Chapter 6

7) In an efficient market, abnormal returns are not possible, even using inside information.

Answer: FALSE

12) Technical analysis is a popular technique used to predict stock prices by studying past stock price data and searching for patterns such as trends and regular cycles.

Answer: TRUE

13) The efficient market hypothesis does not have to imply that financial markets are efficient.

Answer: TRUE

2) If the security markets are truly efficient, there is no need to pay for help selecting securities.

Answer: TRUE

32) An investor gains from short selling by ________ and then later ________. A) buying a stock; selling it at a higher price B) selling a stock; buying it back at a lower price C) buying a stock; selling it at a lower price D) selling a stock; buying it back at a higher price

B) selling a stock; buying it back at a lower price

35) An arrangement with a broker to borrow stocks from them and then sell it in the market, with the hope that they earn a profit by buying the stock back again after it has fallen in price is called A) behavioral finance. B) short sales. C) smart money. D) random walk.

B) short sales.

37) Evidence against market efficiency does not include A) the small-firm effect. B) technical analysis. C) excessive volatility. D) mean reversion.

B) technical analysis.

39) The elimination of a riskless profit opportunity in a market is called A) the efficient market hypothesis. B) random walk. C) arbitrage. D) market fundamentals.

C) arbitrage.

2) According to the efficient market hypothesis, the current price of a financial security A) is the discounted net present value of future interest payments. B) is determined by the highest successful bidder. C) fully reflects all available relevant information. D) is a result of none of the above.

C) fully reflects all available relevant information.

4) Explain what the market reaction will be in an efficient market if a firm announces a fully anticipated filing for bankruptcy.

If the filing for bankruptcy is full anticipated, it will be priced in to the market in an efficient market. No drastic price changes expected.

5) How do loss aversion, overconfidence of investors, and social contagion affect market efficiency?

These are all behavioral reactions that do not follow market fundamentals. As such they make markets less efficient.

41) When a market bubble occurs, ________. A) prices of assets rise well above their fundamental values B) a "thin layer" of trading masks true market movements C) market fundamentals and actual security prices converge D) prices of assets fluctuate rapidly above and below market fundamentals

A) prices of assets rise well above their fundamental values

6) Another way to state the efficient market condition is that in an efficient market, A) unexploited profit opportunities will be quickly eliminated. B) unexploited profit opportunities will never exist. C) arbitrageurs guarantee that unexploited profit opportunities never exist. D) both A and C of the above occur.

A) unexploited profit opportunities will be quickly eliminated.

6) What is a rational bubble?

Although prices may not follow market fundamentals and are driven up by irrational exuberance ( irrational bubble), if the price is driven up by the expectation that prices will rise, this is a rational bubble.

1) Evidence that stock prices sometimes fall when a firm announces good news contradicts the efficient market hypothesis.

Answer: FALSE

10) It is probably a good use of an investor's time to watch as many shows featuring technical analysts as possible.

Answer: FALSE

11) Having performed well in the past indicates that an investment adviser or a mutual fund will perform well in the future.

Answer: FALSE

3) Evidence that a mutual fund has performed extraordinarily well in the past contradicts the efficient market hypothesis.

Answer: FALSE

8) "Short selling" refers to the practice of buying a stock and holding it for only a short time before selling it.

Answer: FALSE

5) The evidence suggests technical analysts are not superior stock pickers.

Answer: TRUE

6) If the markets are efficient, the optimal investment strategy will be to buy and hold so as to minimize transaction costs.

Answer: TRUE

9) Loss aversion means the unhappiness a person feels when he or she suffers a monetary loss exceeds the happiness the same person experiences from receiving a monetary gain of the same amount.

Answer: TRUE

33) Which of the following is an insight from behavioral finance? A) The price of securities fully reflects all available information. B) Investor overconfidence leads to high trading volumes. C) The optimal forecast of a security's return equals the security's equilibrium return. D) Investment advisers cannot consistently beat the market.

B) Investor overconfidence leads to high trading volumes.

30) Which of the following does not weaken the efficient markets hypothesis? A) Mean reversion B) Success of buy-and-hold strategy C) January effect D) Excessive volatility

B) Success of buy-and-hold strategy

8) A situation in which the price of an asset differs from its fundamental market value is called A) an unexploited profit opportunity. B) a bubble. C) a correction. D) a mean reversion.

B) a bubble.

21) Sometimes one observes that the price of a company's stock falls after the announcement of favorable earnings. This phenomenon is A) clearly inconsistent with the efficient market hypothesis. B) consistent with the efficient market hypothesis if the earnings were not as high as anticipated. C) consistent with the efficient market hypothesis if the earnings were not as low as anticipated. D) the result of none of the above.

B) consistent with the efficient market hypothesis if the earnings were not as high as anticipated.

