Chapter 11 - The Efficient Market Hypothesis

CHAPTER11:THEEFFICIENTMARKETHYPOTHESIS
PROBLEMSETS
1.

Thecorrelationcoefficientbetweenstockreturnsfortwononoverlappingperiods
shouldbezero.Ifnot,onecouldusereturnsfromoneperiodtopredictreturnsinlater
periodsandmakeabnormalprofits.

2.

No.Microsoftscontinuingprofitabilitydoesnotimplythatstockmarketinvestorswho
purchasedMicrosoftsharesafteritssuccesswasalreadyevidentwouldhaveearnedan
exceptionallyhighreturnontheirinvestments.

3.

Expectedratesofreturndifferbecauseofdifferentialriskpremiums.

4.

No.Thevalueofdividendpredictabilitywouldbealreadyreflectedinthestock
price.

5.

Overthelonghaul,thereisanexpectedupwarddriftinstockpricesbasedontheirfair
expectedratesofreturn.Thefairexpectedreturnoveranysingledayisverysmall(e.g.,
12%peryearisonlyabout0.03%perday),sothatonanydaythepriceisvirtually
equallylikelytoriseorfall.However,overlongerperiods,thesmallexpecteddaily
returnsaccumulate,andupwardmovesareindeedmorelikelythandownwardones.

6.

c.

Thisisapredictablepatterninreturnswhichshouldnotoccuriftheweakform
EMHisvalid.

7.

c.

Thisisaclassicfilterrulewhichshouldnotproducesuperiorreturnsinanefficient
market.

8.

b.

Thisisthedefinitionofanefficientmarket.

9.

c.

TheP/Eratioispublicinformationandshouldnotbepredictiveofabnormal
securityreturns.
11-1

Chapter 11 - The Efficient Market Hypothesis

10.

d.

11.

Thequestionregardingmarketefficiencyiswhetherinvestorscanearnabnormalrisk
adjustedprofits.Ifthestockpricerunupoccurswhenonlyinsidersareawareofthe
comingdividendincrease,thenitisaviolationofstrongform,butnotsemistrongform,
efficiency.Ifthepublicalreadyknowsoftheincrease,thenitisaviolationof
semistrongformefficiency.

12.

Whilepositivebetastocksrespondwelltofavorablenewinformationaboutthe
economysprogressthroughthebusinesscycle,theyshouldnotshowabnormalreturns
aroundalreadyanticipatedevents.Ifarecovery,forexample,isalreadyanticipated,the
actualrecoveryisnotnews.Thestockpriceshouldalreadyreflectthecomingrecovery.

13.

a.

Consistent.Basedonpureluck,halfofallmanagersshouldbeatthemarketin
anyyear.

b.

Inconsistent.Thiswouldbethebasisofaneasymoneyrule:simplyinvestwith
lastyear'sbestmanagers.

c.

Consistent.Incontrasttopredictablereturns,predictablevolatilitydoesnotconvey
ameanstoearnabnormalreturns.

d.

Inconsistent.TheabnormalperformanceoughttooccurinJanuarywhenearnings
areannounced.

e.

Inconsistent.Reversalsofferameanstoearneasymoney:justbuylastweeks
losers.

14.

Inasemistrongformefficientmarket,itisnotpossibletoearnabnormallyhigh
profitsbytradingonpubliclyavailableinformation.InformationaboutP/Eratios
andrecentpricechangesispubliclyknown.Ontheotherhand,aninvestorwho
hasadvanceknowledgeofmanagementimprovementscouldearnabnormallyhigh
tradingprofits(unlessthemarketisalsostrongformefficient).

Thereturnonthemarketis8%.Therefore,theforecastmonthlyreturnforGMis:
0.10%+(1.18%)=8.9%
GMsactualreturnwas7%,sotheabnormalreturnwas1.9%.

11-2

Chapter 11 - The Efficient Market Hypothesis

15.

16.

a.

Basedonbroadmarkettrends,theCAPMindicatesthatAmbChaserstockshould
haveincreasedby:1.0%+2.0(1.5%1.0%)=2.0%
Itsfirmspecific(nonsystematic)returnduetothelawsuitis$1millionper$100
millioninitialequity,or1%.Therefore,thetotalreturnshouldbe3%.(Itis
assumedherethattheoutcomeofthelawsuithadazeroexpectedvalue.)

b.

Ifthesettlementwasexpectedtobe$2million,thentheactualsettlementwasa
$1milliondisappointment,andsothefirmspecificreturnwouldbe1%,fora
totalreturnof2%1%=1%.

Givenmarketperformance,predictedreturnsonthetwostockswouldbe:
Apex:

0.2%+(1.43%)=4.4%

Bpex:

0.1%+(0.63%)=1.7%

Apexunderperformedthisprediction;Bpexoutperformedtheprediction.Weconclude
thatBpexwonthelawsuit.
17.

a.

E(rM)=12%,rf=4%and=0.5
Therefore,theexpectedrateofreturnis:
4%+0.5(12%4%)=8%
Ifthestockisfairlypriced,thenE(r)=8%.

