Course 3 Module 12: Efficient Market Theory

Modern portfolio theory has a risk-return relationship based on which of the following? Weighted beta Correlated coefficient Alpha Capital Market Line Security Market Line

Capital Market Line The CML specifies the relationship between the risk and return on a variably-weighted market portfolio consisting of all risky assets.

Weak Form testing

Early tests of weak form market efficiency failed to find any evidence that abnormal profits could be earned trading on information related to past prices. That is, knowing how security prices had moved in the past could not be translated into accurate predictions of future security prices. These tests generally concluded that technical analysis was ineffective. Technical analysis relies on forecasting security prices on the basis of past prices. More recent studies, however, have indicated that investors may overreact to certain types of information. This reaction results in driving security prices temporarily away from their investment values. Consequently, it may be possible to earn abnormal profits buying securities that have been "oversold" and selling securities whose prices have been bid up excessively. However, these observations are debatable and have not been universally accepted.

Testing for market efficiency is often conducted using ____ where it can be seen how quickly security prices actually reach the next equilibrium from the release of new information. A pattern search Event studies Performance of professional investors Inside information

Event studies Event studies reveal how fast security prices react to release of information. Pattern searches and performance tests are methods used for testing other aspects of market efficiency. Inside information is not used in testing for market efficiency.

Testing for market efficiency is often conducted using ____ where it can be seen how quickly security prices actually reach the next equilibrium from the release of new information. A pattern search Event studies Performance of professional investors Inside information

Event studies Event studies reveal how fast security prices react to release of information. Pattern searches and performance tests are methods used for testing other aspects of market efficiency. Inside information is not used in testing for market efficiency.

Event Studies

Event studies, thus, are really joint tests. They simultaneously involve tests of the asset pricing model's validity and tests of market efficiency. If the result of an event study shows that prices react slowly to information, it might be due to the markets' being inefficient or the use of an improper asset-pricing model. It could also be due to both of these reasons. As an example of an event study, consider what happens in a perfectly efficient market when information is released. When the information arrives in the marketplace, prices will react instantaneously and, in doing so, will immediately move to their new investment values. When bad news arrives, the price immediately drops to its new equilibrium level. It stays at this level until some additional piece of information arrives. However, situations like the slow reaction of a stock price to the information or over-reaction of a stock price to information cannot occur with regularity in efficient markets. Investors and analysts will tend to buy or sell immediately, thus forcing the prices to come back to the equilibrium. Many event studies have been made about the reaction of security prices, particularly stock prices, to the release of information, such as news pertaining to earnings and dividends, share repurchase programs, stock splits and dividends, stock and bond sales, stock listings, bond rating changes, mergers, acquisitions and divestitures. This area of academic research has become its own virtual growth industry.

In a perfectly efficient market, analysts can gain abnormal returns by using special data and analytical software. T or F

F Analysts may be able to show abnormal returns on their gross returns, but these gains will be offset by the increased cost incurred in using special data and analytical software. The resulting net returns will show that they have earned a fair return and nothing more.

A study of anomalies in the Tokyo Stock Exchange shows that apart from the size effect, none of the other anomalies found in the United States exist in Japan. False True

False In addition to the size effect, the January effect and the day-of-the-week effect also exist in Japan. This also includes the interrelationship between the January effect and size effect.

Identify Mis-Priced Securities Observation 1: In a world where it costs money to analyze securities, analysts will be able to identify mispriced securities.

However, their gain from doing so will be exactly offset by the increased costs that they incur. (For example, these costs may be associated with the money needed to procure data and buy analytical software.) Hence, their gross returns will indicate that they have made abnormal returns, but their net returns will show that they have earned a fair return and nothing more. Of course, they can earn less than a fair return in such an environment if they fail to properly use the data. For example, by rapidly buying and selling securities, they may generate large transaction costs that would more than offset the value of their superior security analysis.

