Market+Efficiency+and+Behavioral+Finance+Solution

Market+Efficiency+and+Behavioral+Finance+Solution - FINA...

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FINA 3104 Practice Problems Fall 2011 The Efficient Market Hypothesis and Behavioral Finance (Suggested Solution) 1. True or False (a) According to the efficient market hypothesis, if stock prices have gone up in the past they should go down in the future, because the average return should be zero. Solution: False. According to the efficient market hypothesis, while average return should be zero (ignoring risk premium), stock prices should be a random walk and future returns do not depend on past realized returns. Even though past realized returns are negative the future expected return is still zero. (b) If you believe that the market is fully semi-strong form efficient, you believe that stock prices reflect all relevant information including historical stock prices and current public information about the firm, but not information that is available only to insiders. Solution: True. Semi-strong form market efficiency includes weak-form efficiency, but not strong form efficiency. (c) Stocks with a higher CAPM beta earn a higher return on average. This evidence suggests that the market is not efficient. Solution: False. In an efficient market, expected return still compensates for the risk taken (i.e., there is a risk premium). Only expected abnormal return, which does not include the risk premium, should be zero. (d) In equilibrium there should be some market inefficiency. Solution: True. In equilibrium there should be some market inefficiency to compensate for research effort, otherwise no one will be analyzing securities. (e) If most (not all) investors are overconfident, then the market cannot be efficient. Solution: False. As long as there are rational investors (or just one rational investor), the market can be efficient. This is because rational investors can take advantage of irrational investors.
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