18.

b.

IfrMfallsshortofyourexpectationby2%(thatis,10%12%)thenyouwould
expectthereturnforChangingFortunesIndustriestofallshortofyouroriginal
expectationby:2%=1%
Therefore,youwouldforecastarevisedexpectationforChangingFortunesof:8%
1%=7%

c.

Givenamarketreturnof10%,youwouldforecastareturnforChangingFortunes
of7%.Theactualreturnis10%.Therefore,thesurpriseduetofirmspecific
factorsis10%7%=3%whichweattributetothesettlement.Becausethefirmis
initiallyworth$100million,thesurpriseamountofthesettlementis3%of$100
million,or$3million,implyingthatthepriorexpectationforthesettlementwas
only$2million.

Implicitinthedollarcostaveragingstrategyisthenotionthatstockpricesfluctuate
aroundanormallevel.Otherwise,thereisnomeaningtostatementssuchas:when
thepriceishigh.Howdoweknow,forexample,whetherapriceof$25todaywill
turnouttobeviewedashighorlowcomparedtothestockpricesixmonthsfrom
now?
11-3

Chapter 11 - The Efficient Market Hypothesis

19.

Themarketrespondspositivelytonewnews.Iftheeventualrecoveryisanticipated,
thentherecoveryisalreadyreflectedinstockprices.Onlyabetterthanexpected
recoveryshouldaffectstockprices.

20.

Buy.Inyourview,thefirmisnotasbadaseveryoneelsebelievesittobe.Therefore,
youviewthefirmasundervaluedbythemarket.Youarelesspessimisticaboutthe
firmsprospectsthanthebeliefsbuiltintothestockprice.

21.

HereweneedatwofactormodelrelatingFordsreturntothoseofboththebroad
marketandtheautoindustry.IfwecallrItheindustryreturn,thenwewouldfirst
estimateparametersa,b,cinthefollowingregression:
rFORD=a+brM+crI+e
GiventheseestimateswewouldcalculateFordsfirmspecificreturnas:
rFORD[a+brM+crI+e]
Thisestimateoffirmspecificnewswouldmeasurethemarketsassessmentofthe
potentialprofitabilityofFordsnewmodel.

22.

Themarketmayhaveanticipatedevengreaterearnings.Comparedtoprior
expectations,theannouncementwasadisappointment.

23.

Thenegativeabnormalreturns(downwarddriftinCAR)justpriortostockpurchases
suggestthatinsidersdeferredtheirpurchasesuntilafterbadnewswasreleasedtothe
public.Thisisevidenceofvaluableinsideinformation.Thepositiveabnormalreturns
afterpurchasesuggestinsiderpurchasesinanticipationofgoodnews.Theanalysisis
symmetricforinsidersales.

CFAPROBLEMS
1.

b.

Semistrongformefficiencyimpliesthatmarketpricesreflectallpublicly
availableinformationconcerningpasttradinghistoryaswellasfundamental
aspectsofthefirm.

2.

a.

Thefullpriceadjustmentshouldoccurjustasthenewsaboutthedividend
becomespubliclyavailable.

3.

d.

IflowP/Estockstendtohavepositiveabnormalreturns,thiswouldrepresentan
unexploitedprofitopportunitythatwouldprovideevidencethatinvestorsarenot
usingallavailableinformationtomakeprofitableinvestments.
11-4

Chapter 11 - The Efficient Market Hypothesis

4.

c.

Inanefficientmarket,nosecuritiesareconsistentlyoverpricedorunderpriced.
Whilesomesecuritieswillturnoutafteranyinvestmentperiodtohaveprovided
positivealphas(i.e.,riskadjustedabnormalreturns)andsomenegativealphas,
thesepastreturnsarenotpredictiveoffuturereturns.

5.

c.

Arandomwalkimpliesthatstockpricechangesareunpredictable,usingpastprice
changesoranyotherdata.

6.

d.

Agradualadjustmenttofundamentalvalueswouldallowfortheuseofstrategies
basedonpastpricemovementsinordertogenerateabnormalprofits.

7.

a.

8.

a.

SomeempiricalevidencethatsupportstheEMH:
(i) professionalmoneymanagersdonottypicallyearnhigherreturnsthancomparable
risk,passiveindexstrategies;
(ii) eventstudiestypicallyshowthatstocksrespondimmediatelytothepublic
releaseofrelevantnews;
(iii) mosttestsoftechnicalanalysisfindthatitisdifficulttoidentifypricetrends
thatcanbeexploitedtoearnsuperiorriskadjustedinvestmentreturns.

b.

SomeevidencethatisdifficulttoreconcilewiththeEMHconcernssimpleportfolio
strategiesthatapparentlywouldhaveprovidedhighriskadjustedreturnsinthepast.
Someexamplesofportfolioswithattractivehistoricalreturns:
(i) lowP/Estocks;
(ii) highbooktomarketratiostocks;
(iii) smallfirmsinJanuary;
(iv) firmswithverypoorstockpriceperformanceinthelastfewmonths.
Otherevidenceconcernspostearningsannouncementstockpricedriftand
intermediatetermpricemomentum.

c.

