CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS

CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS

PROBLEM SETS
1. The correlation coefficient beteen !toc" ret#rn! for to nono$erla%%in& %erio'!
!ho#l' be (ero. If not) ret#rn! fro* one %erio' co#l' be #!e' to %re'ict ret#rn! in
later %erio'! an' *a"e abnor*al %rofit!.
+. No. Micro!oft,! contin#in& %rofitabilit- 'oe! not i*%l- that !toc" *ar"et in$e!tor!
ho %#rcha!e' Micro!oft !hare! after it! !#cce!! a! alrea'- e$i'ent o#l' ha$e
earne' an e.ce%tionall- hi&h ret#rn on their in$e!t*ent!. It !i*%l- *ean! that
Micro!oft ha! *a'e ri!"- in$e!t*ent! o$er the -ear! that ha$e %ai' off in the for* of
increa!e' ca!h flo! an' %rofitabilit-. Micro!oft !harehol'er! ha$e benefite' fro*
the ri!"/e.%ecte' ret#rn tra'eoff) hich i! con!i!tent ith the EMH.
0. E.%ecte' rate! of ret#rn 'iffer beca#!e of 'ifferential ri!" %re*i#*! acro!! all
!ec#ritie!.
1. No. The $al#e of 'i$i'en' %re'ictabilit- o#l' be alrea'- reflecte' in the !toc"
%rice.
2. No) *ar"et! can be efficient e$en if !o*e in$e!tor! earn ret#rn! abo$e the *ar"et
a$era&e. Con!i'er the 3#c"- E$ent i!!#e: I&norin& tran!action co!t!) abo#t 245 of
%rofe!!ional in$e!tor!) b- 'efinition) ill 6beat7 the *ar"et in an- &i$en -ear. The
%robabilit- of beatin& it three -ear! in a ro) tho#&h !*all) i! not in!i&nificant.
8eatin& the *ar"et in the %a!t 'oe! not %re'ict f#t#re !#cce!! a! three -ear! of
ret#rn! *a"e #% too !*all a !a*%le on hich to ba!e correlation let alone ca#!ation.
9. :olatile !toc" %rice! co#l' reflect $olatile #n'erl-in& econo*ic con'ition! a! lar&e
a*o#nt! of infor*ation bein& incor%orate' into the %rice ill ca#!e $ariabilit- in
!toc" %rice. The efficient *ar"et h-%othe!i! !#&&e!t! that in$e!tor! cannot earn
e.ce!! ri!"/a';#!te' rear'!. The $ariabilit- of the !toc" %rice i! th#! reflecte' in the
e.%ecte' ret#rn! a! ret#rn! an' ri!" are %o!iti$el- correlate'.
<. The folloin& effect! !ee* to !#&&e!t %re'ictabilit- ithin e=#it- *ar"et! an' th#!
'i!%ro$e the efficient *ar"et h-%othe!i!. Hoe$er) con!i'er the folloin&:
a. M#lti%le !t#'ie! !#&&e!t that 6$al#e7 !toc"! >*ea!#re' often b- lo P?E
*#lti%le!@ earn hi&her ret#rn! o$er ti*e than 6&roth7 !toc"! >hi&h P?E *#lti%le!@.
Thi! co#l' !#&&e!t a !trate&- for earnin& hi&her ret#rn! o$er ti*e. Hoe$er) another
11/1
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
rational ar&#*ent *a- be that tra'itional for*! of CAPM >!#ch a! Shar%e,! *o'el@
'o not f#ll- acco#nt for all ri!" factor! that affect a fir*,! %rice le$el. A fir* $iee'
a! ri!"ier *a- ha$e a loer %rice an' th#! P?E *#lti%le.
b. The boo"/to/*ar"et effect !#&&e!t! that an in$e!tor can earn e.ce!! ret#rn! b-
in$e!tin& in co*%anie! ith hi&h boo" $al#e >the $al#e of a fir*,! a!!et! *in#! it!