Given the five portfolios (A - E) and the indifference curve shown below, which of the following statements are correct? I. Portfolio A is more efficient than Portfolio C. II. Portfolio E is in the feasible set. III. Portfolio B is the optimal portfolio. IV. Portfolio D is less efficient than Portfolio C.

III, IV A, B and C are on the efficient frontier, meaning all are efficient. A, B, C, and D are attainable and feasible, but D is inefficient. E is unattainable and not feasible. A and C are efficient but are not optimal. B is the optimal portfolio (the point of tangency).

Market Efficient Price

If the price of a security reflects everything that is knowable about the security, we call it a perfectly efficient price. A perfectly efficient price is always equal to the security's value, even though the value may change continuously to reflect the random arrival of new information. In other words, the price and value react in unison to the frequent appearance of news. Smart financial analysts who are active traders will not be able to enrich themselves in a perfectly efficient market because all the securities are priced correctly.

Random Walk

Information arrives randomly in an efficient market. Investors incorporate new information immediately and fully in security prices. Consequently, security price changes are random.

Random Walk:

Information arrives randomly in an efficient market. Investors incorporate new information immediately and fully in security prices. Consequently, security price changes are random.

Sources for Market Information:

Information for weak form is much more readily available than the strong form. In a strong form market efficiency, hard to come by insider information will be readily used.

Observation 6: Past performance is not an indicator of future performance.

Investors who have done well in the past are no more likely to do better in the future than are investors who have done poorly in the past. Those who did well in the past were merely lucky, and those who did poorly merely had a streak of misfortune. As past luck and misfortune do not have a tendency to repeat themselves, historical performance records are useless in predicting future performance records. (Of course, if the poor performance was due to incurring high operating expenses, then poor performers are likely to remain poor performers.)

Strong Form testing

Investors with access to private information might be expected to have an advantage over investors who trade only on publicly available information. In general, studies have shown that corporate insiders and stock exchange specialists have been able to earn abnormally high profits. Such investors have information not readily available to the investing public. Studies do not clearly show the ability of security analysts to produce such abnormal profits. At times, these analysts have direct access to private information. They also "manufacture" their own private information through their research efforts. Some studies have indicated that certain analysts are able to discern mispriced securities, but whether this ability is due to skill or chance is an open issue.

Which of the following statements is not true regarding the results of tests for market efficiency of U.S. securities markets? U.S. securities markets are highly efficient. Information about investment values is reflected quickly and accurately in security prices. No cases of abnormal returns have been identified. Abnormal profits cannot be expected by trading on public information.

No cases of abnormal returns have been identified. Tests for market efficiency of U.S. securities markets have shown that they are highly efficient. They quickly incorporate information to reflect changes in security prices. Therefore, investors cannot expect to earn abnormal profits by trading on publicly available information. Nevertheless, tests have also identified numerous pockets of unexplained abnormal returns that have caused many debates.

Which of the following characteristics would a risk tolerant client not have? Experienced Changes jobs No debt Small amounts of insurance

No debt

The P/E effect is an example of which form of efficient market hypothesis? Strong form Semi-strong form Random walk Weak form None of the these answers

None of the these answers The P/E effect is an anomaly. It would not be expected to happen if EMH were completely true.

Fair Return

Observation 1: Investors should expect to make a fair return on their investment, but no more. Looking for mispriced securities with either technical analysis or fundamental analysis will not prove to be fruitful. Investing money on the basis of either type of analysis will not generate abnormal returns (other than for those few investors who turn out to be lucky).

Passive Investing Advantage

Observation 2: Investors will do just as well using a passive investment strategy where they simply buy the securities in a particular index and hold onto that investment. Such a strategy will minimize transaction costs. It can be expected to do as well as any professionally managed portfolio that actively seeks out mispriced securities and incurs costs in doing so. Such a strategy can be expected to actually outperform any professionally managed portfolio that incurs unnecessary transaction costs (by, for example, trading too often). Note that the gross returns of professionally managed portfolios will exceed those of passively managed portfolios having similar investment objectives. At the same time, the two kinds of portfolios can be expected to have similar net returns. PRACTITIONER ADVICE: If markets were truly efficient, then it would be difficult to outperform indexes over the long term. Expenses and taxes would become important variables. Passive investment has the advantage of low expenses and tax efficiency.

