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.”
Securities all have the same risk adjusted expected return if priced fairly; however,
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
market and some people who do not. The information provided, however, fails to
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.
9. Incorrect. In the short term, markets reflect a random pattern. Information is constantly
flowing in the economy and investors each have different expectations that vary
10. c. If the stocks are overvalued, without regulative restrictions or other constraints on the
trading, some investors observing this trend would be able to form a trading strategy to
11. c. This is a predictable pattern of returns, which should not occur if the stock market is
weakly efficient.
13. c. The P/E ratio is public information so this observation would provide evidence
against the semi-strong form of the efficient market theory.
15. No, this is not a violation of the EMH. This empirical tendency does not provide
investors with a tool that will enable them to earn abnormal returns; in other words, it
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
around a “normal” level. Otherwise, there is no meaning to statements such as “when
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
22. The market may have anticipated even greater earnings. Compared to prior
expectations, the announcement was a disappointment.
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
fundamental analysis. This reduced cash flow represses stock prices.
CFA 1
CFA 2
CFA 3
CFA 4 Answer: c.
CFA 5 Answer: c.
CFA 6 Answer: d.
CFA 7
Answer:
Chapter 08 – The Efficient Market Hypothesis
CFA 8 Answer:
b.
(i) Concentration of one’s portfolio in stocks having very similar attributes may
expose the portfolio to more risk than is desirable. The strategy limits the
CFA 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.
Chapter 08 – The Efficient Market Hypothesis
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
(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. The EMH predicts that most fundamental analysis is doomed
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
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
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;
(ii) high book-to-market ratio stocks;
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