liabilitie! 'i$i'e' b- the n#*ber of !hare! o#t!tan'in&@ to *ar"et $al#e. A !t#'- b-
Fa*a an' French
1
!#&&e!t! that boo"/to/*ar"et $al#e reflect! a ri!" factor that i! not
acco#nte' for b- tra'itional one $ariable CAPM. For e.a*%le) co*%anie!
e.%eriencin& financial 'i!tre!! !ee the ratio of boo" to *ar"et $al#e increa!e. Th#! a
*ore co*%le. CAPM that incl#'e! boo"/to/*ar"et $al#e a! an e.%lanator- $ariable
!ho#l' be #!e' to te!t *ar"et ano*alie!.
c. Stoc" %rice *o*ent#* can be %o!iti$el- correlate' ith %a!t %erfor*ance >!hort
to inter*e'iate hori(on@ or ne&ati$el- correlate' >lon& hori(on@. Hi!torical 'ata
!ee* to i*%l- !tati!tical !i&nificance to the!e %attern!. E.%lanation! for thi! incl#'e a
ban'a&on effect or the beha$iori!t!, >!ee Cha%ter 1+@ e.%lanation that there i! a
ten'enc- for in$e!tor! to #n'erreact to ne infor*ation) th#! %ro'#cin& a %o!iti$e
!erial correlation. Hoe$er) !tati!tical !i&nificance 'oe! not i*%l- econo*ic
!i&nificance. Se$eral !t#'ie! that incl#'e' tran!action co!t! in the *o*ent#* *o'el!
'i!co$ere' that *o*ent#* tra'er! ten'e' to not o#t%erfor* the efficient *ar"et
h-%othe!i! !trate&- of b#- an' hol'.
'. The !*all/fir* effect !tate! that !*aller fir*! %ro'#ce better ret#rn! than lar&er
fir*!. Since 1A+9) ret#rn! fro* !*all fir*! o#t%ace lar&e fir* !toc" ret#rn! b- abo#t
15 %er -ear. Bo !*all ca% in$e!tor! earn e.ce!! ri!"/a';#!te' ret#rn!C
The *ea!#re of !-!te*atic ri!" accor'in& to Shar%e,! CAPM i! the !toc",! beta >or
!en!iti$it- of ret#rn! of the !toc" to *ar"et ret#rn!@. If the !toc",! beta i! the be!t
e.%lanation of ri!") then the !*all/fir* effect 'oe! in'icate an inefficient *ar"et.
Bi$i'in& the *ar"et into 'ecile! ba!e' on their beta! !ho! an increa!in&
relation!hi% beteen beta! an' ret#rn!. Fa*a an' French
+
!ho that the e*%irical
relation!hi% beteen beta an' !toc" ret#rn! i! flat o$er a fairl- lon& hori(on >1A90D
1AA4@. 8rea"in& the *ar"et into 'ecile! ba!e' on !i(e! an' then e.a*inin& the
relation!hi% beteen beta an' !toc" ret#rn! ithin each !i(e 'ecile e.hibit! thi! flat
relation!hi%. Thi! i*%lie! that fir* !i(e *a- be a better *ea!#re of ri!" than beta an'
the !i(e/effect !ho#l' not be $iee' a! an in'icator that *ar"et! are inefficient.
He#ri!ticall- thi! *a"e! !en!e) a! !*aller fir*! are &enerall- $iee' a! ri!"-
co*%are' to lar&er fir*! an' %ercei$e' ri!" an' ret#rn are %o!iti$el- correlate'.
In a''ition thi! effect !ee*! to be en'%oint an' 'ata !en!iti$e. For e.a*%le) !*aller
!toc"! 'i' not o#t%erfor* lar&er !toc"! fro* the *i'/1AE4! thro#&h the 1AA4!. In
a''ition) 'ataba!e! contain !toc" ret#rn! fro* co*%anie! that ha$e !#r$i$e' an' 'o
1
Fama, Eugene and Kenneth French, Common Risk Factors in the Returns on Stocks and Bonds,
Journal of Finance 33:1, pp. 3-56.
