor’s constraints. In an efficient market,
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
the future and thereby downplay the inevitable slowdown. At any given time,
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