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 non-overlapping periods
2. No. Microsoft’s continuing profitability does not imply that stock market investors who
3. Expected rates of return differ because of differential risk premiums.
5. 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.,
6. c. This is a predictable pattern in returns which should not occur if the weak-form
Chapter 11 – The Efficient Market Hypothesis
10. d. In a semistrong-form efficient market, it is not possible to earn abnormally high
profits by trading on publicly available information. Information about P/E ratios
11. The question regarding market efficiency is whether investors can earn abnormal risk-
adjusted profits. If the stock price run-up occurs when only insiders are aware of the
12. While positive beta stocks respond well to favorable new information about the
13. 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 with
14. The return on the market is 8%. Therefore, the forecast monthly return for GM is:
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15. a. Based on broad market trends, the CAPM indicates that AmbChaser stock should
b. If the settlement was expected to be $2 million, then the actual settlement was a
16. Given market performance, predicted returns on the two stocks would be:
Apex: 0.2% + (1.4 3%) = 4.4%
17. a. E(rM ) = 12%, rf = 4% and = 0.5
Therefore, the expected rate of return is:
b. If rM falls short of your expectation by 2% (that is, 10% – 12%) then you would
expect the return for Changing Fortunes Industries to fall short of your original
c. Given a market return of 10%, you would forecast a return for Changing Fortunes
of 7%. The actual return is 10%. Therefore, the surprise due to firm-specific
18. Implicit in the dollar-cost averaging strategy is the notion that stock prices fluctuate
around a “normal” level. Otherwise, there is no meaning to statements such as: “when
the price is high.” How do we know, for example, whether a price of $25 today will
turn out to be viewed as high or low compared to the stock price six months from
now?
Chapter 11 – The Efficient Market Hypothesis
19. The market responds positively to new news. If the eventual recovery is anticipated,
20. Buy. In your view, the firm is not as bad as everyone else believes it to be. Therefore,
21. 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 r I the industry return, then we would first
estimate parameters a, b ,c in the following regression:
Given these estimates we would calculate Ford’s firm-specific return as:
23. 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
CFA PROBLEMS
1. b. Semi-strong form efficiency implies that market prices reflect all publicly
2. a. The full price adjustment should occur just as the news about the dividend
3. d. If low P/E stocks tend to have positive abnormal returns, this would represent an
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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.
i. The weak form of the EMH asserts that stock prices reflect all the information that
can be derived by examining market trading data such as the history of past prices and
trading volume.
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.
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
ii. Fundamental analysis uses earnings and dividend prospects of the firm, expectations
of future interest rates, and risk evaluation of the firm to determine proper stock prices.
Chapter 11 – The Efficient Market Hypothesis
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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, portfolio managers are
responsible for tailoring the portfolio to meet the investor’s needs, rather than to beat
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
b. In efficient markets, the current prices of stocks already reflect all known relevant