2
Ibid
11/+
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
not incl#'e ret#rn! of tho!e that ent ban"r#%t. Th#! !*all/fir* 'ata *a- e.hibit
!#r$i$or!hi% bia!.
E. O$er the lon& ha#l) there i! an e.%ecte' #%ar' 'rift in !toc" %rice! ba!e' on their
fair e.%ecte' rate! of ret#rn. The fair e.%ecte' ret#rn o$er an- !in&le 'a- i! $er-
!*all >e.&.) 1+5 %er -ear i! onl- abo#t 4.405 %er 'a-@) !o that on an- 'a- the %rice
i! $irt#all- e=#all- li"el- to ri!e or fall. O$er lon&er %erio'!) the !*all e.%ecte' 'ail-
ret#rn! acc#*#late) an' #%ar' *o$e! are *ore li"el- than 'onar' one!.
Re*e*ber that econo*ie! ten' to &ro o$er ti*e an' !toc" %rice! ten' to follo
econo*ic &roth) !o it i! onl- nat#ral that there i! an #%ar' 'rift in e=#it- %rice!.
A. c. Thi! i! a %re'ictable %attern in ret#rn! that !ho#l' not occ#r if the ea"/for*
EMH i! $ali'.
14. a. Ac#te *ar"et inefficiencie! are te*%orar- in nat#re an' are *ore ea!il-
e.%loite' than chronic inefficiencie!. A te*%orar- 'ro% in a !toc" %rice '#e to a
lar&e !ale o#l' be *ore ea!il- e.%loite' than the chronic inefficiencie!
*entione' in the other re!%on!e!.
11. c. Thi! i! a cla!!ic filter r#le that !ho#l' not %ro'#ce !#%erior ret#rn! in an
efficient *ar"et.
1+. b. Thi! i! the 'efinition of an efficient *ar"et.
10. a. Tho#&h !toc" %rice! follo a ran'o* al" an' intra'a- %rice chan&e! 'o
a%%ear to be a ran'o* al") o$er the lon& r#n there i! co*%en!ation for
bearin& *ar"et ri!" an' for the ti*e $al#e of *one-. In$e!tin& 'iffer! fro* a
ca!ino in that in the lon&/r#n) an in$e!tor i! co*%en!ate' for the!e ri!"!) hile
a %la-er at a ca!ino face! le!! than fair/&a*e o''!.
b. In an efficient *ar"et) an- %re'ictable f#t#re %ro!%ect! of a co*%an- ha$e
alrea'- been %rice' into the c#rrent $al#e of the !toc". Th#!) a !toc" !hare
%rice can !till follo a ran'o* al".
c. Fhile the ran'o* nat#re of 'art boar' !election !ee*! to follo nat#rall- fro*
efficient *ar"et!) the role of rational %ortfolio *ana&e*ent !till e.i!t!. It e.i!t!
to en!#re a ell/'i$er!ifie' %ortfolio) to a!!e!! the ri!"/tolerance of the
in$e!tor) an' to ta"e into acco#nt ta. co'e i!!#e!.
11. '. In a !e*i!tron&/for* efficient *ar"et) it i! not %o!!ible to earn abnor*all- hi&h
%rofit! b- tra'in& on %#blicl- a$ailable infor*ation. Infor*ation abo#t P?E
11/0
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
ratio! an' recent %rice chan&e! i! %#blicl- "non. On the other han') an
in$e!tor ho ha! a'$ance "nole'&e of *ana&e*ent i*%ro$e*ent! co#l' earn
abnor*all- hi&h tra'in& %rofit! >#nle!! the *ar"et i! al!o !tron&/for* efficient@.
12. Mar"et efficienc- i*%lie! in$e!tor! cannot earn e.ce!! ri!"/a';#!te' %rofit!. If the
!toc" %rice r#n/#% occ#r! hen onl- in!i'er! "no of the co*in& 'i$i'en' increa!e)
then it i! a $iolation of !tron&/for* efficienc-. If the %#blic al!o "no! of the
increa!e) then thi! $iolate! !e*i!tron&/for* efficienc-.
