Solutions for Chapter 5: Questions and Problems
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CHAPTER 5
EFFICIENT CAPITAL MARKETS
Answers to Questions
1. There are several reasons why one would expect capital markets to be efficient, the
foremost being that there are a large number of independent, profit-maximizing investors
engaged in the analysis and valuation of securities. A second assumption is that new
information comes to the market in a random fashion. The third assumption is that the
numerous profit-maximizing investors will adjust security prices rapidly to reflect this
2. The weak-form efficient market hypothesis contends that current stock prices reflect all
available security-market information including the historical sequence of prices, price
changes, and any volume information. The implication is that there should be no
relationship between past price changes and future price changes. Therefore, any trading
Solutions for Chapter 5: Questions and Problems
– 40 –
3. The semistrong-form efficient market hypothesis contends that security prices adjust
rapidly to the release of all new public information and that stock prices reflect all public
information. The semistrong-form goes beyond the weak-form because it includes all
4. Abnormal rate of return is the amount by which a security’s return differs from the
5. The CAPM is grounded in the theory that investors demand higher returns for higher
risks. As a result of risks specific to each individual security, the announcement of a
significant economic event will tend to affect individual stock prices to a greater or lesser
extent than the market as a whole. Fama, Fisher, Jensen, and Roll portrayed this unique
Solutions for Chapter 5: Questions and Problems
As an example of how one would derive abnormal risk-adjusted returns for a stock during
a specific period, assume the following values for a firm:
ai = .01 and Bi = 1.40
If the market return (Rmt) during the specified period were 8%, the expected return for
stock i would be:
6. First, only use information or data that is publicly available at the time of the decision. As
an example, if you use information that is typically not available until six weeks after a
period and you assume you have it four weeks after, your investment results should be
7. A number of studies have examined the adjustment of stock prices to major world events.
These studies analyzed the effect of several unexpected world events on stock prices –
namely, whether prices adjusted before or during the announcement or after it. The
Solutions for Chapter 5: Questions and Problems
8. In the early 1970s, several studies were performed that examined quarterly earnings
reports. The results of the studies provided evidence against the semistrong-form EMH.
9. Studies on market efficiency are considered to be dual tests of the EMH and the CAPM.
These tests involve a joint hypothesis because they consider not only the efficiency of the
10. The strong-form efficient market hypothesis asserts that stock prices fully reflect all
information, whether public or private. It goes beyond the semistrong-form because it
11. The strong-form efficient market hypothesis goes beyond the semistrong-form in that it
calls for perfect markets – i.e., no group of investors has a monopolistic access to
12. In the early 1970s, a study by the SEC found that by having access to the limit order
books as his source of monopolistic information, coupled with low transaction costs, the
13. Studies by several authors examined the risk-adjusted performance of professional money
managers for various periods and found support for the strong-form efficient market
Solutions for Chapter 5: Questions and Problems
14. Behavioural finance deals with individual investor psychology and how it affects
individuals’ actions as investors, analysts, and portfolio managers. The goal of
15. The proponents of behavioural finance contend that, although standard finance theory is
16. The basic premise of technical analysis is that the information dissemination process is
slow-thus the adjustment of prices is not immediate but forms a pattern. This view is
17. The proponents of fundamental analysis advocate that at one point in time there is a basic
intrinsic value for the aggregate stock market, alternative industries, and individual
securities and if this intrinsic value is substantially different from the prevailing market
18. To be superior in an efficient market the analyst must be aware of the relevant variables
influencing stock prices, and be able to consistently project these accurately. If the
analyst does not have access to inside information and lacks superior analytical ability,
Solutions for Chapter 5: Questions and Problems
19. Superior analysts should concentrate their efforts in the second tier of stocks, because
20. The major efforts of the portfolio manager should be directed toward determining the risk
preferences of his clients and offering, accordingly, a portfolio approximating the risk
and return desires of the clientele. Given evidence of the stationarity of beta for a
21. Index funds are security portfolios specially designed to duplicate the performance of the
overall security market as represented by some selected market index series. The first
group of index funds was created in the early 1970s because people started realizing that
capital markets are efficient and it is extremely difficult to be a superior analyst. Thus,
Solutions for Chapter 5: Questions and Problems
22. The portfolio manager should continue to allow his two superior analysts to make
investment recommendations for some proportion of the portfolio, making sure that their
recommendations are implemented in a way that would conform to the mutual funds
states risk profile. They should also be encouraged to concentrate their efforts in the
Solutions for Chapter 5: Questions and Problems
– 46 –
CHAPTER 5
Answers to Problems
1. ARit = Rit – Rmt
ARBt = 11.5 – 4.0 = 7.5
2. ARit = Rit – (beta) (Rmt)
ARBt = 11.5 – .95(4.0) = 7.7
3. The reason for the difference in each case is due to the implications of beta. Beta
determines how the stock will move in relation to movements in the market.
Considering stock C, a 1% change in the market return will result in a 0.70% change in
4. Student Exercise