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SUMMARY
Statisticalresearchhasshownthattoacloseapproximationstockpricesseemtofollowarandomwalk
withnodiscerniblepredictablepatternsthatinvestorscanexploit.Suchfindingsarenowtakentobe
evidenceofmarketefficiency,thatis,evidencethatmarketpricesreflectallcurrentlyavailable
information.Onlynewinformationwillmovestockprices,andthisinformationisequallylikelytobe
goodnewsorbadnews.
Marketparticipantsdistinguishamongthreeformsoftheefficientmarkethypothesis.Theweakform
assertsthatallinformationtobederivedfrompasttradingdataalreadyisreflectedinstockprices.The
semistrongformclaimsthatallpubliclyavailableinformationisalreadyreflected.Thestrongform,which
generallyisacknowledgedtobeextreme,assertsthatallinformation,includinginsiderinformation,is
reflectedinprices.
Technicalanalysisfocusesonstockpricepatternsandonproxiesforbuyorsellpressureinthemarket.
Fundamentalanalysisfocusesonthedeterminantsoftheunderlyingvalueofthefirm,suchascurrent
profitabilityandgrowthprospects.Becausebothtypesofanalysisarebasedonpublicinformation,neither
shouldgenerateexcessprofitsifmarketsareoperatingefficiently.
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Proponentsoftheefficientmarkethypothesisoftenadvocatepassiveasopposedtoactiveinvestment
strategies.Thepolicyofpassiveinvestorsistobuyandholdabroadbasedmarketindex.Theyexpend
resourcesneitheronmarketresearchnoronfrequentpurchaseandsaleofstocks.Passivestrategiesmay
betailoredtomeetindividualinvestorrequirements.
Empiricalstudiesoftechnicalanalysisdonotgenerallysupportthehypothesisthatsuchanalysiscan
generatesuperiortradingprofits.Onenotableexceptiontothisconclusionistheapparentsuccessof
momentumbasedstrategiesoverintermediatetermhorizons.
Severalanomaliesregardingfundamentalanalysishavebeenuncovered.TheseincludetheP/Eeffect,the
smallfirminJanuaryeffect,theneglectedfirmeffect,postearningsannouncementpricedrift,andthe
booktomarketeffect.Whethertheseanomaliesrepresentmarketinefficiencyorpoorlyunderstoodrisk
premiumsisstillamatterofdebate.
Byandlarge,theperformancerecordofprofessionallymanagedfundslendslittlecredencetoclaimsthat
mostprofessionalscanconsistentlybeatthemarket.
KEYTERMS
anomalies,245
booktomarketeffect,246
efficientmarkethypothesis,233
fundamentalanalysis,238
indexfund,239
momentumeffect,243
neglectedfirmeffect,246
passiveinvestmentstrategy,239
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P/Eeffect,245
randomwalk,233
resistancelevel,237
reversaleffect,244
semistrongformEMH,236
smallfirmeffect,245
strongformEMH,236
supportlevel,237
technicalanalysis,237
weakformEMH,236
PROBLEMSETS
SelectproblemsareavailableinMcGrawHill'sConnect.Pleaseseethe
Supplementssectionofthebook'sfrontmatterformoreinformation.
1. Ifmarketsareefficient,whatshouldbethecorrelationcoefficientbetweenstockreturnsfortwo
nonoverlappingtimeperiods?(LO81)
2. Ifallsecuritiesarefairlypriced,allmustofferequalexpectedratesofreturn.Comment.(LO81)
3. Ifpricesareaslikelytoincreaseasdecrease,whydoinvestorsearnpositivereturnsfromthemarketon
average?(LO81)
4. AsuccessfulfirmlikeMicrosofthasconsistentlygeneratedlargeprofitsforyears.Isthisaviolationofthe
EMH?(LO82)
5. Atacocktailparty,yourcoworkertellsyouthathehasbeatenthemarketforeachofthelastthreeyears.
Supposeyoubelievehim.Doesthisshakeyourbeliefinefficientmarkets?(LO82)
6. Whichofthefollowingstatementsaretrueiftheefficientmarkethypothesisholds?(LO81)
a. Itimpliesthatfutureeventscanbeforecastwithperfectaccuracy.
b. Itimpliesthatpricesreflectallavailableinformation.