19. Fhile %o!iti$e beta !toc"! re!%on' ell to fa$orable ne infor*ation abo#t the
econo*-,! %ro&re!! thro#&h the b#!ine!! c-cle) the- !ho#l' not !ho abnor*al
ret#rn! aro#n' alrea'- antici%ate' e$ent!. If a reco$er-) for e.a*%le) i! alrea'-
antici%ate') the act#al reco$er- i! not ne!. The !toc" %rice !ho#l' alrea'- reflect
the co*in& reco$er-.
1<. a. Con!i!tent. 8a!e' on %#re l#c") half of all *ana&er! !ho#l' beat the *ar"et in
an- -ear.
b. Incon!i!tent. Thi! o#l' be the ba!i! of an 6ea!- *one-7 r#le: !i*%l- in$e!t
ith la!t -earG! be!t *ana&er!.
c. Con!i!tent. In contra!t to %re'ictable ret#rn!) %re'ictable volatility 'oe! not
con$e- a *ean! to earn abnor*al ret#rn!.
'. Incon!i!tent. The abnor*al %erfor*ance o#&ht to occ#r in Han#ar- hen
earnin&! are anno#nce'.
e. Incon!i!tent. Re$er!al! offer a *ean! to earn ea!- *one-: ;#!t b#- la!t
ee",! lo!er!.
1E. The ret#rn on the *ar"et i! E5. Therefore) the foreca!t *onthl- ret#rn for For' i!:
4.145 I >1.1 J E5@ K E.A5
For',! act#al ret#rn a! <5) !o the abnor*al ret#rn a! D1.A5.
1A. a. 8a!e' on broa' *ar"et tren'!) the CAPM in'icate! that A*bCha!er !toc"
!ho#l' ha$e increa!e' b-: 1.45 I +.4 J >1.25 D 1.45@ K +.45
It! fir*/!%ecific >non!-!te*atic@ ret#rn '#e to the la!#it i! L1 *illion %er
L144 *illion initial e=#it-) or 15. Therefore) the total ret#rn !ho#l' be 05. >It
i! a!!#*e' here that the o#tco*e of the la!#it ha' a (ero e.%ecte' $al#e.@
11/1
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
b. If the !ettle*ent a! e.%ecte' to be L+ *illion) then the act#al !ettle*ent a!
a 6L1 *illion 'i!a%%oint*ent)7 an' !o the fir*/!%ecific ret#rn o#l' be D15)
for a total ret#rn of +5 D 15 K 15.
+4. Mi$en *ar"et %erfor*ance) %re'icte' ret#rn! on the to !toc"! o#l' be:
A%e.: 4.+5 I >1.1 J 05@ K 1.15
8%e.: D4.15 I >4.9 J 05@ K 1.<5
A%e. #n'er%erfor*e' thi! %re'ictionN 8%e. o#t%erfor*e' the %re'iction. Fe
concl#'e that 8%e. on the la!#it.
+1. a. E>rM @ K 1+5) rf K 15 an' O K 4.2
Therefore) the e.%ecte' rate of ret#rn i!:
15 I 4.2 J >1+5 D 15@ K E5
If the !toc" i! fairl- %rice') then E>r@ K E5.
b. If rM fall! !hort of -o#r e.%ectation b- +5 >that i!) 145 D 1+5@ then -o#
o#l' e.%ect the ret#rn for Chan&in& Fort#ne! In'#!trie! to fall !hort of -o#r
ori&inal e.%ectation b-: O J +5 K 15
Therefore) -o# o#l' foreca!t a re$i!e' e.%ectation for Chan&in& Fort#ne! of:
E5 D 15 K <5
c. Mi$en a *ar"et ret#rn of 145) -o# o#l' foreca!t a ret#rn for Chan&in&
Fort#ne! of <5. The act#al ret#rn i! 145. Therefore) the !#r%ri!e '#e to fir*/
!%ecific factor! i! 145 D <5 K 05) hich e attrib#te to the !ettle*ent.
8eca#!e the fir* i! initiall- orth L144 *illion) the !#r%ri!e a*o#nt of the
!ettle*ent i! 05 of L144 *illion) or L0 *illion) i*%l-in& that the %rior
e.%ectation for the !ettle*ent a! onl- L+ *illion.
