Chapter 8-The Efficient Market Hypothesis

Why are the following "effects" considered efficient market anomalies? Are there rational explanations for these effects? a. P/E effect b. Book-to-market effect c. Momentum effect d. Small-firm effect

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.

At a cocktail party, your co-worker tells you that he has beaten the market for each of the last three years. Suppose you believe him. Does this shake your belief in efficient markets?

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.

Which of the following phenomena would be either consistent with or a violation of the efficient market hypothesis? Explain briefly. a. Nearly half of all professionally managed mutual funds are able to outperform the S&P 500 in a typical year. b. Money managers that outperform the market (on a risk-adjusted basis) in one year are likely to outperform again the following year. c. Stock prices tend to be predictably more volatile in January than in other months. d. Stock prices of companies that announce increased earning in January tend to out-perform the market in February. e. Stocks that perform well in one week perform poorly in the following week.

a. Consistent. Half of all managers should outperform the market based on pure luck in any year. b. Violation. This would be the basis for an "easy money" rule: simply invest with last year's best managers. c. Consistent. Predictable volatility does not convey a means to earn abnormal returns. d. Violation. The abnormal performance ought to occur in January, when the increased earnings are announced. e. Violation. Reversals offer a means to earn easy money: simply buy last week's losers.

Which of the following statements are true if the efficient market hypothesis holds? a. it implies that future events can be forecast with perfect accuracy. b. It implies that prices reflect all available information. c, It implies that security prices change for no discernible reason. d. It implies that prices do not fluctuate.

b. This is the definition of an efficient market.

Which of the following most appears to contradict the proposition that the stock market is weakly efficient? Explain. a. Over 25% of mutual funds outperform the market on average. b. Insiders earn abnormal trading profits. c. Every January, the stock market earns abnormal returns.

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

Which of the following observations would provide evidence against the semistrong form of the efficient market theory? Explain. a. Mutual fund managers do not on average make superior returns. b. You cannot make superior profits by buying (or selling) stocks after the announcement of an abnormal rise in dividends. c. Low P/E stocks tend to have positive abnormal returns. d. In any year approximately 50% of pension funds outperform the market.

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

In an efficient market, professional portfolio management can offer all of the following benefits except a. Low-cost diversification. b. A targeted risk level. c. Low-cost record keeping. d. A superior risk-return trade-off.

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