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c. Itimpliesthatsecuritypriceschangefornodiscerniblereason.
d. Itimpliesthatpricesdonotfluctuate.

7. Inanefficientmarket,professionalportfoliomanagementcanofferallofthefollowingbenefitsexcept
whichofthefollowing?(LO84)
a. Lowcostdiversification.
b. Atargetedrisklevel.
c. Lowcostrecordkeeping.
d. Asuperiorriskreturntradeoff.

8.

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Whichversionoftheefficientmarkethypothesis(weak,semistrong,orstrongform)focusesonthemost
inclusivesetofinformation?(LO81)

9. Highlyvariablestockpricessuggestthatthemarketdoesnotknowhowtopricestocks.Respond.(LO8
1)
10.
Whichofthefollowingsourcesofmarketinefficiencywouldbemosteasilyexploited?(LO
84)
a. Astockpricedropssuddenlyduetoalargeblocksalebyaninstitution.
b. Astockisoverpricedbecausetradersarerestrictedfromshortsales.
c. Stocksareovervaluedbecauseinvestorsareexuberantoverincreasedproductivityintheeconomy.

11. Whichofthefollowingmostappearstocontradictthepropositionthatthestockmarketisweaklyefficient?
Explain.(LO83)
a. Over25%ofmutualfundsoutperformthemarketonaverage.
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b. Insidersearnabnormaltradingprofits.
c. EveryJanuary,thestockmarketearnsabnormalreturns.

12. Supposethat,afterconductingananalysisofpaststockprices,youcomeupwiththefollowing
observations.Whichwouldappeartocontradicttheweakformoftheefficientmarkethypothesis?Explain.
(LO83)
a. Theaveragerateofreturnissignificantlygreaterthanzero.
b. Thecorrelationbetweenthereturnduringagivenweekandthereturnduringthefollowingweekis
zero.
c. Onecouldhavemadesuperiorreturnsbybuyingstockaftera10%riseinpriceandsellingaftera10%
fall.
d. Onecouldhavemadehigherthanaveragecapitalgainsbyholdingstockswithlowdividendyields.

13. Whichofthefollowingobservationswouldprovideevidenceagainstthesemistrongformoftheefficient
markettheory?Explain.(LO83)
a. Mutualfundmanagersdonotonaveragemakesuperiorreturns.
b. Youcannotmakesuperiorprofitsbybuying(orselling)stocksaftertheannouncementofanabnormal
riseindividends.
c. LowP/Estockstendtohavepositiveabnormalreturns.
d. Inanyyearapproximately50%ofpensionfundsoutperformthemarket.

14. SteadyGrowthIndustrieshasnevermissedadividendpaymentinits94yearhistory.Doesthismakeit
moreattractivetoyouasapossiblepurchaseforyourstockportfolio?(LO84)
15. Supposeyoufindthatpricesofstocksbeforelargedividendincreasesshowonaverageconsistently
positiveabnormalreturns.IsthisaviolationoftheEMH?(LO83)
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16. Ifthebusinesscycleispredictable,andastockhasapositivebeta,thestock'sreturnsalsomustbe
predictable.Respond.(LO81)
17. Whichofthefollowingphenomenawouldbeeitherconsistentwithoraviolationoftheefficientmarket
hypothesis?Explainbriefly.(LO83)
a. NearlyhalfofallprofessionallymanagedmutualfundsareabletooutperformtheS&P500inatypical
year.
b. Moneymanagerswhooutperformthemarket(onariskadjustedbasis)inoneyeararelikelyto
outperforminthefollowingyear.
c. StockpricestendtobepredictablymorevolatileinJanuarythaninothermonths.
d. StockpricesofcompaniesthatannounceincreasedearningsinJanuarytendtooutperformthemarketin
February.
e. Stocksthatperformwellinoneweekperformpoorlyinthefollowingweek.

18. Whyarethefollowingeffectsconsideredefficientmarketanomalies?Arethererationalexplanationsfor
theseeffects?(LO82)
a. P/Eeffect
b. Booktomarketeffect
c.

