Chapter 11_Solution - Chapter 11 The Efficient Market...

Chapter 11 - The Efficient Market Hypothesis
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
PROBLEM SETS
5. 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 accumulate, and upward moves are indeed more likely than downward ones.
6. c.This is a predictable pattern in returns which should not occur if the weak-form EMH
is valid.
7. c.This is a classic filter rule which should not produce superior returns in an efficient
market.
8. b. This is the definition of an efficient market.
9. c.The P/E ratio is public information and should not be predictive of abnormal security
returns.
10. d. In a semistrong-form efficient market, it is not possible to earn abnormally high
profits by trading on publicly available information. Information about P/E ratios
and recent price changes is publicly known. On the other hand, an investor who
has advance knowledge of management improvements could earn abnormally high
trading profits (unless the market is also strong-form efficient).
11. 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.
12. 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 should already reflect the coming recovery.
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Chapter 11 - The Efficient Market Hypothesis
13. a.Consistent. Based on pure luck, half of all managers should beat the market in any
year.
b. Inconsistent. This would be the basis of an “easy money” rule: simply invest with
last year's best managers.
c.Consistent. In contrast to predictable returns, predictable volatility does not convey a
means to earn abnormal returns.
d. Inconsistent. The abnormal performance ought to occur in January when earnings
are announced.
e.Inconsistent. Reversals offer a means to earn easy money: just buy last week’s
losers.
14. The return on the market is 8%. Therefore, the forecast monthly return for GM is:
0.10% + (1.1
×
8%) = 8.9%
GM’s actual return was 7%, so the abnormal return was –1.9%.
15. a.Based on broad market trends, the CAPM indicates that AmbChaser stock should have
increased by: 1.0% + 2.0(1.5% – 1.0%) = 2.0%
Its firm-specific (nonsystematic) return due to the lawsuit is $1 million per $100
million initial equity, or 1%. Therefore, the total return should be 3%. (It is
assumed here that the outcome of the lawsuit had a zero expected value.)
b.