++. I*%licit in the 'ollar/co!t a$era&in& !trate&- i! the notion that !toc" %rice!
fl#ct#ate aro#n' a 6nor*al7 le$el. Otheri!e) there i! no *eanin& to !tate*ent!
!#ch a!: 6hen the %rice i! hi&h.7 Ho 'o e "no) for e.a*%le) hether a %rice
of L+2 to'a- ill t#rn o#t to be $iee' a! hi&h or lo co*%are' to the !toc" %rice
!i. *onth! fro* noC
+0. The *ar"et re!%on'! %o!iti$el- to new ne!. If the e$ent#al reco$er- i! antici%ate')
then the reco$er- i! alrea'- reflecte' in !toc" %rice!. Onl- a better/than/e.%ecte'
reco$er- !ho#l' affect !toc" %rice!.
+1. 8#-. In -o#r $ie) the fir* i! not a! ba' a! e$er-one el!e belie$e! it to be. Therefore)
-o# $ie the fir* a! #n'er$al#e' b- the *ar"et. Yo# are le!! %e!!i*i!tic abo#t the
fir*,! %ro!%ect! than the belief! b#ilt into the !toc" %rice.
11/2
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
+2. Here e nee' a to/factor *o'el relatin& For',! ret#rn to tho!e of both the broa'
*ar"et an' the a#to in'#!tr-. If e call rI the in'#!tr- ret#rn) then e o#l' fir!t
e!ti*ate %ara*eter!
P)O )O
M IND
in the folloin& re&re!!ion:
FORB
P O O Q
M M IND IND
r r r = + + +
Mi$en the!e e!ti*ate! e o#l' calc#late For',! fir*/!%ecific ret#rn a!:
FORB
RP O O QS
M M IND IND
r r r + + +
Thi! e!ti*ate of fir*/!%ecific ne! o#l' *ea!#re the *ar"et,! a!!e!!*ent of the
%otential %rofitabilit- of For',! ne *o'el.
+9. The *ar"et *a- ha$e antici%ate' e$en &reater earnin&!. Compared to prior
expectations, the anno#nce*ent a! a 'i!a%%oint*ent.
+<. Thinl- tra'e' !toc"! ill not ha$e a con!i'erable a*o#nt of *ar"et re!earch
%erfor*e' on the co*%anie! the- re%re!ent. Thi! ne&lecte'/fir* effect i*%lie! a
&reater 'e&ree of #ncertaint- ith re!%ect to !*aller co*%anie!. Th#! %o!iti$e
CAPM al%ha! a*on& thinl- tra'e' !toc"! 'o not nece!!aril- $iolate the efficient
*ar"et h-%othe!i! !ince the!e hi&her al%ha! are act#all- ri!" %re*i#*!) not *ar"et
inefficiencie!.
+E. The ne&ati$e abnor*al ret#rn! >'onar' 'rift in CAR@ ;#!t %rior to !toc"
%#rcha!e! !#&&e!t that in!i'er! 'eferre' their %#rcha!e! #ntil after ba' ne! a!
relea!e' to the %#blic. Thi! i! e$i'ence of $al#able in!i'e infor*ation. The %o!iti$e
abnor*al ret#rn! after %#rcha!e !#&&e!t in!i'er %#rcha!e! in antici%ation of &oo'
ne!. The anal-!i! i! !-**etric for in!i'er !ale!.
+A. a. The *ar"et ri!" %re*i#* *o$e! co#nterc-clical to the econo*-) %ea"in& in
rece!!ion!. A $iolation of the efficient *ar"et h-%othe!i! o#l' i*%l- that in$e!tor!
co#l' ta"e a'$anta&e of thi! %re'ictabilit- an' earn e.ce!! ri!" a';#!te' ret#rn!.
Hoe$er) !e$eral !t#'ie!) incl#'in& Sie&el)
0
!ho that !#cce!!f#ll- ti*in& the
chan&e! ha$e el#'e' %rofe!!ional in$e!tor! th#! far. Moreo$er a chan&in& ri!"
