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CHAPTER 12: MARKET EFFICIENCY AND BEHAVIORAL FINANCE 1. The correlation coefficient between stock returns for two non-overlapping periods should be zero. If not, one could use returns from one period to predict returns in later periods and make abnormal profits. 2. c.This is a predictable pattern in returns which should not occur if the weak-form EMH is valid. 3. c.This is a classic filter rule which should not produce superior returns in an efficient market. 4. b. This is the definition of an efficient market. 5. c.The P/E ratio is public information and should not be predictive of abnormal security returns. 6. b. Semi-strong form efficiency implies that market prices reflect all publicly available information concerning past trading history as well as fundamental aspects of the firm. 7. a.The full price adjustment should occur just as the news about the dividend becomes publicly available. 8. d. If low P/E stocks tend to have positive abnormal returns, this would represent an unexploited profit opportunity that would provide evidence that investors are not using all available information to make profitable investments. 9. c.In an efficient market, no securities are consistently overpriced or underpriced. While some securities will turn out after any investment period to have provided positive alphas (i.e., risk-adjusted abnormal returns) and some negative alphas, these past returns are not predictive of future returns. 10. c.A random walk implies that stock price changes are unpredictable, using past price changes or any other data. 12-1
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11. d. A gradual adjustment to fundamental values would allow for the use of strategies based on past price movements in order to generate abnormal profits. 12. a. 13. b. The contrarian technical analyst would notice that other investors have become deeply pessimistic about prices, and therefore would take this as a bullish indicator, reasoning that market sentiment swings too widely and that stock prices reflect a too-pessimistic view of the economy. 14. No. Microsoft’s continuing profitability does not imply that stock market investors who purchased Microsoft shares after its success was already evident would have earned an exceptionally high return on their investments. 15. The question regarding market efficiency is whether investors can earn abnormal risk-adjusted profits. If the stock price run-up occurs when only insiders are aware of the coming dividend increase, then it is a violation of strong-form, but not semistrong-form, efficiency. If the public already knows of the increase, then it is a violation of semistrong-form efficiency. 16. While positive beta stocks respond well to favorable new information about the economy’s progress through the business cycle, they 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 already should reflect the coming recovery. 17.
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This note was uploaded on 03/10/2011 for the course FMIS 3601 taught by Professor Vizanko during the Spring '08 term at University of Minnesota Duluth.

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