No Abnormal Returns

Observation 3: Publicly known investment strategies cannot be expected to generate abnormal returns. Somebody may have a strategy that generated abnormal returns in the past. If the strategy is subsequently divulged to the public (for example, by publishing a book or article about it), then the usefulness of the strategy will be destroyed. The strategy, whatever it is based on, must provide some means to identify mispriced securities. The reason that it will not work after it is made public is that the investors who know the strategy will try to capitalize on it. In doing so, they will then force prices to equal investment values the moment the strategy indicates a security is mispriced. The action of investors following the strategy will eliminate its effectiveness at identifying mispriced securities.

No Professional Advantage

Observation 5: Professional investors should fare no better in picking securities than ordinary investors. Prices always reflect investment value, and hence the search for mispriced securities is futile. Consequently, professional investors do not have an edge over ordinary investors when it comes to identifying mispriced securities and generating abnormally high returns. If the market were not efficient, experienced managers would consistently perform better than their benchmark index. Since there are very few managers who beat the market, and fewer who can consistently beat the market, it would seem that the market is fairly efficient. However, sub-sectors of the market, such as international and small cap markets, are less efficient. In those markets, experienced managers can take advantage of hidden value. Those who outperform the market often create value in what they are investing. For example, when Warren Buffet purchased Jordan's Furniture in the Northeast, he was able to immediately improve profits for the company because of the furniture distribution companies he owned.

In a perfectly efficient market: Investors who have the resources should rely on investment advisors for pricing decisions. Investment analysts will be highly regarded and actively pursued for their advice. Professional investors should fare no better in stock selection than the uninformed investors. Professional investors have an edge in generating abnormally high returns.

Professional investors should fare no better in stock selection than the uninformed investors. In a perfectly efficient market, prices always reflect investment value, and hence, professional investors do not have an edge over ordinary investors when it comes to stock selection. Therefore, investors need not rely on investment advisors or analysts for pricing decisions.

Jack Jones is a professional investor. He wants to purchase stocks of Instapro and Deltapro. He also wishes to sell stocks of Techpro and Softpro. Instapro and Techpro are large firms while Deltapro and Softpro are small firms. According to the study of anomalies, he should: (Select all that apply) Purchase stocks of Deltapro in late December or earlier. Sell stocks of Deltapro in mid-January or later. Purchase stocks of Softpro in late December or earlier. Purchase stocks of Instapro in early February or later. Sell stocks of Instapro in late December or earlier.

Purchase stocks of Deltapro in late December or earlier. Purchase stocks of Instapro in early February or later. Market anomalies suggest that Jack Jones should: purchase stocks of small firms (Deltapro) in late December or earlier; sell stocks of small firms (Softpro) in mid-January or later; purchase stocks of large firms (Instapro) in early February or later; and sell stocks of large firms (Techpro) in late December or earlier.

Efficient Market Model

Reference to efficient markets usually denotes semi-strong form efficient markets. This is because of the strict laws in most countries about the use of insider information to formulate buying and selling decisions. Hence, it is interesting to investigate whether markets are semi-strong form efficient. In such markets analysts are restricted to using the set of publicly available information for preparing their recommendations.

Anomalies

Researchers have uncovered certain empirical regularities in common stocks. That is, certain cross-sectional differences among stock returns have been found to occur with regularity. The regularities are not predicted by any of the traditional asset pricing models. Accordingly, they are sometimes also referred to as anomalies. This lesson will examine some calendar anomalies and present some international evidence that indicates that such anomalies also exist in other countries. Anomalies prove that the market is not perfectly efficient. Observations of stock returns have revealed that certain empirical regularities do exist. These anomalies cannot be explained using an asset-pricing model. Knowing these anomalies could help improve returns, but there is no guarantee that the irregularities will hold true in the future.

