23 Problems on Efficient Market Hypothesis - Homework | FIR 3710, Assignments of Investment Theory

Download 23 Problems on Efficient Market Hypothesis - Homework | FIR 3710 and more Assignments Investment Theory in PDF only on Docsity! CHAPTER 8: THE EFFICIENT MARKET HYPOTHESIS 1. The assumptions consistent with efficient markets are (a) and (c). Many independent, profit-maximizing participants [statement (a)] leads to efficient markets. Statement (c) is the result of efficient markets. 2. 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. 3. c. This is a predictable pattern in returns, which should not occur if the stock market is weakly efficient. 4. c. This is a classic filter rule, which would appear to contradict the weak form of the efficient market hypothesis. 5. b. This is the definition of an efficient market. 6. d. 7. c. The P/E ratio is public information so this observation would provide evidence against the semistrong form of the efficient market theory. 8. No, this is not a violation of the EMH. Intel’s continuing large profits do not imply that stock market investors who purchased Intel shares after its success already was evident would have earned a high return on their investments. 9. 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 stock splits occur as a response to good performance (i.e., positive abnormal returns) which drives up the stock price above a desired "trading range" and then leads managers to split the stock. After the fact, the stocks that happen to have performed the best will be split candidates, but this does not imply that you can identify the best performers early enough to earn abnormal returns. 8-1 10. 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. 11. Expected rates of return differ because of differential risk premiums. 12. 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 should affect stock prices. 13. 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. 14. 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. 15. 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. 16. a. The grandson is recommending taking advantage of (i) the small firm in January anomaly and (ii) the weekend 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 8-2 that the abnormal returns on these strategies would not appear so high if we could more accurately risk-adjust performance. 8-5 23. 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. 8-6