28) The efficient markets hypothesis is weakened by evidence that A) stock prices tend to follow a random walk. B) stock prices are more volatile than fluctuations in their fundamental values can explain. C) technical analysis does not outperform the overall market. D) an investment adviser's past success or failure at picking stocks does not predict his or her future performance.

B) stock prices are more volatile than fluctuations in their fundamental values can explain.

7) Another way to state the efficient market hypothesis is that in an efficient market, A) unexploited profit opportunities will never exist as market participants, such as arbitrageurs, ensure that they are instantaneously dissipated. B) unexploited profit opportunities will not exist for long, as market participants will act quickly to eliminate them. C) every financial market participant must be well informed about securities. D) only A and C of the above.

B) unexploited profit opportunities will not exist for long, as market participants will act quickly to eliminate them.

7) Give evidence both for and against market efficiency.

For - random walk, markets unpredictable, no benefit from tech analysis or stock pickers. Against - January effect, volatility, small firm effect.

3) The efficient market hypothesis A) is based on the assumption that prices of securities fully reflect all available information. B) holds that the expected return on a security equals the equilibrium return. C) both A and B. D) neither A nor B.

C) both A and B.

27) The small-firm effect refers to the observation that small firms' stocks A) follow a random walk but large firms' stocks do not. B) have earned abnormally low returns given their greater risk. C) have earned abnormally high returns even taking into account their greater risk. D) sell for lower prices than do large firms' stocks.

C) have earned abnormally high returns even taking into account their greater risk.

12) Raj Rajaratnam, a successful investor in the 2000s who consistently beat the market, was able to outperform the market on a consistent basis, indicating that A) securities markets are not efficient. B) unexploited profit opportunities were abundant. C) investors can outperform the market with inside information. D) only B and C of the above.

C) investors can outperform the market with inside information.

11) The efficient market hypothesis suggests that allocating your funds in the financial markets on the advice of a financial analyst A) will certainly mean higher returns than if you had made selections by throwing darts at the financial page. B) will always mean lower returns than if you had made selections by throwing darts at the financial page. C) is not likely to prove superior to a strategy of making selections by throwing darts at the financial page. D) is good for the economy.

C) is not likely to prove superior to a strategy of making selections by throwing darts at the financial page.

9) A situation in which the price of an asset differs from its fundamental market value A) indicates that unexploited profit opportunities exist. B) indicates that unexploited profit opportunities do not exist. C) need not indicate that unexploited profit opportunities exist. D) indicates that the efficient market hypothesis is fundamentally flawed.

C) need not indicate that unexploited profit opportunities exist.

29) Mean reversion refers to the observation that A) stock prices overact to news announcements. B) stocks prices are more volatile than fluctuations in their fundamental value would predict. C) stocks with low returns are likely to have high returns in the future. D) stocks with low returns are likely to have even lower returns in the future.

C) stocks with low returns are likely to have high returns in the future.

16) Tests used to rate the performance of rules developed in technical analysis conclude that A) technical analysis outperforms the overall market. B) technical analysis far outperforms the overall market, suggesting that stockbrokers provide valuable services. C) technical analysis does not outperform the overall market. D) technical analysis does not outperform the overall market, suggesting that stockbrokers do not provide services of any value.

C) technical analysis does not outperform the overall market.

34) Which of the following is empirical evidence indicating that the efficient market hypothesis may not always be generally applicable? A) Small-firm effect B) January effect C) Market overreaction D) All of the above

D) All of the above

22) Important implications of the efficient market hypothesis include which of the following? A) Future changes in stock prices should, for all practical purposes, be unpredictable. B) Stock prices will respond to announcements only when the information in these announcements is new. C) Sometimes a stock price declines when good news is announced. D) All of the above. E) Only A and B of the above.

D) All of the above.

17) Which of the following types of information will most likely enable the exploitation of a profit opportunity? A) Financial analysts' published recommendations B) Technical analysis C) Hot tips from a stockbroker D) Insider information

D) Insider information

18) Which of the following types of information will most likely enable the exploitation of a profit opportunity? A) Financial analysts' published recommendations B) Technical analysis C) Hot tips from a stockbroker D) None of the above

D) None of the above

20) The efficient market hypothesis suggests that A) investors should not try to outguess the market by constantly buying and selling securities. B) investors do better on average if they adopt a "buy and hold" strategy. C) buying into a mutual fund is a sensible strategy for a small investor. D) all of the above are sensible strategies. E) only A and B of the above are sensible strategies.

D) all of the above are sensible strategies.

36) Evidence in favor of market efficiency includes A) performance of investment analysts and mutual funds. B) whether stock prices reflect publicly available information. C) the random-walk behavior of stock prices. D) all of the above.

D) all of the above.