What is the most fundamental, distinguishing characteristic of the Markowitz efficient frontier? Return Correlation Risk Covariance

Risk Return, covariance and correlation play a "supporting" role in determining the efficient frontier. But, risk is the most fundamental, distinguishing characteristic of the efficient frontier.

EMH suggests that financial planners should direct their activities to selecting securities based on which of the following? Security selection Technical analysis Fundamental analysis Risk-return profile

Risk-return profile EMH implies that because analysts as a group are so effective, the efforts of an individual in trying to find mispriced securities may be a waste of time.

semi-strong form efficiency

Semi-Strong Form: Public information includes both historical information and all current publicly known information. This information would include published financial data about companies, government data about the state of the economy, earnings estimates disseminated by companies and securities analysts, and so on. It is important to note, that since all public information is already factored into equity prices, under the semi-strong form fundamental analysis is worthless. The only way to differentiate semi-strong form from the weak form is with the fact that fundamental analysis works under the weak form only. Furthermore, as we will discuss next, under the strong form even inside information has already been factored into a securities price. Therefore, the only way to differentiate the semi-strong and strong forms, is with the use of inside information. (does not allow someone to out-perform the market under the strong form, but does under the semi-strong form).

Small Firm Effect

Small firms have higher returns than large firms, and their returns are higher in January than in any other month.

In a perfectly efficient market, which of the following investment choices is the most logical for someone looking to invest in the stock market? Stock Index Funds Contrarian Stock Funds Momentum Stock Funds Growth Stocks Value Stocks

Stock Index Funds In a perfectly efficient market, there is no opportunity to gain abnormal returns beyond the market. Therefore, a stock index fund would produce the most returns possible.

The day-of-the week effect states that: Small firms have lower returns on Monday. Stocks tend to open below their Friday closing prices on Monday. Stock returns in January are higher. Small firms have higher returns than larger firms.

Stocks tend to open below their Friday closing prices on Monday. The day-of-the-week effect shows that returns on Monday are lower and in the negative. The January effect and size effect indicate the other regularities. No regularity has been found stating that small firms have lower returns on Monday.

Neglected Firm Effect

Stocks that are not covered or followed by the Investment Analyst community are referred to as neglected stocks. These stocks tend to be smaller capitalization stocks so there is a correlation with this anomaly and the small firm effect. Basically, these stocks are "below the radar screen" and have been proven to be a method for investors to outperform the general stock market. An investor can out perform the market by investing in firms that are not followed by equity analysts.

Which form of Efficient Market Hypothesis reflects all information including insider information? Semi-strong form Strong form Weak form Strong and semi-strong forms All three forms

Strong form Strong form fully reflects all information, public or private.

Test Results

Tests of market efficiency are really joint tests about whether markets are efficient and whether security prices are set according to a specific asset-pricing model. Many tests have been conducted over the years examining the degree to which security markets are efficient. Some general conclusions can be drawn from the most prominent of these studies. Evidence suggests that U.S. financial markets are highly efficient. PRACTITIONER ADVICE: Market efficiency is very difficult to test. Calculating risk-adjusted returns requires assumptions made about discount rates. Interpretation of what is a piece of relevant information is subjective. There will be people who perform well based on luck. Finally, different people may interpret data and charts differently. It is sometimes called data snooping. Some analysts will see one formation in the charts while others see something different.

Random walk hypothesis suggests which of the following? That fundamental analysts can outperform the market. That security pricing reflects all known information. That technical analysts can outperform the market. That the next price change of a stock is unrelated to past price behavior.

That the next price change of a stock is unrelated to past price behavior. If prices move randomly, technical analysis is useless. Weak form is related to, but not identical with random walk. The definition of EMH is that security pricing reflects all known information.

