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
returns from one period to predict returns in later periods and therefore earn abnormal
profits.

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, however, actual results can
and do vary. Unknown events cause certain securities to outperform others. This is not
known in advance so expectations are set by known information.

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., 12% per year is only about 0.03% per day), so that on any day the price is
virtually equally likely to rise or fall. However, over longer periods, the small expected
daily returns cumulate, and upward moves are indeed more likely than downward ones.

4. No, this is not a violation of the EMH. Microsoft’s continuing large profits do not
imply that stock market investors who purchased Microsoft shares after its success
already was evident would have earned a high return on their investments.

5. No. Random walk theory naturally expects there to be some people who beat the
market and some people who do not. The information provided, however, fails to
consider the risk of the investment. Higher risk investments should have higher returns.
As presented, it is possible to believe him without violating the EMH.

6. b. This is the definition of an efficient market.

7. d. It is not possible to offer a higher risk risk-return trade off if markets are efficient.

8. Strong firm efficiency includes all information; historical, public and private.

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
constantly. A fluctuating market accurately reflects this logic. Furthermore, while
increased variability may be the result of an increase in unknown variables, this merely
increases risk and the price is adjusted downward as a result.

10. c
This is a predictable pattern in returns, which should not occur if the stock
market is weakly efficient.

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11. c
This is a classic filter rule, which would appear to contradict the weak form of
the efficient market hypothesis.

12. c
The P/E ratio is public information so this observation would provide evidence
against the semi-strong form of the efficient market theory.

13. No, it is not more attractive as a possible purchase. Any value associated with dividend
predictability is already reflected in the stock price.

14. 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
does not suggest that investors are failing to use all available information. An investor
could not use this phenomenon to choose undervalued stocks today. The phenomenon
instead reflects the fact that dividends occur as a response to good performance. After
the fact, the stocks that happen to have performed the best will pay higher dividends,
but this does not imply that you can identify the best performers early enough to earn
abnormal returns.

15. While positive beta stocks respond well to favorable new information about the
economy’s progress through the business cycle, these should not show abnormal
returns around already anticipated events. If a recovery, for example, is already
anticipated, the actual recovery is not news. The stock price should already reflect the
coming recovery.

16.
b. Consistent. Half of all managers should outperform the market based on pure
luck in any year.

c. Violation. This would be the basis for an "easy money" rule: simply invest with
last year's best managers.

d. Consistent. Predictable volatility does not convey a means to earn abnormal

returns.

e. Violation. The abnormal performance ought to occur in January, when the

increased earnings are announced.

f. Violation. Reversals offer a means to earn easy money: simply buy last week's
losers.

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17. An anomaly is considered an EMH exception because there is historical data to

substantiated a claim that said anomalies have produced excess risk adjusted abnormal
returns in the past. Several anomalies regarding fundamental analysis have been
uncovered. These include the P/E effect, the small-firm-in-January effect, the
neglected- firm effect, post–earnings-announcement price drift, and the book-to-market
effect. Whether these anomalies represent market inefficiency or poorly understood risk
premiums is still a matter of debate. There are rational explanations for each, but not
everyone agrees on the explanation. One dominant explanation is that many of these
firms are also neglected firms, due to low trading volume, thus they are not part of an
efficient market or offer more risk as a result of their reduced liquidity.

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 be
viewed as high or low compared to the stock price in six months from now?

19. The market responds positively to new news. If the eventual recovery is anticipated,
then the recovery is already reflected in stock prices. Only a better-than-expected
recovery (or a worse-than-expected recovery) should affect stock prices.

20. You should buy the stock. In your view, the firm’s management is not as bad as
everyone else believes it to be. Therefore, you view the firm as undervalued by the
market. You are less pessimistic about the firm’s prospects than the beliefs built into
the stock price.

21. The market may have anticipated even greater earnings. Compared to prior
expectations, the announcement was a disappointment.

22. 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
public. This is evidence of valuable inside information. The positive abnormal returns
after purchase suggest insider purchases in anticipation of good news. The analysis is
symmetric for insider sales.

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
public. This is evidence of valuable inside information. The positive abnormal returns
after purchase suggest insider purchases in anticipation of good news. The analysis is
symmetric for insider sales.