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Momentumeffect

d. Smallfirmeffect

19. Dollarcostaveragingmeansthatyoubuyequaldollaramountsofastockeveryperiod,forexample,$500
permonth.Thestrategyisbasedontheideathatwhenthestockpriceislow,yourfixedmonthlypurchase
willbuymoreshares,andwhenthepriceishigh,fewershares.Averagingovertime,youwillendup
buyingmoreshareswhenthestockischeaperandfewerwhenitisrelativelyexpensive.Therefore,by
design,youwillexhibitgoodmarkettiming.Evaluatethisstrategy.(LO84)
20. Weknowthatthemarketshouldrespondpositivelytogoodnewsandthatgoodnewseventssuchasthe
comingendofarecessioncanbepredictedwithatleastsomeaccuracy.Why,then,canwenotpredictthat
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themarketwillgoupastheeconomyrecovers?(LO81)
21. YouknowthatfirmXYZisverypoorlyrun.Onascaleof1(worst)to10(best),youwouldgiveitascore
of3.Themarketconsensusevaluationisthatthemanagementscoreisonly2.Shouldyoubuyorsellthe
stock?(LO84)
22. GoodNews,Inc.,justannouncedanincreaseinitsannualearnings,yetitsstockpricefell.Istherea
rationalexplanationforthisphenomenon?(LO81)
23. SharesofsmallfirmswiththinlytradedstockstendtoshowpositiveCAPMalphas.Isthisaviolationofthe
efficientmarkethypothesis?(LO83)
Challenge
24. Examinetheaccompanyingfigure,whichpresentscumulativeabnormalreturnsbothbeforeandafterdates
onwhichinsidersbuyorsellsharesintheirfirms.Howdoyouinterpretthisfigure?Whatarewetomake
ofthepatternofCARsbeforeandaftertheeventdate?(LO83)

25.

Source:NejatH.Seyhun,Insiders,Profits,CostsofTradingandMarketEfficiency,JournalofFinancial
Economics16pp.189212.
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Supposethatastheeconomymovesthroughabusinesscycle,riskpremiumsalsochange.Forexample,ina
recessionwhenpeopleareconcernedabouttheirjobs,risktolerancemightbelowerandriskpremiums
mightbehigher.Inaboomingeconomy,toleranceforriskmightbehigherandriskpremiumslower.(LO8
3)
a. Wouldapredictablyshiftingriskpremiumsuchasdescribedherebeaviolationoftheefficientmarket
hypothesis?

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b. Howmightacycleofincreasinganddecreasingriskpremiumscreateanappearancethatstockprices
overreact,firstfallingexcessivelyandthenseemingtorecover?

CFAProblems
1. Thesemistrongformoftheefficientmarkethypothesisassertsthatstockprices:(LO81)
a. Fullyreflectallhistoricalpriceinformation.
b. Fullyreflectallpubliclyavailableinformation.
c. Fullyreflectallrelevantinformationincludinginsiderinformation.
d. Maybepredictable.

2. Assumethatacompanyannouncesanunexpectedlylargecashdividendtoitsshareholders.Inanefficient
marketwithoutinformationleakage,onemightexpect:(LO81)
a. Anabnormalpricechangeattheannouncement.
b. Anabnormalpriceincreasebeforetheannouncement.
c. Anabnormalpricedecreaseaftertheannouncement.
d. Noabnormalpricechangebeforeoraftertheannouncement.

3. Whichoneofthefollowingwouldprovideevidenceagainstthesemistrongformoftheefficientmarket
theory?(LO83)
a. About50%ofpensionfundsoutperformthemarketinanyyear.
b. Youcannotmakeabnormalprofitsbybuyingstocksafteranannouncementofstrongearnings.
c. Trendanalysisisworthlessinforecastingstockprices.

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d. LowP/Estockstendtohavepositiveabnormalreturnsoverthelongrun.

4. Accordingtotheefficientmarkethypothesis:(LO83)
a. Highbetastocksareconsistentlyoverpriced.
b. Lowbetastocksareconsistentlyoverpriced.
c. Positivealphasonstockswillquicklydisappear.
d. Negativealphastocksconsistentlyyieldlowreturnsforarbitrageurs.

5. Arandomwalkoccurswhen:(LO81)
a. Stockpricechangesarerandombutpredictable.
b. Stockpricesrespondslowlytobothnewandoldinformation.
c. Futurepricechangesareuncorrelatedwithpastpricechanges.
d. Pastinformationisusefulinpredictingfutureprices.