Fama's Formula

The Fama's Formula of the efficient market model is a notation describing how investors generate price expectation for securities. The equation states that expected price for a security at the end of a period is based on the security's expected normal rate of return during that period, which is determined by the information set available at the start of the period. Abnormal profits could not be earned if all information was available.

Seasonality

The January Effect states that the average return in January is higher than the average return in any other month. The Day-of-the-week Effect (Weekend Effect) shows that the average return on Monday was lower than the average return on any other day of the week and negative while the other days were positive. The Holiday Effect indicates that average stock returns on trading days around the annual federal holidays are far higher than on other days. International evidence indicates that most of the anomalies existing in the United States also exist in other countries, such as Japan.

Value Line Phenomenon

The Value Line Investment Survey began in the early 1960s. Their basic service is equity research and is available by subscription. The service ranks the most widely traded 1,700 stocks into one of five categories. Stocks ranked 1 or 2 are forecasted to outperform the market over the next 6 to 12 months. Stocks ranked 3 are expected to return amounts that mirror the general market average, and stocks ranked 4 or 5 are expected to under perform the stock market returns over the next 6 to 12 months. Not allowing for taxes or transaction costs, an investor who committed to invest in stocks ranked 1 by Value Line, would have outperformed the Dow Industrial average by 20 fold, and the would have out performed the S&P 500 Index by 17 fold since the mid 1960s. For further detail of the Value Line performance record, please click on the following link: Valueline.com. Over the last 40 + years, the proprietary Value Line ranking method has dramatically out performed the major stock market indices.

About Transaction Costs

The efficient market model assumes that investors have free access to all information relevant to setting security prices. In reality, it is expensive to collect and process such information. Furthermore, investors cannot adjust their portfolios in response to new information without incurring transaction costs. How does the existence of these costs affect the efficient market model? Sanford Grossman and Joseph Stiglitz considered this issue and arrived at two important observations about perfectly efficient markets with transactions costs: 1. Analysts will be able to identify mispriced securities. 2. Investors will simply buy the securities in a particular index and hold onto that investment.

Which one of the following would best justify an investor hiring an active portfolio manager even though markets have been shown to be semi-strong form efficient? The existence of market "anomalies" has been discovered. Analysts have incorporated relevant information quickly and accurately. Technical trading rules have been proven to be ineffective. The results from studies on efficiency are debatable and not universally accepted.

The existence of market "anomalies" has been discovered. Various market "anomalies" have been discovered in tests of a semi-strong form market. Securities with certain characteristics or during certain time periods appear to produce abnormally high returns. The help of an active portfolio manager aware of such anomalies would help an investor. It is in highly efficient markets, such as the U.S., that analysts have incorporated information quickly and accurately. In weak form markets technical analysis based on past records has proved to be ineffective.

Which the following is true about a perfectly efficient market with transaction costs? (Select all that apply) Passive managers will out perform active managersYou shouldn't have checked this. The net return of passive and active managers will be similar Active managers' returns will be offset by cost to acquire information and make frequent trades

The net return of passive and active managers will be similar Active managers' returns will be offset by cost to acquire information and make frequent trades Active managers may be able to find better returns, but their costs for information and transactions will offset any additional gains. This will result in a similar net return for both passive and active managers.

Market Efficiency:

The notion that stock prices already reflect all available information is referred to as the efficient market hypothesis. It is commonly distinguished into three categories:

Need for Non-Believers Observation 2: Markets will be efficient only if enough investors believe that they are not efficient.

The reason for this paradox is straightforward: it is the actions of investors who carefully analyze securities that make prices reflect investment values. However, if everyone believed that markets are perfectly efficient, then everyone would realize that nothing is to be gained by searching for undervalued securities. Hence, nobody would bother to analyze securities. Consequently, security prices would not react instantaneously to the release of information but instead would respond more slowly. Thus, in a classic "Catch-22" situation, markets would become inefficient if investors believed that they are efficient, yet they are efficient because investors believe them to be inefficient. If the market did not have people who persistently try to gain benefits from charting or fundamental analysis, then it would be less efficient. One of the more well-known technical analysis theories is called the Dow Theory. The theory is based on a series of observations made by Charles H. Dow on prices of stocks followed by certain series of index movements.

