Class notes
Fin 3710 Chapter 8 Notes
- Course
- FIN 3710
- Institution
- Baruch College
This is a comprehensive and detailed note on Chapter 8; the efficient market hypothesis fin 3710. *Essential Study Material!!
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Chapter 08 - The Efficient Market HypothesisCHAPTER 08
THE EFFICIENT MARKET HYPOTHESIS
1. The correlation coefficient should be zero. If it were not zero, then one could use
returns from one period to predict returns in later periods and therefore earn abnormal
profits.
2. The phrase would be correct if it were modified to say “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.
3. 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 0.03% 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 cumulate, and upward moves are indeed more likely than downward ones.
4. 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.
5. 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.
6. b. This is the definition of an efficient market.
7. d. It is not possible to offer a higher risk-return trade off if markets are efficient.
8. Strong-form efficiency includes all information: historical, public, and private.
9. 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.
10. 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.
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
, Chapter 08 - The Efficient Market Hypothesis
11. c. This is a predictable pattern of returns, which should not occur if the stock market is
weakly efficient.
12. c. This is a filter rule, a classic technical trading rule, which would appear to contradict
the weak form of the efficient market hypothesis.
13. c. The P/E ratio is public information so this observation would provide evidence
against the semi-strong form of the efficient market theory.
14. No, it is not more attractive as a possible purchase. Any value associated with dividend
predictability is already reflected in the stock price.
15. 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. The phenomenon
instead reflects the fact that dividends occur as a response to good performance. After
the fact, the stocks that happen to have performed the best will pay higher dividends,
but this does not imply that you can identify the best performers early enough to earn
abnormal returns.
16. 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.
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Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
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