1. Chapter 12 The Efficient Market Hypothesis

2. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Random Walk - stock prices are random Actually submartingale Expected price is positive over time Positive trend and random about the trend Random Walk and the EMH

3. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. SecurityPrices Time Random Walk with Positive Trend

4. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why are price changes random? Prices react to information Flow of information is random Therefore, price changes are random Random Price Changes

5. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. EMH and Competition Stock prices fully and accurately reflect publicly available information Once information becomes available, market participants analyze it Competition assures prices reflect information

6. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Forms of the EMH Weak Semi-strong Strong

7. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Stock Analysis Technical Analysis - using prices and volume information to predict future prices Weak form efficiency & technical analysis Fundamental Analysis - using economic and accounting information to predict stock prices Semi strong form efficiency & fundamental analysis

8. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Active Management Security analysis Timing Passive Management Buy and Hold Index Funds Implications of Efficiency for Active or Passive Management

9. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Even if the market is efficient a role exists for portfolio management Appropriate risk level Tax considerations Other considerations Market Efficiency and Portfolio Management

10. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Small Firm Effect (January Effect) Neglected Firm Market to Book Ratios Post-Earnings Announcement Drift Tests of Semi-strong Form: Anomalies

11. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Implications of Test Results Risk Premiums or market inefficiencies Anomalies or data mining Behavioral Interpretation Inefficiencies exist Caused by human behavior

12. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Behavioral Possibilities Forecasting Errors Overconfidence Regret avoidance Framing and mental accounting errors

13. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. When the market risk premium declines, stock prices will ________. A) rise B) fall C) recover D) have excess volatility Answer B

14. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. According to the efficient market hypothesis, __________. A) positive alphas on stocks will disappear quickly B) low beta stocks are consistently underpriced C) high beta stocks are consistently overpriced D) None of the above answers is correct Answer A

15. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Research on the strong form of market efficiency shows that ________ are generally able to achieve superior returns. A) members of the SEC B) the majority of professional mutual fund managers C) corporate insiders D) stock brokers Answer C

16. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The ______________ of the efficient market hypothesis suggests that there is little or nothing to be gained from studying past stock price trends. A) weak form B) semi-weak form C) semi-strong form D) strong form Answer A

17. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Which one of the following forms of market efficiency is violated if you can earn excess return by buying stocks of firms which make merger announcements? A) Weak form. B) Semi-weak form. C) Semi-strong form. D) Strong form. Answer C

18. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The efficient market hypothesis suggests that ___________. A) no investors can earn a positive return at any point in time. B) no investors can earn a positive return persistently over time. C) no investors can earn an excess return at any point in time. D) no investors can earn an excess return persistently over time Answer D

19. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The January effect of small firms is greatest ________. A) in leap years B) in presidential election years C) late in the month D) early in the month Answer D

20. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Which of the following has(have) been considered market anomalies? A) the reversal effect B) the book-to-market effect C) the small-firm January effect D) All of the above have been considered market anomalies Answer D

21. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Empirical evidence supporting the semi- strong form market efficiency suggests that investors should follow ____________ investment strategy. A) a passive B) an active C) a conservative D) an aggressive Answer A