Semi-Strong Form testing

The results of tests of semi-strong form market efficiency have been mixed. Most event studies have failed to demonstrate sufficiently large inefficiencies to overcome transaction costs. However, various market "anomalies" have been discovered. Securities with certain characteristics or during certain time periods appear to produce abnormally high returns. For example, as previously discussed, common stocks in January have been shown to offer returns much higher than those earned in the other 11 months of the year.

Patterns

The second method to test for market efficiency is to look for patterns in security price movements, attributable to something unexpected. Securities can be expected to provide a rate of return over a given time period in accord with an asset-pricing model. Such a model asserts that a security's expected rate of return is equal to a risk-free rate of return plus a "risk premium" with a magnitude based on the riskiness of the security. If the risk-free rate and risk premium are both unchanging over time, then securities with high average returns in the past can be expected to have high returns in the future. However, the risk premium may change over time, making it difficult to see if there are patterns in security prices. Any testing done for the existence of price patterns will once again be joint tests of both market efficiency and the asset pricing model that is used to estimate the risk premiums on securities. In recent years, a large number of these patterns have been identified and labeled as empirical regularities or market anomalies. For example, one of the most prominent market anomalies is the January effect. Security returns appear to be abnormally high in the month of January. Other months show no similar anomalies. This pattern has a long and consistent track record and no convincing explanations have been proposed.

In perfectly efficient markets, the investors who profited in the past: Have a higher probability of profiting in the future Were most often lucky Learned valuable trading rules for the future Used professional advice

Though some investment advisors or analysts may display impressive performance records, it is merely due to luck or chance. Their past performance cannot be relied upon as a basis for predicting their future performance.

T or F: When a series of prices represents a situation in which changes in the value of the prices are independent and identically distributed, we refer to the series as a random walk.

True The random walk model is a situation in which changes in the value of a random variable are independent and identically distributed. When applied to common stocks, it refers to a situation in which security price changes are independent and identically distributed. This means that the size of a security's price change, from one period to the next, can be viewed as being determined by the spin of a roulette wheel.

A portfolio that is positioned outside (above) the efficient frontier is: Inefficient Unattainable Attainable Optimal

Unattainable

Which of the following statements does not apply to an efficient market? (Select all that apply) Investors generate price expectations for securities. Under or overvaluation of securities can be expected. Abnormal profits can be made by using a set of information to formulate buying and selling decisions. Investors must make full and accurate use of the available information set.

Under or overvaluation of securities can be expected. Abnormal profits can be made by using a set of information to formulate buying and selling decisions. Investors must make full and accurate use of the available information set. In an efficient market it is impossible to make abnormal profits by using a particular set of information to formulate buying and selling decisions. That is, investors should expect to make only normal profits by earning a normal rate of return on their investments. An efficient market is defined as one in which every security's price equals its investment value at all times. In an efficient market, a set of information is fully and immediately reflected in market prices.

weak form efficiency

Weak Form: Historical information on a company would be available from libraries, bookstores, computer databases and the Internet. This information represents past data. Technical analysts rely on past performance data that would lead to security selection. It is in fact the ability to perform fundamental analysis with the expectation of out-performing the market, that is the key difference between the weak form and the other forms (semi and strong). Only under the weak form, can one analyze all available public information (annual reports, develop and study financial ratios, review all press releases for the company and industry, etc.) and expect to out perform the market. Since under the weak form, fundamental analysis is worthwhile, it is the one form that is most readily acceptable to the financial analyst community.

