Chapter 13
Efficient Markets and Behavioral Finance
Multiple Choice Questions
1. A small business is receiving a five-year $1,000,000 loan at a subsidized rate of 3% per year. The firm will pay 3% annual interest payment each year and the principal at the end of five years. If market interest rate on similar loans is 6% per year, what is the NPV of the loan? (Ignore taxes.)
A. +$127,371 B. +$348,369 C. -$501,595
D. None of the above
2. A large firm is receiving a loan guarantee from the government. Because of the guarantee, the firm is able to borrow $50 million for five years at 8% interest rate per year instead of 10% per year. Calculate the value of the guarantee to the firm. (Ignore taxes.)
A. +$53.79 million B. +$3.79 million C. -$3.79 million D. None of the above
3. If the capital markets are efficient, then the sale or purchase of any security at the prevailing market price is:
A. Always a positive NPV transaction B. Generally a zero NPV transaction C. Is always a negative NPV transaction D. None of the above
4. Financing decisions differ from investment decisions for which of the following reasons? I) You cannot use NPV to evaluate financing decisions
II) The market for financial assets is more active
III) It is easier to find financing decisions with positive NPV than to find investment decisions with positive NPV
A. I only B. II only C. III only D. I and III only
5. Financing decisions differ from investment decisions because: I) it is easy to reverse a financing decision
II) the market for financial assets is very competitive III) generally, financing decisions have zero NPV A. I only
B. I and II only C. I, II, and III D. II and III only
6. Generally, a firm is able to find positive NPV opportunities with: I) Financing decisions
II) Capital investment decisions III) Short-term borrowing decisions A. I only
B. I and III only C. III only D. II only
7. The statement that stock prices follow a random walk implies that: I) Successive price changes are independent of each other
II) Successive price changes are positively related III) Successive price changes are negatively related IV) The autocorrelation coefficient is either +1 or -1 A. I only
B. II and III only C. IV only D. III only
8. A random walk process consists of the toss of a fair coin at the end of each day. If the outcome is heads stock price increases by 1.25% and if the outcome is tails the stock price decreases by 0.75%. What is the drift of such a process?
A. +1.25% B. -0.75% C. +0.25%
D. None of the above
9. The statement that stock prices follow a random walk implies that:
I) The correlation coefficient between successive price changes (auto correlation) is not significantly different from zero.
II) Successive price changes are positively related. III) Successive price changes are negatively related. IV) The autocorrelation coefficient is positive. A. I only
B. II only
C. II and III only D. IV only
10. Stock price cycles or patterns self-destruct as soon as investors recognize them through: A. stock market regulation by the Securities and Exchange Commission (SEC)
B. price fixing by the specialists on New York Stock Exchange C. trading by the investors
11. Which of the following is a statement of weak form efficiency?
I) If markets are efficient in the weak form, then it is impossible to make consistently superior profits by using trading rules based on past returns
II) If the markets are efficient in the weak form, then prices will adjust immediately to public information
III) If the markets are efficient in the weak form, then prices reflect all information A. I only
B. II only
C. II and III only D. III only
12. Different forms of market efficiency are: I) Weak form
II) Semi-strong form III) Strong form A. I only
B. I and II only C. I and III only D. I, II and III
13. Which of the following statement(s) is/are true if the efficient market hypothesis holds? I) It implies perfect forecasting ability
II) It implies market is irrational
III) It implies that prices follow a particular pattern IV) It implies that prices reflect all available information A. I only
B. II only C. I and III only D. IV only
14. Strong form market efficiency states that the market incorporates all information in the stock price. Strong form efficiency implies that:
I) An investor can only earn risk-free rates of return II) An investor can always rely on technical analysis
III) An insider or corporate officer can not outperform the market by trading on the inside information
A. I only B. II only C. III only D. I, II, and III
15. If the weak form of market efficiency holds then: I) Technical analysis is useless
II) Stock prices reflect information contained in past prices III) Stock price changes follow a random walk