6. Amarketanomalyrefersto:(LO83)
a. Anexogenousshocktothemarketthatissharpbutnotpersistent.
b. Apriceorvolumeeventthatisinconsistentwithhistoricalpriceorvolumetrends.
c. Atradingorpricingstructurethatinterfereswithefficientbuyingandsellingofsecurities.
d. Pricebehaviorthatdiffersfromthebehaviorpredictedbytheefficientmarkethypothesis.

7. Somescholarscontendthatprofessionalmanagersareincapableofoutperformingthemarket.Otherscome
toanoppositeconclusion.Compareandcontrasttheassumptionsaboutthestockmarketthatsupport(a)
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passiveportfoliomanagementand(b)activeportfoliomanagement.(LO82)
8.

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Youareaportfoliomanagermeetingaclient.Duringtheconversationthatfollowsyourformalreviewof
heraccount,yourclientasksthefollowingquestion:(LO82)
Mygrandson,whoisstudyinginvestments,tellsmethatoneofthebestwaystomakemoneyinthestock
marketistobuythestocksofsmallcapitalizationfirmslateinDecemberandtosellthestocksonemonth
later.Whatishetalkingabout?
a. Identifytheapparentmarketanomaliesthatwouldjustifytheproposedstrategy.
b. Explainwhyyoubelievesuchastrategymightormightnotworkinthefuture.

9.
a. Brieflyexplaintheconceptoftheefficientmarkethypothesis(EMH)andeachofitsthreeformsweak,
semistrong,andstrongandbrieflydiscussthedegreetowhichexistingempiricalevidencesupports
eachofthethreeformsoftheEMH.(LO82)
b. Brieflydiscusstheimplicationsoftheefficientmarkethypothesisforinvestmentpolicyasitappliesto:
(LO84)
i. Technicalanalysisintheformofcharting.
ii. Fundamentalanalysis.

c. Brieflyexplaintherolesorresponsibilitiesofportfoliomanagersinanefficientmarketenvironment.
(LO84)

10. Growthandvaluecanbedefinedinseveralways.Growthusuallyconveystheideaofaportfolio
emphasizingorincludingonlycompaniesbelievedtopossessaboveaveragefutureratesofpershare
earningsgrowth.Lowcurrentyield,highpricetobookratios,andhighpricetoearningsratiosaretypical
characteristicsofsuchportfolios.Valueusuallyconveystheideaofportfoliosemphasizingorincluding
onlyissuescurrentlyshowinglowpricetobookratios,lowpricetoearningsratios,aboveaveragelevels
ofdividendyield,andmarketpricesbelievedtobebelowtheissues'intrinsicvalues.(LO83)
a. Identifyandprovidereasonswhy,overanextendedperiodoftime,valuestockinvestingmight
outperformgrowthstockinvesting.
b.
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Explainwhytheoutcomesuggestedin(a)shouldnotbepossibleinamarketwidelyregardedasbeing
highlyefficient.

