CFA 47: Market Efficiency

With respect to efficient market theory, when a market allows short selling, the efficiency of the market is most likely to: increase. decrease. remain the same.

A is correct. According to theory, reducing the restrictions on trading will allow for more arbitrage trading, thereby promoting more efficient pricing. Although regulators argue that short selling exaggerates downward price movements, empirical research indicates that short selling is helpful in price discovery.

If a researcher conducting empirical tests of a trading strategy using time series of returns finds statistically significant abnormal returns, then the researcher has most likely found: a market anomaly. evidence of market inefficiency. a strategy to produce future abnormal returns.

A is correct. Finding significant abnormal returns does not necessarily indicate that markets are inefficient or that abnormal returns can be realized by applying the strategy to future time periods. Abnormal returns are considered market anomalies because they may be the result of the model used to estimate the expected returns or may be the result of underestimating transaction costs or other expenses associated with implementing the strategy, rather than because of market inefficiency.

Researchers have found that value stocks have consistently outperformed growth stocks. An investor wishing to exploit the value effect should purchase the stock of companies with above-average: dividend yields. market-to-book ratios. price-to-earnings ratios.

A is correct. Higher than average dividend yield is a characteristic of a value stock, along with low price-to-earnings and low market-to-book ratios. Growth stocks are characterized by low dividend yields and high price-to-earnings and high market-to-book ratios.

An increase in the time between when an order to trade a security is placed and when the order is executed most likely indicates that market efficiency has: decreased. remained the same. increased.

A is correct. Operating inefficiencies reduce market efficiency.

Regulation that restricts some investors from participating in a market will most likely: impede market efficiency. not affect market efficiency. contribute to market efficiency.

A is correct. Reducing the number of market participants can accentuate market imperfections and impede market efficiency (e.g., restrictions on foreign investor trading).

Which of the following market regulations will most likely impede market efficiency? Restricting traders' ability to short sell. Allowing unrestricted foreign investor trading. Penalizing investors who trade with nonpublic information.

A is correct. Restricting short selling will reduce arbitrage trading, which promotes market efficiency. Permitting foreign investor trading increases market participation, which makes markets more efficient. Penalizing insider trading encourages greater market participation, which increases market efficiency.

With respect to rational and irrational investment decisions, the efficient market hypothesis requires: only that the market is rational. that all investors make rational decisions. that some investors make irrational decisions.

A is correct. The efficient market hypothesis and asset-pricing models only require that the market is rational. Behavioral finance is used to explain some of the market anomalies as irrational decisions.

With respect to the efficient market hypothesis, if security prices reflect only past prices and trading volume information, then the market is: weak-form efficient. strong-form efficient. semi-strong-form efficient.

A is correct. The weak-form efficient market hypothesis is defined as a market where security prices fully reflect all market data, which refers to all past price and trading volume information.

If markets are efficient, the difference between the intrinsic value and market value of a company's security is: negative. zero. positive.

B is correct. A security's intrinsic value and market value should be equal when markets are efficient.

Observed overreactions in markets can be explained by an investor's degree of: risk aversion. loss aversion. confidence in the market.

B is correct. Behavioral theories of loss aversion can explain observed overreaction in markets, such that investors dislike losses more than comparable gains (i.e., risk is not symmetrical).

If markets are semi-strong-form efficient, then passive portfolio management strategies are most likely to: earn abnormal returns. outperform active trading strategies. underperform active trading strategies.

B is correct. Costs associated with active trading strategies would be difficult to recover; thus, such active trading strategies would have difficulty outperforming passive strategies on a consistent after-cost basis.

If markets are semi-strong efficient, standard fundamental analysis will yield abnormal trading profits that are: negative. equal to zero. positive.

B is correct. If all public information should already be reflected in the market price, then the abnormal trading profit will be equal to zero when fundamental analysis is used.

If a market is semi-strong-form efficient, the risk-adjusted returns of a passively managed portfolio relative to an actively managed portfolio are most likely: lower. higher. the same.

B is correct. In a semi-strong-form efficient market, passive portfolio strategies should outperform active portfolio strategies on a risk-adjusted basis.

Which one of the following statements best describes the semi-strong form of market efficiency? Empirical tests examine the historical patterns in security prices. Security prices reflect all publicly known and available information. Semi-strong-form efficient markets are not necessarily weak-form efficient.