A. I only B. I and II only C. I, II, and III D. I and III only
16. Which of the following is a statement of semi-strong form efficiency?
I) If the markets are efficient in the semi-strong form then prices will adjust immediately to public information
II) If the markets are efficient in the semi-strong form then prices reflect all information III) If the markets are efficient in the semi-strong form then prices will adjust to newly published information after a long time delay
A. I only B. II only
C. II and III only D. III only
17. If the efficient market hypothesis holds, investors should expect: I) to receive a fair price for their security
II) to earn a normal rate of return on their investments III) to be able to pick stocks that will outperform the market A. I only
B. II only C. III only D. I and II only
18. Predictable cycles in stock price movements: I) persist for a long time
II) self destruct as soon as investors recognize them
III) never appear as the stock price movements are random A. I only
B. II only C. III only D. I, II, and III
19. Informational efficiency in financial markets result in stock prices being: A. higher
B. lower C. fairer
D. none of the above
20. Weak form efficiency implies that past stock price(s) A. patterns tend to repeat itself in the future
B. are major inputs to the investors for forming trading strategies C. do not matter
D. none of the above
21. If the markets are efficient, which of the following investors should have above normal return on assets over time?
A. Those who choose their stocks by throwing darts at a list of stocks found in the financial pages of a newspaper.
B. Analysts who spend considerable time evaluating the best stocks to buy. C. Mutual fund managers who manage other people's money for a living. D. None of the above
22. One important implication of the efficient markets hypothesis is that: A. investors should hold a diversified portfolio and avoid active trading. B. investors can benefit by engaging in day trading.
C. investors should trade actively help to ensure the highest overall gain in their portfolios. D. all of the above.
23. The semi-strong form of efficiency deals with the following type of information: A. insider information
B. publicly available information C. privileged information
D. all of the above
24. The semi-strong form of has been tested by measuring how rapidly security prices react various news items like:
I) earnings announcements II) dividend announcements III) news of takeovers
IV) macroeconomic information A. I and II only
B. I, II and III only C. IV only
D. I, II, III and IV
25. Adjusted stock return is calculated as: A. actual stock return-expected stock return B. return on stock-return on market
C. return on stock for the current period-return on stock for the previous period D. none of the above
26. In order to test the efficient-market hypothesis in the weak form, researchers have used the following methods except:
A. Estimation of the serial correlation (autocorrelation) for securities and markets B. Measurement of the profitability of trading rules used by technical analysts C. Measurement of how rapidly security prices adjust to different news items D. All of the above are methods used for testing weak-form market efficiency
27. Abnormal stock return is calculated as: A. actual stock return-expected stock return B. return on stock-return on market
C. return on stock for the current period-return on stock for the previous period D. none of the above
28. In order to test the efficient-market hypothesis in the semi-strong form, researchers have used (the):
A. Estimation of the serial correlation (autocorrelation) for securities and markets B. Measurement of the performance of mutual fund managers over the years C. Measurement of how rapidly security prices adjust to different news items D. All of the above
29. Analysis of past monthly movements in Wal-Mart's stock price has produced the following estimates: α = -0.45% and β = 0. 5. If the market index subsequently rises by 5% one month and Mart's stock price rises by 3%, what is the abnormal change in Wal-Mart's stock price?
A. -0.95% B. +0.95% C. +0.05%
30. Analysis of past monthly movements in IBM's stock price produces the following estimates: α = 2. 5% and β = 1. 6. If the market index subsequently rises by 12% in one month and IBM's stock price increases by 20%, what is the abnormal change in IBM's stock price?
A. +1.7% B. +8% C. -1.7%
D. None of the above
31. If the abnormal return for a stock during the first week is +5% and during the second week is +3%, what is the abnormal return for the two-week period?