Aninvestormightchoosenottoindexevenifmarketsareefficientbecauseheor
shemaywanttotailoraportfoliotospecifictaxconsiderationsortospecificrisk
managementissues,forexample,theneedtohedge(oratleastnotaddto)exposure
toaparticularsourceofrisk(e.g.,industryexposure).

11-5

Chapter 11 - The Efficient Market Hypothesis

9.

a.

Theefficientmarkethypothesis(EMH)statesthatamarketisefficientifsecurity
pricesimmediatelyandfullyreflectallavailablerelevantinformation.Ifthe
marketfullyreflectsinformation,theknowledgeofthatinformationwouldnot
allowaninvestortoprofitfromtheinformationbecausestockpricesalready
incorporatetheinformation.
i.TheweakformoftheEMHassertsthatstockpricesreflectalltheinformationthat
canbederivedbyexaminingmarkettradingdatasuchasthehistoryofpastpricesand
tradingvolume.
AstrongbodyofevidencesupportsweakformefficiencyinthemajorU.S.securities
markets.Forexample,testresultssuggestthattechnicaltradingrulesdonotproduce
superiorreturnsafteradjustingfortransactioncostsandtaxes.
ii.Thesemistrongformstatesthatafirmsstockpricereflectsallpubliclyavailable
informationaboutafirmsprospects.Examplesofpubliclyavailableinformationare
companyannualreportsandinvestmentadvisorydata.
Evidencestronglysupportsthenotionofsemistrongefficiency,butoccasional
studies(e.g.,thoseidentifyingmarketanomaliessuchasthesmallfirminJanuary
orbooktomarketeffects)andevents(suchasthestockmarketcrashofOctober19,
1987)areinconsistentwiththisformofmarketefficiency.However,thereisa
questionconcerningtheextenttowhichtheseanomaliesresultfromdatamining.
iii.ThestrongformoftheEMHholdsthatcurrentmarketpricesreflectall
information(whetherpubliclyavailableorprivatelyheld)thatcanberelevanttothe
valuationofthefirm.
Empiricalevidencesuggeststhatstrongformefficiencydoesnothold.Ifthisform
werecorrect,priceswouldfullyreflectallinformation.Thereforeeveninsiders
couldnotearnexcessreturns.Buttheevidenceisthatcorporateofficersdohave
accesstopertinentinformationlongenoughbeforepublicreleasetoenablethemto
profitfromtradingonthisinformation.

b.

i.Technicalanalysisinvolvesthesearchforrecurrentandpredictablepatternsinstock
pricesinordertoenhancereturns.TheEMHimpliesthattechnicalanalysisiswithout
value.Ifpastpricescontainnousefulinformationforpredictingfutureprices,thereis
nopointinfollowinganytechnicaltradingrule.
ii.Fundamentalanalysisusesearningsanddividendprospectsofthefirm,expectations
offutureinterestrates,andriskevaluationofthefirmtodetermineproperstockprices.
TheEMHpredictsthatmostfundamentalanalysisisdoomedtofailure.Accordingto
semistrongformefficiency,noinvestorcanearnexcessreturnsfromtradingrules
basedonpubliclyavailableinformation.Onlyanalystswithuniqueinsightachieve
superiorreturns.

11-6

Chapter 11 - The Efficient Market Hypothesis

Insummary,theEMHholdsthatthemarketappearstoadjustsoquicklytoinformation
aboutbothindividualstocksandtheeconomyasawholethatnotechniqueofselecting
aportfoliousingeithertechnicalorfundamentalanalysiscanconsistentlyoutperforma
strategyofsimplybuyingandholdingadiversifiedportfolioofsecurities,suchasthose
comprisingthepopularmarketindexes.

10.

c.

Portfoliomanagershaveseveralrolesandresponsibilitieseveninperfectlyefficient
markets.Themostimportantresponsibilityistoidentifytherisk/returnobjectivesfora
portfoliogiventheinvestorsconstraints.Inanefficientmarket,portfoliomanagersare
responsiblefortailoringtheportfoliotomeettheinvestorsneeds,ratherthantobeat
themarket,whichrequiresidentifyingtheclientsreturnrequirementsandrisk
tolerance.Rationalportfoliomanagementalsorequiresexaminingtheinvestors
constraints,includingliquidity,timehorizon,lawsandregulations,taxes,andunique
preferencesandcircumstancessuchasageandemployment.

a.

Theearnings(anddividend)growthrateofgrowthstocksmaybeconsistently
overestimatedbyinvestors.Investorsmayextrapolaterecentgrowthtoofarintothe
futureandtherebydownplaytheinevitableslowdown.Atanygiventime,growth
stocksarelikelytorevertto(lower)meanreturnsandvaluestocksarelikelytorevert
to(higher)meanreturns,oftenoveranextendedfuturetimehorizon.

b.

Inefficientmarkets,thecurrentpricesofstocksalreadyreflectallknownrelevant
information.Inthissituation,growthstocksandvaluestocksprovidethesamerisk
adjustedexpectedreturn.

11-7