B is correct. In semi-strong-form efficient markets, security prices reflect all publicly available information.

Technical analysts assume that markets are: weak-form efficient. weak-form inefficient. semi-strong-form efficient.

B is correct. Technical analysts use past prices and volume to predict future prices, which is inconsistent with the weakest form of market efficiency (i.e., weak-form market efficiency). Weak-form market efficiency states that investors cannot earn abnormal returns by trading on the basis of past trends in price and volume.

Which of the following is least likely to explain the January effect anomaly? Tax-loss selling. Release of new information in January. Window dressing of portfolio holdings.

B is correct. The excess returns in January are not attributed to any new information or news; however, research has found that part of the seasonal pattern can be explained by tax-loss selling and portfolio window dressing.

The intrinsic value of an undervalued asset is: less than the asset's market value. greater than the asset's market value. the value at which the asset can currently be bought or sold.

B is correct. The intrinsic value of an undervalued asset is greater than the market value of the asset, where the market value is the transaction price at which an asset can be currently bought or sold.

The market value of an undervalued asset is: greater than the asset's intrinsic value. the value at which the asset can currently be bought or sold. equal to the present value of all the asset's expected cash flows.

B is correct. The market value is the transaction price at which an asset can be currently bought or sold.

If prices reflect all public and private information, the market is best described as: weak-form efficient. strong-form efficient. semi-strong-form efficient.

B is correct. The strong-form efficient market hypothesis assumes all information, public or private, has already been reflected in the prices.

Which of the following market anomalies is inconsistent with weak-form market efficiency? Earnings surprise. Momentum pattern. Closed-end fund discount.

B is correct. Trading based on historical momentum indicates that price patterns exist and can be exploited by using historical price information. A momentum trading strategy that produces abnormal returns contradicts the weak form of the efficient market hypothesis, which states that investors cannot earn abnormal returns on the basis of past trends in prices.

Like traditional finance models, the behavioral theory of loss aversion assumes that investors dislike risk; however, the dislike of risk in behavioral theory is assumed to be: leptokurtic. symmetrical. asymmetrical.

C is correct. Behavioral theories of loss aversion allow for the possibility that the dislike for risk is not symmetrical, which allows for loss aversion to explain observed overreaction in markets such that investors dislike losses more than they like comparable gains.

Fundamental analysts assume that markets are: weak-form inefficient. semi-strong-form efficient. semi-strong-form inefficient.

C is correct. Fundamental analysts use publicly available information to estimate a security's intrinsic value to determine if the security is mispriced, which is inconsistent with the semi-strong form of market efficiency. Semi-strong-form market efficiency states that investors cannot earn abnormal returns by trading based on publicly available information.

With respect to efficient markets, a company whose share price reacts gradually to the public release of its annual report most likely indicates that the market where the company trades is: semi-strong-form efficient. subject to behavioral biases. receiving additional information about the company.

C is correct. If markets are efficient, the information from the annual report is reflected in the stock prices; therefore, the gradual changes must be from the release of additional information.

If a market is weak-form efficient but semi-strong-form inefficient, then which of the following types of portfolio management is most likely to produce abnormal returns? Passive portfolio management. Active portfolio management based on technical analysis. Active portfolio management based on fundamental analysis.

C is correct. If markets are not semi-strong-form efficient, then fundamental analysts are able to use publicly available information to estimate a security's intrinsic value and identify misvalued securities. Technical analysis is not able to earn abnormal returns if markets are weak-form efficient. Passive portfolio managers outperform fundamental analysis if markets are semi-strong-form efficient.

Which of the following regulations will most likely contribute to market efficiency? Regulatory restrictions on: short selling. foreign traders. insiders trading with nonpublic information.

C is correct. Regulation to restrict unfair use of nonpublic information encourages greater participation in the market, which increases market efficiency. Regulators (e.g., US SEC) discourage illegal insider trading by issuing penalties to violators of their insider trading rules.

In an efficient market, the change in a company's share price is most likely the result of: insiders' private information. the previous day's change in stock price. new information coming into the market.

C is correct. Today's price change is independent of the one from yesterday, and in an efficient market, investors will react to new, independent information as it is made public.