A. 5% B. 3% C. 8.15%
D. None of the above
32. The "event study" methodology is used in the test of: A. weak form efficiency
B. semi-strong form efficiency C. strong form efficiency D. none of the above
33. In order to test the strong form of market efficiency, researchers have: I) examined the recommendations of professional security analysts II) performance of mutual funds
III) performance of pension funds A. I only
B. I and II only C. I, II, and III only D. II and III only
34. Which of the following observations would provide evidence against the strong form of efficient market theory?
I) Mutual fund managers do not on average make superior returns
II) In any year approximately 50% of all pension funds outperform the market III) Managers who trade in their own firm's stocks make superior returns A. I only
B. II only C. III only D. I and II only
35. A lawyer works for a firm that advises corporate firms planning to sue other corporations for antitrust damages. He finds that he can "beat the market" by short selling the stock of the firm that will be sued. This finding is in violation of the:
A. Weak form market efficiency B. Semi-strong form market efficiency C. Strong form market efficiency D. None of the above
36. Strong-form efficiency implies that mutual fund managers:
A. Buy the index that maximizes diversification and minimizes cost of managing portfolios B. Actively seek under performing stocks and buy them
C. Fund mangers can consistently earn superior returns year after year D. None of the above
37. The following are anomalies associated with market efficiency except: I) the small-firm effect
II) the earnings announcement puzzle III) the new-issue puzzle
IV) trading rules based on patterns A. I only
B. I and II only C. I, II, and III only D. IV only
38. The annual expected dividend on the S&P index was about 154.6. If the dividend is expected to grow at a steady rate of 8% a year and the required annual rate of return is 10%, what is the value of the index?
A. 1193 B. 1700 C. 7730
D. None of the above
39. The various lessons of market efficiency are: I) Markets have no memory
II) Trust market prices III) Read the entrails
IV) There are no financial illusions V) The do-it yourself alternative VI) Seen one stock, seen them all A. I and II only
B. I, II, III and IV only C. I, II, III, IV and V only D. I, II, III, IV, V and VI
40. Studies on behavioral finance have been developed using: A. market evidence
B. economic evidence C. psychological evidence D. none of the above
41. Investors are particularly averse to the possibility of even a very small loss and need a high return to compensate for it. Such a concept is related to what theory?
A. Market efficiency theory B. Random walk theory C. Convergence trading D. Prospect theory
42. Which theory offers an explanation for the crash of a stock market one day and its rebound the next?
A. Market efficiency theory B. Random walk theory C. Convergence trading D. Prospect theory
True / False Questions
43. For a corporation, financing decisions are harder to reverse than investment decisions. True False
44. If capital markets are efficient, then the purchase or sale of any security at the prevailing market price is never a positive-NPV transaction.
True False
45. In an efficient market, information is costless. True False
46. In a competitive market, security prices follow a random walk. True False
47. The weak form of efficient market theory implies that technical analysis is valuable. True False
48. When a firm announces a dividend change or publishes its latest earnings, the major part of the price adjustment takes place within a few minutes of the announcement.
True False
49. The small-firm effect is cited as evidence against market efficiency. True False
50. The evidence against market efficiency are called puzzles or anomalies. True False
51. Behavioral finance deals with the idea that individual investors have built-in biases and misconceptions that can drive prices away from fair values.
True False
52. In an efficient market, investors will not pay others what they can do equally well themselves.
True False
53. Behavioral finance and technical analysis are basically the same theory. True False
54. A majority of research supports the theory that past stock movements can predict future asset prices.
True False
Short Answer Questions
55. State the important differences between investment decisions and financing decisions.
56. Briefly explain why, in a competitive securities market, successive price changes are random.
57. List the three forms of market efficiency and explain the basis for it.
58. State the strong form of market efficiency.
59. State the weak form of market efficiency and its implications.
60. State the semi-strong form of market efficiency and its implications.
61. What are puzzles and anomalies?
62. Briefly discuss some of the important findings of behavioral finance studies.
63. List the six lessons of market efficiency.
64. How does the random walk theory explain market crashes?
Chapter 13 Efficient Markets and Behavioral Finance
Answer Key
Multiple Choice Questions
1. A small business is receiving a five-year $1,000,000 loan at a subsidized rate of 3% per year. The firm will pay 3% annual interest payment each year and the principal at the end of five years. If market interest rate on similar loans is 6% per year, what is the NPV of the loan? (Ignore taxes.)
