FINC 8

4. A successful firm like Microsoft has consistently generated large profits for years . Is this a violation of the 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. And those investors who purchased the shares prior did not know success was certain; risk was present. For example, many firms did not survive the bursting of the dot-com bubble.

8. Which version of the efficient market hypothesis ( weak , semistrong , or strong - form ) focuses on the most inclusive set of information ? ( LO 8-1 )

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

1. If markets are efficient , what should be the correlation coefficient between stock returns for two nonoverlapping time periods ? ( LO 8-1 )

The correlation coefficient should be zero. If it were not zero, then returns from one period to predict returns in later periods and therefore earn abnormal profits.

20. We know that the market should respond positively to good news and that good - news events such as the coming end of a recession can be predicted with at least some accuracy . Why , then , can we not predict that the market will go up as the economy recovers ? ( LO 8-1 )

The market responds positively to new good news. If the eventual recovery is anticipated, then the recovery is already reflected in stock prices. Only a better-than-expected recovery (or a worse-than-expected recovery) should affect stock prices.

6. Which of the following statements are true if the efficient market hypothesis holds ? ( LO 8-1 ) 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.

7. a . Briefly explain the concept of the efficient market hypothesis ( EMH ) and each of its three forms - weak , semistrong , and strong - and briefly discuss the degree to which existing empirical evidence supports each of the three forms of the EMH . ( LO 8-2 ) b . Briefly discuss the implications of the efficient market hypothesis for investment policy as it applies to : ( LO 8-4 ) i . Technical analysis in the form of charting . ii . Fundamental analysis . c . Briefly explain the roles or responsibilities of portfolio managers in an efficient market environment . ( LO 8-4 )

b.(i) Technical analysis involves the search for recurrent and predictable patterns in stock prices in order to enhance returns. The EMH implies that technical analysis is without value. If past prices contain no useful information for predicting future prices, there is no point in following any technical trading rule. (ii) Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. The EMH predicts that most fundamental analysis is doomed to failure. According to semistrong-form efficiency, no investor can earn excess returns from trading rules based on publicly available information. Only analysts with unique insight achieve superior returns. In summary, the EMH holds that the market appears to adjust so quickly to information about both individual stocks and the economy as a whole that no technique of selecting a portfolio using either technical or fundamental analysis can consistently outperform a strategy of simply buying and holding a diversified portfolio of securities, such as those comprising the popular market indexes. c. Portfolio managers have several roles and responsibilities even in perfectly efficient markets. The most important responsibility is to identify the risk/return objectives for a portfolio given the investor's constraints. In an efficient market, portfolio managers are responsible for tailoring the portfolio to meet the investor's needs, rather than to beat the market, which requires identifying the client's return requirements and risk tolerance. Rational portfolio management also requires examining the investor's constraints, including liquidity, time horizon, laws and regulations, taxes, and unique preferences and circumstances such as age and employment.

7. In an efficient market , professional portfolio management can offer all of the following benefits except which of the following ? ( LO 8-4 ) 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.

11. Which of the following would most appear to contradict the proposition that the stock market is weakly efficient ? Explain . ( LO 8-3 ) 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 .

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

17. Which of the following phenomena would be either consistent with or a violation of the efficient market hypothesis ? Explain briefly . ( LO 8-3 ) a . Nearly half of all professionally managed mutual funds are able to outperform the S & P 500 in a typical year . b . Money managers who outperform the market ( on a risk adjusted basis ) in one year are likely to outperform in 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 earnings in January tend to outperform the market in February . e . Stocks that perform well in one week perform poorly in the following week .

17.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.

21. You know that firm XYZ is very poorly run . On a scale of 1 ( worst ) to 10 ( best ) , you would give it a score of 3. The market score is only 2. Should you buy or sell the stock ? ( LO 8-4 )

21. You should buy the stock. The firm's management is not as bad as everyone else believes it to be, therefore, the firm is undervalued by the market. You are less pessimistic about the firm's prospects than the beliefs built into the stock price.

3. A " random walk " occurs when : ( LO 8-1 ) a . Stock price changes are random but predictable b . Stock prices respond slowly to both new and old information . c . Future price changes are uncorrelated with past price changes . d . Past information is useful in predicting future prices .

A random walk reflects no other information and is thus random.

4. A market anomaly refers to : ( LO 8-3 ) a . An exogenous shock to the market that is sharp but not persistent . b . A price or volume event that is inconsistent with historical price or volume trends . c . A trading or pricing structure that interferes with efficient buying and selling of securities . d . Price behavior that differs from the behavior predicted by the efficient market hypothesis .

Answer: d.Unexpected results are by definition an anomaly.

1. The semistrong form of the efficient market hypothesis asserts that stock prices : ( LO 8-1 ) a . Fully reflect all historical price information . b . Fully reflect all publicly available information . c . Fully reflect all relevant information including insider information . d . May be predictable .

b.Public information constitutes semi-string efficiency, while the addition of private information leads to strong form efficiency.