4) If the optimal forecast of the return on a security exceeds the equilibrium return, then A) the market is inefficient. B) an unexploited profit opportunity exists. C) the market is in equilibrium. D) only A and B of the above are true. E) only B and C of the above are true.

D) only A and B of the above are true.

13) To say that stock prices follow a "random walk" is to argue that A) stock prices rise, then fall. B) stock prices rise, then fall in a predictable fashion. C) stock prices tend to follow trends. D) stock prices are, for all practical purposes, unpredictable.

D) stock prices are, for all practical purposes, unpredictable.

14) To say that stock prices follow a "random walk" is to argue that A) stock prices rise, then fall, then rise again. B) stock prices rise, then fall in a predictable fashion. C) stock prices tend to follow trends. D) stock prices cannot be predicted based on past trends.

D) stock prices cannot be predicted based on past trends.

38) Evidence in favor of market efficiency does not include A) random-walk behavior. B) technical analysis. C) performance of investment analysts and mutual funds. D) the January effect.

D) the January effect.

10) Studies of mutual fund performance indicate that mutual funds that outperformed the market in one time period A) usually beat the market in the next time period. B) usually beat the market in the next two subsequent time periods. C) usually beat the market in the next three subsequent time periods. D) usually do not beat the market in the next time period.

D) usually do not beat the market in the next time period.

23) Although the verdict is not yet in, the available evidence indicates that, for many purposes, the efficient market hypothesis is A) a good starting point for analyzing expectations. B) not a good starting point for analyzing expectations. C) too general to be a useful tool for analyzing expectations. D) none of the above.

A) a good starting point for analyzing expectations.

15) Rules used to predict movements in stock prices based on past patterns are, according to the efficient markets theory, A) a waste of time. B) profitably employed by all financial analysts. C) the most efficient rules to employ. D) consistent with the random walk hypothesis.

A) a waste of time.

25) The efficient market hypothesis applies to A) both the stock market and the foreign exchange market. B) the stock market but not the foreign exchange market. C) the foreign exchange market but not the stock market. D) neither the stock market nor the foreign exchange market.

A) both the stock market and the foreign exchange market.

26) According to the January effect, stock prices A) experience an abnormal price rise from December to January. B) experience an abnormal price decline from December to January. C) follow a random walk during January. D) set the pattern for the entire year in January.

A) experience an abnormal price rise from December to January.

31) An important lesson from the Black Monday Crash of 1987 and the tech crash of 2000 is that A) factors other than market fundamentals affect stock prices. B) the strong version of the efficient market hypothesis, that stock prices reflect the true fundamental value of securities, is correct. C) market psychology has little if any effect on stock prices. D) there is no such thing as a rational bubble.

A) factors other than market fundamentals affect stock prices.

24) The efficient market hypothesis suggests that A) investors should purchase no-load mutual funds, which have low management fees. B) investors can use the advice of technical analysts to outperform the market. C) investors let too many unexploited profit opportunities go by if they adopt a "buy and hold" strategy. D) only A and B of the above are sensible strategies.

A) investors should purchase no-load mutual funds, which have low management fees.

40) According to the strong view of the efficient markets hypothesis, security prices reflect ________ and so financial markets are efficient. A) market fundamentals B) rational expectations C) momentum effects D) current market trends

A) market fundamentals

19) The advantage of a "buy and hold strategy" is that A) net profits will tend to be higher because there will be fewer brokerage commissions. B) losses will eventually be eliminated. C) the longer a stock is held, the higher its price will be. D) only B and C of the above are true.

A) net profits will tend to be higher because there will be fewer brokerage commissions.

9) Discuss why Black Monday, the day when the DJIA declined more than 20%, is not evidence against the efficient market hypothesis.

Black Monday is not evidence against the efficient market hypothesis as long as the crash could not have been predicted.

3) What is the optimal investment strategy according to the efficient market hypothesis? Why?

Buy and hold. less transaction costs.

1) Why are expectations important in understanding how financial instruments are valued?

Expectations of risk, returns, and liquidity affect pricing in an efficient market

1) How expectations are formed is important because expectations influence A) the demand for assets. B) bond prices. C) the risk structure of interest rates. D) the term structure of interest rates. E) all of the above.

E) all of the above.

5) According to the efficient market hypothesis A) one cannot expect to earn an abnormally high return by purchasing a security. B) information in newspapers and in the published reports of financial analysts is already reflected in market prices. C) unexploited profit opportunities abound, thereby explaining why so many people get rich by trading securities. D) all of the above are true. E) only A and B of the above are true.

E) only A and B of the above are true.

2) How is it possible that a firm can announce a record-breaking loss, yet its stock price rises when the announcement is made?

Loss could be less than expected

8) Does the efficient market hypothesis imply that financial markets are efficient? Explain.

No - markets can be inefficient when influenced by insider trading and behavioral factors outside of market fundamentals that drive trades.