A. +$127,371
B. +$348,369
C. -$501,595
D. None of the above
NPV = +1,000,000 - [((30,000/1.06) + . . + (30,000/(1.06^5)) + (1,000,000/(1.06^5))] = 126,371
Type: Medium
2. A large firm is receiving a loan guarantee from the government. Because of the guarantee, the firm is able to borrow $50 million for five years at 8% interest rate per year instead of 10% per year. Calculate the value of the guarantee to the firm. (Ignore taxes.)
A. +$53.79 million
B. +$3.79 million
C. -$3.79 million
D. None of the above
NPV = +50 - [(4.0/1.1) + . . . +(4.0/ (1.1^5)) + (50/ (1.1^5)] = +3.79
3. If the capital markets are efficient, then the sale or purchase of any security at the prevailing market price is:
A. Always a positive NPV transaction
B. Generally a zero NPV transaction
C. Is always a negative NPV transaction
D. None of the above
Type: Medium
4. Financing decisions differ from investment decisions for which of the following reasons? I) You cannot use NPV to evaluate financing decisions
II) The market for financial assets is more active
III) It is easier to find financing decisions with positive NPV than to find investment decisions with positive NPV
A. I only
B. II only
C. III only
D. I and III only
Type: Easy
5. Financing decisions differ from investment decisions because: I) it is easy to reverse a financing decision
II) the market for financial assets is very competitive III) generally, financing decisions have zero NPV
A. I only
B. I and II only
C. I, II, and III
D. II and III only
6. Generally, a firm is able to find positive NPV opportunities with: I) Financing decisions
II) Capital investment decisions III) Short-term borrowing decisions
A. I only
B. I and III only
C. III only
D. II only
Type: Easy
7. The statement that stock prices follow a random walk implies that: I) Successive price changes are independent of each other
II) Successive price changes are positively related III) Successive price changes are negatively related IV) The autocorrelation coefficient is either +1 or -1
A. I only
B. II and III only
C. IV only
D. III only
Type: Medium
8. A random walk process consists of the toss of a fair coin at the end of each day. If the outcome is heads stock price increases by 1.25% and if the outcome is tails the stock price decreases by 0.75%. What is the drift of such a process?
A. +1.25%
B. -0.75%
C. +0.25%
D. None of the above
Drift = (0.5)(1.25) + (0.5)(-0.75) = +0.25%
9. The statement that stock prices follow a random walk implies that:
I) The correlation coefficient between successive price changes (auto correlation) is not significantly different from zero.
II) Successive price changes are positively related. III) Successive price changes are negatively related. IV) The autocorrelation coefficient is positive.