%re*i#* i*%lie! chan&in& re=#ire' rate! of ret#rn for !toc"! rather than an
inefficienc- ith the *ar"et.
b. A! the *ar"et ri!" %re*i#* increa!e! '#rin& a rece!!ion) !toc"! %rice! ten' to fall.
A! the econo*- reco$er!) the *ar"et ri!" %re*i#* fall!) an' !toc" %rice! ten' to
ri!e. The!e chan&e! co#l' &i$e in$e!tor! the i*%re!!ion that *ar"et! o$erreact)
0
Here*- Sie&el) Stocks for the Long !n" #he Definitive $!ide to %inancial Market et!rns
and Long&#erm Investment Strategies) +44+) Ne Yor": McMra/Hill.
11/9
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
e!%eciall- if the #n'erl-in& chan&e! in the *ar"et ri!" %re*i#* are !*all b#t
c#*#lati$e. For e.a*%le) the October Cra!h of 1AE< i! co**onl- $iee' a! an
e.a*%le of *ar"et o$erreaction. Hoe$er) in the ee"! r#nnin& #% to *i'/October)
!e$eral #n'erl-in& chan&e! to the *ar"et ri!" %re*i#* occ#rre' >in a''ition to
chan&e! in the -iel'! on lon&/ter* Trea!#r- 8on'!@. Con&re!! threatene' in$e!tor!
ith a 6*er&er ta.7 that o#l' ha$e tr#ncate' the boo*in& *er&er in'#!tr- an'
loo!ene' the 'i!ci%line that the threat of *er&er! %ro$i'e! to a fir*,! *ana&e*ent.
In a''ition) the Secretar- of Trea!#r- threatene' f#rther 'e%reciation in the $al#e of
the 'ollar) fri&htenin& forei&n in$e!tor!. The!e e$ent! *a- ha$e increa!e' the *ar"et
ri!" %re*i#* an' loere' !toc" %rice! in a !ee*in& o$erreaction.
CFA PROBLEMS
1. b. Se*i!tron& for* efficienc- i*%lie! that *ar"et %rice! reflect all p!'licly
availa'le infor*ation concernin& %a!t tra'in& hi!tor- a! ell a! f#n'a*ental
a!%ect! of the fir*.
+. a. The f#ll %rice a';#!t*ent !ho#l' occ#r ;#!t a! the ne! abo#t the 'i$i'en'
beco*e! %#blicl- a$ailable.
0. '. If lo P?E !toc"! ten' to ha$e %o!iti$e abnor*al ret#rn!) thi! o#l' re%re!ent
an #ne.%loite' %rofit o%%ort#nit- that o#l' %ro$i'e e$i'ence that in$e!tor!
are not #!in& all a$ailable infor*ation to *a"e %rofitable in$e!t*ent!.
1. c. In an efficient *ar"et) no !ec#ritie! are con!i!tentl- o$er%rice' or #n'er%rice'.
Fhile !o*e !ec#ritie! ill t#rn o#t after an- in$e!t*ent %erio' to ha$e
%ro$i'e' %o!iti$e al%ha! >i.e.) ri!"/a';#!te' abnor*al ret#rn!@ an' !o*e
ne&ati$e al%ha!) the!e %a!t ret#rn! are not %re'icti$e of f#t#re ret#rn!.
2. c. A ran'o* al" i*%lie! that !toc" %rice chan&e! are #n%re'ictable) #!in& %a!t
%rice chan&e! or an- other 'ata.
9. '. A &ra'#al a';#!t*ent to f#n'a*ental $al#e! o#l' allo for the #!e of !trate&ie!
ba!e' on %a!t %rice *o$e*ent! in or'er to &enerate abnor*al %rofit!.
<. a.
E. a. So*e e*%irical e$i'ence that !#%%ort! the EMH:
>i@ Profe!!ional *one- *ana&er! 'o not t-%icall- earn hi&her ret#rn! than
co*%arable ri!") %a!!i$e in'e. !trate&ie!.