Tony Jackson is an investor who follows a buy-hold strategy. He also relies on in-depth research to reposition his portfolio from time to time. His research focuses on financial statement analysis. Which approach is he using? Semi-strong form of EMH Strong form of EMH P/E effect Weak form of EMH

Weak form of EMH He follows fundamental analysis (which supports the weak form). It does not say he is factoring the P/E ratio to reposition his portfolio, and the tone of the question is passive.

Forms of Market Efficiency

Weak: Can't use technical analysis Semi-strong: Can't use technical or fundamental analysis Strong: Can't use anything, including insider information

The Efficient Market Hypothesis is an important aspect of the CFP Certification Exam. The most important points to remember are:

differentiating among the three forms of the EMH, and knowing the proven anomalies to the EMH.

In an efficient market a security's market price will

fully reflect all available information relevant to the security's value at that time.

Observations

in perfectly efficient markets indicate that abnormal returns cannot be expected regardless of the methods of analysis, strategies, or past performance of investors.

Low P/E Effect

indicates that over the business cycle, value investing has produced greater returns than growth investing. This contradicts the usefulness of active management in a perfectly efficient market.

Anomalies

or empirical regularities are commonly related to seasonal effects, small firm or size effects, neglected firm effect, low P/E effect, and the Value Line phenomenon.

Efficient Market Model

states that the value of a security is a reflection of the information available about it. There are three forms: Weak Form, in which a security's price reflects historical data; Semi-strong Form, in which a security's price reflects historical and current public information; and Strong Form, in which a security's price reflects all information (past, present, public and insider).

Tests of Market Efficiency

use three main methods: event studies on how quickly security prices react to release of information; pattern searches to seek repeating abnormal returns; and performance of professional investors in seeking a consistent high performer.

Observations about Perfectly Efficient Markets

-Fair return on investment, -The need for non-believers, -Investment strategies and abnormal returns, -Impressive records of investors, -Comparison between professional and ordinary investors, and -Relationship of past performance to future.

The following observations have been made in a perfectly efficient market:

-Only a fair return on investments can be expected. -Investors must believe that markets are not efficient. -Publicly known strategies do not generate abnormal returns. -Impressive performance is due to chance. -Professional investors do not have any added advantage. -Past performance is not an indicator of future performance.

Market Efficient Price:

A perfectly efficient price would react immediately to new information and adjust to the new price. Less efficient prices will react differently; some will overreact, while others may lag.

What is the level of market efficiency, in which only previous security prices and volume data are reflected in current security prices, called? A strong form efficient market A semi-strong form efficient market A weak form efficient market A perfectly efficient market

A weak form efficient marketYou correctly checked this. A weak form efficient market exists when the market prices reflect only previous or historical information. In a semi-strong efficient market, the market prices reflect all public information. A strong form or perfectly efficient market exists when the market prices reflect everything that is knowable. This includes both historical and public information in addition to other information.

Strong Form (Perfectly Efficient Market):

All information, including historical, public, and private information is reflected in price. Knowable information would include all relevant valuation data. For example, this includes information known only to corporate insiders, such as imminent corporate takeover plans and extraordinary positive or negative future earnings announcements. Such inside information can be used in two ways: 1. A corporation's board of directors can direct the corporation to buy back some of it's own shares. This is a way of creating new treasury stock. Thus, the inside information about what the directors think the stock is worth has an impact on the market prices. It is legal to use inside information in this manner. 2. On the other hand, one of the corporation's directors, or an outsider, may engage in private trading, based on such inside information. In some countries, including the U.S., it is illegal to utilize inside information in this manner.

What types of information do perfectly efficient prices reflect? (Select all that apply) Historical information Public information Inside information of the company Additional information that is more difficult to obtain

All of the above A strong form or perfectly efficient market exists when the market prices reflect everything that is knowable. This includes both historical and public information in addition to other information. Knowable information also includes inside information of the company. However, this must be used only in a legally approved manner.

Two more important observations have been made in a perfectly efficient market with transaction costs:

Analysts will be able to identify mispriced securities. Investors using a passive investment strategy do just as well.