A. I only
B. II only
C. II and III only
D. IV only
Type: Medium
10. Stock price cycles or patterns self-destruct as soon as investors recognize them through:
A. stock market regulation by the Securities and Exchange Commission (SEC)
B. price fixing by the specialists on New York Stock Exchange
C. trading by the investors
D. none of the above
Type: Medium
11. Which of the following is a statement of weak form efficiency?
I) If markets are efficient in the weak form, then it is impossible to make consistently superior profits by using trading rules based on past returns
II) If the markets are efficient in the weak form, then prices will adjust immediately to public information
III) If the markets are efficient in the weak form, then prices reflect all information
A. I only
B. II only
C. II and III only
D. III only
12. Different forms of market efficiency are: I) Weak form
II) Semi-strong form III) Strong form
A. I only
B. I and II only
C. I and III only
D. I, II and III
Type: Easy
13. Which of the following statement(s) is/are true if the efficient market hypothesis holds? I) It implies perfect forecasting ability
II) It implies market is irrational
III) It implies that prices follow a particular pattern IV) It implies that prices reflect all available information
A. I only
B. II only
C. I and III only
D. IV only
Type: Medium
14. Strong form market efficiency states that the market incorporates all information in the stock price. Strong form efficiency implies that:
I) An investor can only earn risk-free rates of return II) An investor can always rely on technical analysis
III) An insider or corporate officer can not outperform the market by trading on the inside information
A. I only
B. II only
C. III only
D. I, II, and III
15. If the weak form of market efficiency holds then: I) Technical analysis is useless
II) Stock prices reflect information contained in past prices III) Stock price changes follow a random walk
A. I only
B. I and II only
C. I, II, and III
D. I and III only
Type: Medium
16. Which of the following is a statement of semi-strong form efficiency?
I) If the markets are efficient in the semi-strong form then prices will adjust immediately to public information
II) If the markets are efficient in the semi-strong form then prices reflect all information III) If the markets are efficient in the semi-strong form then prices will adjust to newly published information after a long time delay
A. I only
B. II only
C. II and III only
D. III only
Type: Easy
17. If the efficient market hypothesis holds, investors should expect: I) to receive a fair price for their security
II) to earn a normal rate of return on their investments III) to be able to pick stocks that will outperform the market
A. I only B. II only C. III only D. I and II only Type: Medium
18. Predictable cycles in stock price movements: I) persist for a long time
II) self destruct as soon as investors recognize them
III) never appear as the stock price movements are random
A. I only
B. II only
C. III only
D. I, II, and III
Type: Medium
19. Informational efficiency in financial markets result in stock prices being:
A. higher
B. lower
C. fairer
D. none of the above
Type: Easy
20. Weak form efficiency implies that past stock price(s)
A. patterns tend to repeat itself in the future
B. are major inputs to the investors for forming trading strategies
C. do not matter
D. none of the above
Type: Easy
21. If the markets are efficient, which of the following investors should have above normal return on assets over time?
A. Those who choose their stocks by throwing darts at a list of stocks found in the financial pages of a newspaper.
B. Analysts who spend considerable time evaluating the best stocks to buy.
22. One important implication of the efficient markets hypothesis is that:
A. investors should hold a diversified portfolio and avoid active trading.
B. investors can benefit by engaging in day trading.
C. investors should trade actively help to ensure the highest overall gain in their portfolios.
D. all of the above.
Type: Medium
23. The semi-strong form of efficiency deals with the following type of information:
A. insider information
B. publicly available information
C. privileged information
D. all of the above
Type: Medium
24. The semi-strong form of has been tested by measuring how rapidly security prices react various news items like:
I) earnings announcements II) dividend announcements III) news of takeovers
IV) macroeconomic information
A. I and II only
B. I, II and III only
C. IV only
D. I, II, III and IV
Type: Difficult
25. Adjusted stock return is calculated as:
A. actual stock return-expected stock return
B. return on stock-return on market
C. return on stock for the current period-return on stock for the previous period
D. none of the above
26. In order to test the efficient-market hypothesis in the weak form, researchers have used the following methods except:
A. Estimation of the serial correlation (autocorrelation) for securities and markets
B. Measurement of the profitability of trading rules used by technical analysts
C. Measurement of how rapidly security prices adjust to different news items
D. All of the above are methods used for testing weak-form market efficiency
Type: Medium
27. Abnormal stock return is calculated as:
A. actual stock return-expected stock return
B. return on stock-return on market
C. return on stock for the current period-return on stock for the previous period
D. none of the above
Type: Medium
28. In order to test the efficient-market hypothesis in the semi-strong form, researchers have used (the):
A. Estimation of the serial correlation (autocorrelation) for securities and markets
B. Measurement of the performance of mutual fund managers over the years
C. Measurement of how rapidly security prices adjust to different news items
D. All of the above
29. Analysis of past monthly movements in Wal-Mart's stock price has produced the following estimates: α = -0.45% and β = 0. 5. If the market index subsequently rises by 5% one month and Mart's stock price rises by 3%, what is the abnormal change in Wal-Mart's stock price?