11/<
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
>ii@ E$ent !t#'ie! t-%icall- !ho that !toc"! re!%on' i**e'iatel- to the
%#blic relea!e of rele$ant ne!.
>iii@ Mo!t te!t! of technical anal-!i! fin' that it i! 'iffic#lt to i'entif- %rice
tren'! that can be e.%loite' to earn !#%erior ri!"/a';#!te' in$e!t*ent
ret#rn!.
b. So*e e$i'ence that i! 'iffic#lt to reconcile ith the EMH concern! !i*%le
%ortfolio !trate&ie! that a%%arentl- o#l' ha$e %ro$i'e' hi&h ri!"/a';#!te'
ret#rn! in the %a!t. So*e e.a*%le! of %ortfolio! ith attracti$e hi!torical ret#rn!:
>i@ 3o P?E !toc"!.
>ii@ Hi&h boo"/to/*ar"et ratio !toc"!.
>iii@ S*all fir*! in Han#ar-.
>i$@ Fir*! ith $er- %oor !toc" %rice %erfor*ance in the la!t fe *onth!.
Other e$i'ence concern! %o!t/earnin&!/anno#nce*ent !toc" %rice 'rift an'
inter*e'iate/ter* %rice *o*ent#*.
c. An in$e!tor *i&ht choo!e not to in'e. e$en if *ar"et! are efficient beca#!e he
or !he *a- ant to tailor a %ortfolio to !%ecific ta. con!i'eration! or to !%ecific
ri!" *ana&e*ent i!!#e!) for e.a*%le) the nee' to he'&e >or at lea!t not a'' to@
e.%o!#re to a %artic#lar !o#rce of ri!" >e.&.) in'#!tr- e.%o!#re@.
A. a. The efficient *ar"et h-%othe!i! >EMH@ !tate! that a *ar"et i! efficient if
!ec#rit- %rice! i**e'iatel- an' f#ll- reflect all a$ailable rele$ant infor*ation. If
the *ar"et f#ll- reflect! infor*ation) the "nole'&e of that infor*ation o#l'
not allo an in$e!tor to %rofit fro* the infor*ation beca#!e !toc" %rice!
alrea'- incor%orate the infor*ation.
i. The weak form of the EMH a!!ert! that !toc" %rice! reflect all the infor*ation
that can be 'eri$e' b- e.a*inin& *ar"et tra'in& 'ata !#ch a! the hi!tor- of %a!t
%rice! an' tra'in& $ol#*e.
A !tron& bo'- of e$i'ence !#%%ort! ea"/for* efficienc- in the *a;or T.S.
!ec#ritie! *ar"et!. For e.a*%le) te!t re!#lt! !#&&e!t that technical tra'in& r#le! 'o
not %ro'#ce !#%erior ret#rn! after a';#!tin& for tran!action co!t! an' ta.e!.
ii. The semistrong form !tate! that a fir*,! !toc" %rice reflect! all %#blicl-
a$ailable infor*ation abo#t a fir*,! %ro!%ect!. E.a*%le! of %#blicl- a$ailable
infor*ation are co*%an- ann#al re%ort! an' in$e!t*ent a'$i!or- 'ata.
E$i'ence !tron&l- !#%%ort! the notion of !e*i!tron& efficienc-) b#t occa!ional
!t#'ie! >e.&.) i'entif-in& *ar"et ano*alie! !#ch a! the !*all/fir*/in/Han#ar- or
boo"/to/*ar"et effect!@ an' e$ent! >e.&. !toc" *ar"et cra!h of October 1A)
1AE<@ are incon!i!tent ith thi! for* of *ar"et efficienc-. There i! a =#e!tion
concernin& the e.tent to hich the!e 6ano*alie!7 re!#lt fro* 'ata *inin&.
iii. The strong form of the EMH hol'! that c#rrent *ar"et %rice! reflect all
infor*ation >hether %#blicl- a$ailable or %ri$atel- hel'@ that can be rele$ant to
the $al#ation of the fir*.
