FIN 431 CH.8

"Highly variable stock prices suggest that the market does not know how to price stocks." Respond.

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.

Steady growth industries has never missed a dividend payment in its 94-year history. Does this make it more attractive to you as a possible purchase for your stock portfolio?

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

A successful firm like Microsoft has consistently generated large profit for years. Is this a violation of EMH?

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.

Suppose you find that prices of stocks before large dividend increases show on average consistently positive abnormal returns. Is this a violation of the EMH?

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.

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

No. The notion of random walk 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.

If prices are likely to increase as decrease, why do investors earn positive returns from the market on average?

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.

Which version of the efficient market hypothesis focuses on the most inclusive set of information? (weak, semistrong, stron-form)

Strong-form efficiency includes all information: historical, public, and private.

If Markets are efficient, what should be the correlation coefficient between stock returns for two nonoverlapping time periods?

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.

"If all securities are fairly prices, all must offer equal expected rates of return." Comment.

The phrase would be correct if it were modified to say "expected risk adjusted returns." Securities all have the same risk adjusted expected return if priced fairly; 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.

"If the business cycle is predictable, and a stock has a positive beta, the stock's returns also must be predictable." Respond.

While positive beta stocks respond well to favorable new information about the economy's progress through the business cycle, the stock's returns should be predictable and 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. The level of the stock price will be unpredictable only when responding to new information.

Index Fund

a mutual fund holding shares in proportion to their representation in a market index such as the S&P 500

resistance level

a price level above which it is supposedly unlikely for a stock or stock index to rise

support level

a price level below which it is supposedly unlikely for a stock or stock index to fall

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 price 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.

passive investment strategy

buying a well-diversified portfolio without attempting to search out mispriced securities

Which of the following sources of market inefficiency would be most easily exploited? a. A stock price drops suddenly due to a large block sale by an institution. b. A stock is overpriced because traders are restricted from short sales. c. Stocks are overvalued because investors are exuberant over increased productivity in the economy.

c. If the stocks are overvalued, without regulative restrictions or other constraints on the trading, some investors observing this trend would be able to form a trading strategy to profit from the mispricing, thereby exploiting the inefficiency and forcing the price to the correct level.

Suppose that, after conducting an analysis of past stock prices, you come up with the following observations. Which would appear to contradict the weak form of the efficient market hypothesis? a. The average rate of return is significantly greater than zero b. the correlation between the return during a given week and the return during the following week is zero. c. One could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall. d. One could have made higher than average capital gains by holding stocks with low dividend yields.

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

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 of returns, which should not occur if the stock market is weakly efficient.

If an efficient market, professional portfolio management can offer all of the following benefits except which of the following? 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-return trade off if markets are efficient.

anomalies

patterns of returns that seem to contradict the efficient market hypothesis

P/E effect

portfolios of low P/E stocks have exhibited higher average risk-adjusted returns than high P/E stocks

Fundamental Analysis

research on determinants of stock value, such as earnings and dividend prospects, expectations for future interest rates, and risk of the firm

Technical Analysis

research on recurrent and predictable stock price patterns and on proxies for buy or sell pressure in the market

small-firm effect

stocks of small firms have earned abnormal returns, primarily in the month of January

Weak-form EMH

the assertion that stock prices already reflect all information contained in the history of past trading

Semistrong-form EMH

the assertion that stock prices already reflect all publicly available information

Strong-form EMH

the assertion that stock prices reflect all relevant information, including inside information

Efficient Market Hypothesis

the hypothesis that prices of securities fully reflect available information about securities

Random Walk

the notion that stock price changes are random and unpredictable

book-to-market effect

the tendency for investments in shares of firms with high ratios of book value to market value to generate abnormal returns

neglected-firm effect

the tendency of investments in stock of less well-known firms to generate abnormal returns

momentum effect

the tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods

reversal effect

the tendency of poorly performing stocks and well-performing stocks in one period to experience reversals in the following period