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24. 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 is consistent with
EMH since the shift occurs after a recession or recovery occurs. As the news hits the
market, the risk premiums are adjusted. 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. Simultaneously, the recession causes risk premiums to rise, thus
increasing the denominator in the fundamental analysis calculation. An increase in the
denominator further reduces the price. The result is the appearance of an overreaction.

CFA 1
b
Public information constitutes semi-string efficiency, while the addition of
private information leads to strong form efficiency.

CFA 2
a
The information should be absorbed instantly.

CFA 3
b
Since information is immediately included in stock prices, there is no benefit to
buying stock after an announcement.

CFA 4
c
Stocks producing abnormal excess returns will increase in price to eliminate the
positive alpha.

CFA 5
c
A random walk reflects no other information and is thus random.

CFA 6
d
Unexpected results are by definition an anomaly.

CFA 7
Assumptions supporting passive management are:
a. informational efficiency
b. primacy of diversification motives
Active management is supported by the opposite assumptions, in particular, that
pockets of market inefficiency exist.

CFA 8

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a. The grandson is recommending taking advantage of (i) the small firm anomaly and
(ii) the January anomaly. In fact, this seems to be one anomaly: the small-firm-in-
January anomaly.

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
potential for diversification.
(ii) Even if the study results are correct as described, each such study covers a
specific time period. There is no assurance that future time periods would
yield similar results.
(iii) After the results of the studies became publicly known, investment
decisions might nullify these relationships. If these firms in fact offered
investment bargains, their prices may be bid up to reflect the now-known
opportunity.

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.
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.
A strong body of evidence supports weak-form efficiency in the major U.S.
securities markets. For example, test results suggest that technical trading rules do
not produce superior returns after adjusting for transaction costs and taxes.
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.
Evidence strongly supports the notion of semistrong efficiency, but occasional
studies (e.g., those identifying market anomalies such as the small-firm-in-January
or book-to-market effects) and events (such as the stock market crash of October 19,
1987) are inconsistent with this form of market efficiency. However, there is a
question concerning the extent to which these “anomalies” result from data mining.
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.

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Empirical evidence suggests that strong-form efficiency does not hold. If this form
were correct, prices would fully reflect all information. Therefore even insiders
could not earn excess returns. But the evidence is that corporate officers do have
access to pertinent information long enough before public release to enable them to
profit from trading on this information.

b. 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.
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 to failure.
According to semistrong-form efficiency, no investor can earn excess returns from
trading rules based on publicly available information. Only analysts with unique
insight achieve superior returns.
In summary, the EMH holds that the market appears to adjust so quickly to
information about both individual stocks and the economy as a whole that no
technique of selecting a portfolio using either technical or fundamental analysis can
consistently outperform a strategy of simply buying and holding a diversified
portfolio of securities, such as those comprising the popular market indexes.

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 the market, which requires identifying the client’s return
requirements and risk tolerance. Rational portfolio management also requires
examining the investor’s constraints, including liquidity, time horizon, laws and
regulations, taxes, and unique preferences and circumstances such as age and
employment.

CFA 10
a. The earnings (and dividend) growth rates of growth stocks may be consistently
overestimated by investors. Investors may extrapolate recent earnings (and
dividend) growth too far into the future and thereby downplay the inevitable
slowdown. At any given time, growth stocks are likely to revert to (lower)
mean returns and value stocks are likely to revert to (higher) mean returns, often
over an extended future time horizon.

b. In efficient markets, the current prices of stocks already reflect all known,
relevant information. In this situation, growth stocks and value stocks provide
the same risk-adjusted expected return.

CFA 11
a. Some empirical evidence that supports the EMH is:

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(i) professional money managers do not typically earn higher returns than
comparable risk, passive index strategies;
(ii) event studies typically show that stocks respond immediately to the public
release of relevant news;
(iii) most tests of technical analysis find that it is difficult to identify price trends
that can be exploited to earn superior risk-adjusted investment returns.

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;
(iii) small firms in January;
(iv)firms with very poor stock price performance in the last few months.
Other evidence concerns post-earnings-announcement stock price drift and
intermediate-term price momentum.

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).

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