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

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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. 11-1
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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.
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