11/E
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
E*%irical e$i'ence !#&&e!t! that !tron&/for* efficienc- 'oe! not hol'. If thi!
for* ere correct) %rice! o#l' f#ll- reflect all infor*ation. Therefore e$en
in!i'er! co#l' not earn e.ce!! ret#rn!. 8#t the e$i'ence i! that cor%orate
officer! 'o ha$e acce!! to %ertinent infor*ation lon& eno#&h before %#blic
relea!e to enable the* to %rofit fro* tra'in& on thi! infor*ation.
b. i. #echnical analysis in$ol$e! the !earch for rec#rrent an' %re'ictable %attern! in
!toc" %rice! in or'er to enhance ret#rn!. The EMH i*%lie! that technical anal-!i! i!
itho#t $al#e. If %a!t %rice! contain no #!ef#l infor*ation for %re'ictin& f#t#re
%rice!) there i! no %oint in folloin& an- technical tra'in& r#le.
ii. %!ndamental analysis #!e! earnin&! an' 'i$i'en' %ro!%ect! of the fir*)
e.%ectation! of f#t#re intere!t rate!) an' ri!" e$al#ation of the fir* to 'eter*ine
%ro%er !toc" %rice!. The EMH %re'ict! that *o!t f#n'a*ental anal-!i! i! 'oo*e'
to fail#re. Accor'in& to !e*i!tron&/for* efficienc-) no in$e!tor can earn e.ce!!
ret#rn! fro* tra'in& r#le! ba!e' on %#blicl- a$ailable infor*ation. Onl- anal-!t!
ith #ni=#e in!i&ht achie$e !#%erior ret#rn!.
In !#**ar-) the EMH hol'! that the *ar"et a%%ear! to a';#!t !o =#ic"l- to
infor*ation abo#t both in'i$i'#al !toc"! an' the econo*- a! a hole that no
techni=#e of !electin& a %ortfolio #!in& either technical or f#n'a*ental anal-!i! can
con!i!tentl- o#t%erfor* a !trate&- of !i*%l- b#-in& an' hol'in& a 'i$er!ifie'
%ortfolio of !ec#ritie!) !#ch a! tho!e co*%ri!in& the %o%#lar *ar"et in'e.e!.
c. Portfolio *ana&er! ha$e !e$eral role! an' re!%on!ibilitie! e$en in %erfectl- efficient
*ar"et!. The *o!t i*%ortant re!%on!ibilit- i! to i'entif- the ri!"?ret#rn ob;ecti$e!
for a %ortfolio &i$en the in$e!tor,! con!traint!. In an efficient *ar"et) %ortfolio
*ana&er! are re!%on!ible for tailorin& the %ortfolio to *eet the in$e!tor,! nee'!)
rather than to beat the *ar"et) hich re=#ire! i'entif-in& the client,! ret#rn
re=#ire*ent! an' ri!" tolerance. Rational %ortfolio *ana&e*ent al!o re=#ire!
e.a*inin& the in$e!tor,! con!traint!) incl#'in& li=#i'it-) ti*e hori(on) la! an'
re&#lation!) ta.e!) an' #ni=#e %reference! an' circ#*!tance! !#ch a! a&e an'
e*%lo-*ent.
14. a. The earnin&! >an' 'i$i'en'@ &roth rate of &roth !toc"! *a- be con!i!tentl-
o$ere!ti*ate' b- in$e!tor!. In$e!tor! *a- e.tra%olate recent &roth too far into
the f#t#re an' thereb- 'on%la- the ine$itable !lo'on. At an- &i$en ti*e)
&roth !toc"! are li"el- to re$ert to >loer@ *ean ret#rn! an' $al#e !toc"! are
li"el- to re$ert to >hi&her@ *ean ret#rn!) often o$er an e.ten'e' f#t#re ti*e
hori(on.
b. In efficient *ar"et!) the c#rrent %rice! of !toc"! alrea'- reflect all "non rele$ant
infor*ation. In thi! !it#ation) &roth !toc"! an' $al#e !toc"! %ro$i'e the !a*e ri!"/
a';#!te' e.%ecte' ret#rn.
11/A