Investments Exam 3 Chapter Questions

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 are historical data to substantiate a claim that says 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 momentum 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.

some scholars contend that professional managers are incapable of outperforming the market. Others come to an opposite conclusion. Compare and contrast the assumptions about the stock market that support (a) passive portfolio management and (b) active portfolio management

Assumptions supporting passive management are: a. informational efficiency b. primacy of diversification motives Active management is supported by the opposite assumptions, in particular, that pockets of market inefficiency exist.

A random walk occurs when:

Future price changes are uncorrelated with past price changes

Constantly fluctuating stock prices suggest that the market inefficiency would be most easily exploited?

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 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.

Suppose you find that before large dividend increases, stocks 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.

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. 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 as 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 0.033% 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 accumulate, and upward moves are indeed more likely than downward ones.

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

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.

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.

Shares of small firms with thinly traded stocks tend to show positive CAPM alphas. Is this a violation of the efficient market hypothesis?

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

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?

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.

"if all securities are fairly priced, all must offer equal expected rates of return"

The phrase would be correct if it were modified to "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 return also must be predictable"

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.

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 consensus evaluation is that the management score is only 2. Should you buy or sell the stock?

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.

Which of the following phenomena would be either consistent with or a violation of the efficient market hypothesis? a. nearly half of all professionally managed mutual funds are able to outperform 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

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.

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

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 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.

Which of the following observations would provide evidence against the semi-strong form of the efficient market theory? a. mutual fund managers do not on average maker 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 mutual 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.

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 0 b. the correlation between the return during a given week and the return during the following week is 0 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 would most appear to contradict the proposition that the stock market is weakly efficient? 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.

In 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.

The Semistrong form of the efficient market hypothesis asserts that stock prices:

fully reflect all publicly available information

A market anomaly refers to:

price behavior that differs from the behavior predicted by the efficient market hypothesis

Which version of the efficient market hypothesis focuses on the most inclusive set of information?

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