11. Yourinvestmentclientasksforinformationconcerningthebenefitsofactiveportfoliomanagement.Sheis
particularlyinterestedinthequestionofwhetheractivemanagerscanbeexpectedtoconsistentlyexploit
inefficienciesinthecapitalmarketstoproduceaboveaveragereturnswithoutassuminghigherrisk.
Thesemistrongformoftheefficientmarkethypothesisassertsthatallpubliclyavailableinformationis
rapidlyandcorrectlyreflectedinsecuritiesprices.Thisimpliesthatinvestorscannotexpecttoderive
aboveaverageprofitsfrompurchasesmadeafterinformationhasbecomepublicbecausesecurityprices
alreadyreflecttheinformation'sfulleffects.(LO82)
a. IdentifyandexplaintwoexamplesofempiricalevidencethattendtosupporttheEMHimplication
statedabove.
b. IdentifyandexplaintwoexamplesofempiricalevidencethattendtorefutetheEMHimplicationstated
above.
c. Discussreasonswhyaninvestormightchoosenottoindexevenifthemarketswere,infact,
semistrongformefficient.
WEBmaster
1. Usedatafromfinance.yahoo.comtoanswerthefollowingquestions.
a. Collectthefollowingdatafor25firmsofyourchoosing.
i. Booktomarketratio.
ii. Priceearningsratio.
iii. Marketcapitalization(size).
iv. Pricecashflowratio(i.e,marketcapitalization/operatingcashflow).
v. Anothercriterionthatinterestsyou.
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YoucanfindthisinformationbychoosingacompanyandthenclickingonKeyStatistics.Rankthefirms
basedoneachofthecriteriaseparately,anddividethefirmsintofivegroupsbasedontheirrankingfor
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eachcriterion.Calculatetheaveragerateofreturnforeachgroupoffirms.
Doyouconfirmorrejectanyoftheanomaliescitedinthischapter?Canyouuncoveranewanomaly?
Note:Foryourtesttobevalid,youmustformyourportfoliosbasedoncriteriaobservedatthebeginning
oftheperiodwhenyouformthestockgroups.Why?
b. UsethepricehistoryfromtheHistoricalPricestabtocalculatethebetaofeachofthefirmsinpart(a).
Usethisbeta,theTbillrate,andthereturnontheS&P500tocalculatetheriskadjustedabnormalreturn
ofeachstockgroup.Doesanyanomalyuncoveredinthepreviousquestionpersistaftercontrollingfor
risk?
c. Nowformstockgroupsthatusetwocriteriasimultaneously.Forexample,formaportfolioofstocksthat
arebothinthelowestquintileofpriceearningsratioandinthehighestquintileofbooktomarketratio.
Doesselectingstocksbasedonmorethanonecharacteristicimproveyourabilitytodeviseportfolioswith
abnormalreturns?Repeattheanalysisbyforminggroupsthatmeetthreecriteriasimultaneously.Does
thisyieldanyfurtherimprovementinabnormalreturns?
SOLUTIONSTO
CONCEPTchecks
8.1
a. Ahighlevelmanagermightwellhaveprivateinformationaboutthefirm.Herabilitytotradeprofitably
onthatinformationisnotsurprising.Thisabilitydoesnotviolateweakformefficiency:Theabnormal
profitsarenotderivedfromananalysisofpastpriceandtradingdata.Iftheywere,thiswouldindicate
thatthereisvaluableinformationthatcanbegleanedfromsuchanalysis.Butthisabilitydoesviolate
strongformefficiency.Apparently,thereissomeprivateinformationthatisnotalreadyreflectedin
stockprices.
b. Theinformationsetsthatpertaintotheweak,semistrong,andstrongformoftheEMHcanbedescribed
bythefollowingillustration:

Theweakforminformationsetincludesonlythehistoryofpricesandvolumes.Thesemistrongform
setincludestheweakformsetplusallotherpubliclyavailableinformation.Inturn,thestrongformset
includesthesemistrongsetplusinsiders'information.Itisillegaltoactonthisincrementalinformation
(insiders'privateinformation).Thedirectionofvalidimplicationis

Thereversedirectionimplicationisnotvalid.Forexample,stockpricesmayreflectallpastpricedata
(weakformefficiency)butmaynotreflectrelevantfundamentaldata(semistrongforminefficiency).
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8.2 Thepointwemadeintheprecedingdiscussionisthattheveryfactthatweobservestockpricesnearso
calledresistancelevelsbeliestheassumptionthatthepricecanbearesistancelevel.Ifastockisobserved
tosellatanyprice,theninvestorsmustbelievethatafairrateofreturncanbeearnedifthestockis
purchasedatthatprice.Itislogicallyimpossibleforastocktohavearesistancelevelandofferafairrateof
returnatpricesjustbelowtheresistancelevel.Ifweacceptthatpricesareappropriate,wemustrejectany
presumptionconcerningresistancelevels.
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Ifeveryonefollowsapassivestrategy,soonerorlaterpriceswillfailtoreflectnewinformation.Atthis
pointthereareprofitopportunitiesforactiveinvestorswhouncovermispricedsecurities.Astheybuyand
selltheseassets,pricesagainwillbedriventofairlevels.

8.4 Theanswerdependsonyourpriorbeliefsaboutmarketefficiency.Miller'sinitialrecordwasincredibly
strong.Ontheotherhand,withsomanyfundsinexistence,itislesssurprisingthatsomefundwould
appeartobeconsistentlysuperiorafterthefact.Exceptionalpastperformanceofasmallnumberof
managersispossiblebychanceeveninanefficientmarket.Abettertestisprovidedincontinuation
studies.Arebetterperformersinoneperiodmorelikelytorepeatthatperformanceinlaterperiods?
Miller'srecordinthelastthreeyearsfailsthecontinuationorconsistencycriterion.

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