Ch 8 EMH book questions

Which of the following phenomena would be either consistent with or a violation of the efficient market hypothesis?

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Which of the following would be a viable way to earn abnormally high trading profits if markets are semistrong-form efficient?

Buy shares in companies for which you have advance knowledge of an improvement in the management team Reasoning-->in a semistrong-form efficient market, it is not possible to earn abnormally high profits by trading on pubically available information. Info about P/E ratios and recent price changes is pubically known. On the other hand, an investor who has knowledge of management improvements could abnormally high trading profits (unless the market is also strong-form efficient)

Which of the following most appears to contradict the proposition that the stock market is weakly efficient?

Every January, the stock market earns abnormal returns Reasoning--->This is a predictable pattern in returns which should not occur if the weak form EMH is valid

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

Expected rates of return differ because of differential risk premiums

Which of the following statements are true if the efficient market hypothesis holds?

It implies that all prices reflect all available information Reasoning-->This is the definition of an efficient market

Which one of the following would provide evidence against the semistrong form of the efficient market theory?

Low P/E stocks tend to have positive abnormal returns over the long run Reasoning -->if low P/E stocks tend to have positive abnormal returns, this would represent an unexploited profit opportunity that would provide evidence that investors are not using all available information to make profitable 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?

Market efficiency implies investors cannot earn excess risk-adjusted profits. If the stock price run-up occurs when only insiders know of the coming dividend increase, then it is a violation of strong-form efficiency. If the public also knows of the increase, then this violates semisrong-form efficiency.

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

No. Microsoft's continuing profitability does not imply that stock market investors who purchased Microsoft shares after its success was already evident would have earned an exceptionally high return on their investments.

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. The value of dividend predictability would be already reflected in the stock price

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?

One could have made superior returns by buying stock after 10% rise in price and selling after a 10% fall Reasoning--->This is a classic filter rule which should not produce superior returns in an efficient market

Nearly half of all professionally managed mutual funds are able to outperform the S&P 500 in a typical year.

Reasoning --> Consistent. Based on pure luck, half of all managers should beat the market in any year.

Money managers that outperform the market (on a risk-adjusted basis) in one year are likely to outperform in the following year

Reasoning--> Inconsistent. This would be the basis of an "easy money" rule: simply invest with last year's best managers

Stock prices tend to be predictably more volatile in January than in other months

Reasoning-->Consistent. In constrast to predictable returns, predictable volatility does not convey a means to earn abnormal returns

Stocks that perform well in one week perform poorly in the following week.

Reasoning-->Inconsistent. Reversals offer a means to earn easy money: just buy last week's losers.

Stock prices of companies that announce increased earnings in January tend to outperform the market in February

Reasoning-->Inconsistent. The abnormal performance out to occur in January when earnings are announced.

If markets are efficient, what should be the correlation coefficient between stock returns for two non-overlapping time periods?

The correlation coefficient between stock returns for two non-overlapping periods should be zero. If not, one could use returns from one period to predict returns in later periods and make abnormal profits.

Good News, Inc. just announced an increase in its annual earnings, yet its stock price fell. Is there a rational explanation for this phenomenon?

The market may have anticipated even greater earnings. Compared to prior expectations, the announcement was a disappointment.

Assume that a company announces an unexpectedly large cash dividend to its shareholders. In an efficient market without information leakage, one might expect

an abnormal price change at the announcement

The semistrong form of efficient market hypothesis asserts that stock prices:

fully reflect all publicly available information

A "random walk" occurs when:

future price changes are uncorrelated with past price changes Reasoning --> a random walk implies that stock price changes are unpredictable, using past price changes or any other data

According to the efficient market hypothesis:

positive alphas on stocks will quickly disappear