A. -0.95%
B. +0.95%
C. +0.05%
D. None of the above
Expected change: - 0.45 + 0. 5(5) = 2.05; Abnormal return = 3 - 2.05 = +0.95%
Type: Medium
30. Analysis of past monthly movements in IBM's stock price produces the following estimates: α = 2. 5% and β = 1. 6. If the market index subsequently rises by 12% in one month and IBM's stock price increases by 20%, what is the abnormal change in IBM's stock price?
A. +1.7%
B. +8%
C. -1.7%
D. None of the above
Expected change = 2.5 + 1.6(12) = 21.7; Abnormal change = 20 - 21.7 = -1.7%
Type: Medium
31. If the abnormal return for a stock during the first week is +5% and during the second week is +3%, what is the abnormal return for the two-week period?
A. 5%
B. 3%
C. 8.15%
D. None of the above
Abnormal Return = (1.05)(1.03) - 1 = 8.15%
32. The "event study" methodology is used in the test of:
A. weak form efficiency
B. semi-strong form efficiency
C. strong form efficiency
D. none of the above
Type: Difficult
33. In order to test the strong form of market efficiency, researchers have: I) examined the recommendations of professional security analysts II) performance of mutual funds
III) performance of pension funds
A. I only
B. I and II only
C. I, II, and III only
D. II and III only
Type: Medium
34. Which of the following observations would provide evidence against the strong form of efficient market theory?
I) Mutual fund managers do not on average make superior returns
II) In any year approximately 50% of all pension funds outperform the market III) Managers who trade in their own firm's stocks make superior returns
A. I only B. II only C. III only D. I and II only Type: Medium
35. A lawyer works for a firm that advises corporate firms planning to sue other corporations for antitrust damages. He finds that he can "beat the market" by short selling the stock of the firm that will be sued. This finding is in violation of the:
A. Weak form market efficiency
B. Semi-strong form market efficiency
C. Strong form market efficiency
D. None of the above
Type: Medium
36. Strong-form efficiency implies that mutual fund managers:
A. Buy the index that maximizes diversification and minimizes cost of managing portfolios
B. Actively seek under performing stocks and buy them
C. Fund mangers can consistently earn superior returns year after year
D. None of the above
Type: Medium
37. The following are anomalies associated with market efficiency except: I) the small-firm effect
II) the earnings announcement puzzle III) the new-issue puzzle
IV) trading rules based on patterns
A. I only
B. I and II only
C. I, II, and III only
D. IV only
38. The annual expected dividend on the S&P index was about 154.6. If the dividend is expected to grow at a steady rate of 8% a year and the required annual rate of return is 10%, what is the value of the index?
A. 1193
B. 1700
C. 7730
D. None of the above
PV(Index) = 154.6/(0.12 - 0.1) = 7730
Type: Medium
39. The various lessons of market efficiency are: I) Markets have no memory
II) Trust market prices III) Read the entrails
IV) There are no financial illusions V) The do-it yourself alternative VI) Seen one stock, seen them all
A. I and II only
B. I, II, III and IV only
C. I, II, III, IV and V only
D. I, II, III, IV, V and VI
Type: Medium
40. Studies on behavioral finance have been developed using:
A. market evidence
B. economic evidence
C. psychological evidence
D. none of the above
41. Investors are particularly averse to the possibility of even a very small loss and need a high return to compensate for it. Such a concept is related to what theory?
A. Market efficiency theory
B. Random walk theory
C. Convergence trading
D. Prospect theory
Type: Easy
42. Which theory offers an explanation for the crash of a stock market one day and its rebound the next?
A. Market efficiency theory
B. Random walk theory
C. Convergence trading
D. Prospect theory
Type: Easy
True / False Questions
43. For a corporation, financing decisions are harder to reverse than investment decisions.
FALSE
Type: Medium
44. If capital markets are efficient, then the purchase or sale of any security at the prevailing market price is never a positive-NPV transaction.
TRUE
45. In an efficient market, information is costless.
FALSE
Type: Medium
46. In a competitive market, security prices follow a random walk.
TRUE
Type: Medium
47. The weak form of efficient market theory implies that technical analysis is valuable.
FALSE
Type: Medium
48. When a firm announces a dividend change or publishes its latest earnings, the major part of the price adjustment takes place within a few minutes of the announcement.
TRUE
Type: Medium
49. The small-firm effect is cited as evidence against market efficiency.
TRUE
Type: Easy
50. The evidence against market efficiency are called puzzles or anomalies.
51. Behavioral finance deals with the idea that individual investors have built-in biases and misconceptions that can drive prices away from fair values.
TRUE
Type: Medium
52. In an efficient market, investors will not pay others what they can do equally well themselves.
TRUE
Type: Medium
53. Behavioral finance and technical analysis are basically the same theory.
FALSE
Type: Medium
54. A majority of research supports the theory that past stock movements can predict future asset prices. FALSE Type: Medium
Short Answer Questions
55. State the important differences between investment decisions and financing decisions. Generally, investment decisions have positive NPVs, while financing decisions have zero NPV. Mostly, investment decisions are irreversible while financing decisions are reversible. Investment decisions are made in factor markets while financing decisions are made in financial markets.
Type: Easy
56. Briefly explain why, in a competitive securities market, successive price changes are random.
In a competitive market, prices reflect all available information. The only reason prices change is because of new information. By definition new information arrives randomly. Therefore security prices change randomly.
Type: Difficult
57. List the three forms of market efficiency and explain the basis for it. • Weak-form efficiency
• Semi-strong form efficiency • Strong form efficiency
These distinctions are based on the level of information reflected in the security prices. Weak-form efficiency deals with historical prices. Semi-strong Weak-form deals with publicly available information that also includes historical information. Lastly, strong-form which includes all information.
Type: Easy
59. State the weak form of market efficiency and its implications.
Security prices reflect the information contained in the record of past prices. This implies that prices will follow a random walk. It is impossible to make consistently superior profits by studying past returns.
Type: Medium
60. State the semi-strong form of market efficiency and its implications.
Security prices reflect all publicly available information. If markets are efficient in this sense, then prices will adjust immediately to public announcements.
Type: Medium
61. What are puzzles and anomalies?
Puzzles and anomalies are abnormal behavior of stocks that apparently contradict the efficient market hypothesis. There are quite a few of them. For example, stocks of small firms have provided abnormally high returns compared to stocks of large firms.
62. Briefly discuss some of the important findings of behavioral finance studies.
Behavioral finance studies have focused on three important areas: (1) limits to arbitrage, (2) attitudes toward risk, and (3) beliefs about probabilities.
Arbitrage is defined as a strategy that exploits market inefficiency and generates superior returns if and when the prices return to efficient market prices or equilibrium prices. If arbitrage is not powerful enough to drive all prices to equilibrium levels, it will result in mispricing. This is caused by investors' attitude towards risk and the way the investors assess probabilities. This has led to the development of "prospect theory." Most investors are either too conservative or overconfident. In other words, investors are not 100% rational 100% of the time. Thus behavioral finance provides new interpretations of some long-standing puzzles and anomalies.
Type: Medium
63. List the six lessons of market efficiency. • Markets have no memory
• Trust market prices • Read the entrails
• There are no financial illusions • The Do-it yourself alternative • Seen one stock, seen them all.
Type: Medium
64. How does the random walk theory explain market crashes?
Random walk theory relies upon the concept of a normal or lognormal distribution pattern for stocks. This requires that the stock price gains and losses reflect a normal distribution. For this to occur, there must, on rare occasion, be large movements in stock prices in either direction. Thus, a large drop in stock prices must occur for the movement to truly be random.
