Efficient Market Theory (EMT) - Review Questions Flashcards

1
Q

In a perfectly efficient market, which of the following investment choices is the most logical for someone looking to invest in the stock market?

Choose the best answer.

1) Value Stocks
2) Growth Stocks
3) Contrarian Stock Funds
4) Momentum Stock Funds
5) Stock Index Funds

A

5) Stock Index Funds

In a perfectly efficient market, there is no opportunity to gain abnormal returns beyond the market. Therefore, a stock index fund would produce the most returns possible.

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2
Q

Which of the following statements is not true regarding the Efficient Market Hypothesis (EMH)?

1) Investors see through accounting changes that are often used by firms to improve bottom line earnings.

2) Investors have a preference for well diversified companies. The reason for this is that owning this type of stock introduces diversity of their portfolios.

3) Financial markets have no memory. In other words, all valuation is based on available information regarding expected future cash flows.

4) Security prices reflect all available information in an efficient market.

A

2) Investors have a preference for well diversified companies. The reason for this is that owning this type of stock introduces diversity of their portfolios.

The use of diversification to create superior returns is contrary to the EMH theory.

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3
Q

Which of the following correctly represents a market anomaly?

1) Small company stocks outperform large company stocks.

2) Stocks that are followed by analysts outperform neglected firms.

3) Stocks with high P/E ratios perform better than those stocks with low P/E ratios.

4) Stocks rated “V” by Value Line outperform stocks rated “I”.

A

1) Small company stocks outperform large company stocks.

The “small-firm effect” is an anomaly where the stocks of small firms outperform larger firm stocks over long periods of time. All other descriptions of market anomalies are incorrectly stated.

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4
Q

Which of the following is evidence of the semi-strong form of the EMH?

1) Limit orders create a lags in price adjustments that prohibit prices from following a random walk.

2) Insider trading has no effects on the price of a firm’s securities.

3) When transaction costs and taxes are taken into account, investors can’t earn superior returns by following the recommendations of market analysts.

4) Despite theories that dispute its merit, technical analysis continues to be popular among analysts.

A

3) When transaction costs and taxes are taken into account, investors can’t earn superior returns by following the recommendations of market analysts.

The semi-strong of the efficient market hypothesis states that prices are based upon past and all publicly available information.

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5
Q

Which of the following statements is true about the Efficient Market Hypothesis (EMH)?

1) The strong form of the EMH implies that stock prices reflect all available information.

2) The weak form of the EMH implies that past stock prices are good predictors of future returns.

3) The EMH implies that prices do not fluctuate.

4) The EMH implies that markets are irrational and are driven by sophisticated investors.

A

1) The strong form of the EMH implies that stock prices reflect all available information.

The strong form of the EMH implies that prices reflect all information: past, public, and private.

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6
Q

Which of the following statements concerning the Efficient Market Hypothesis (EMH) is correct?

1) The semi-strong form of the EMH holds that technical analysis cannot produce the superior returns that fundamental analysis can.

2) The strong form of the EMH holds that investors who get insider information cannot achieve superior returns.

3) The strong form of the EMH holds that fundamental analysis can be effective in achieving superior returns.

4) The semi-strong form holds that technical analysis can produce superior returns while the weak form does not make this allowance.

A

2) The strong form of the EMH holds that investors who get insider information cannot achieve superior returns.

The weak form of the EMH holds that technical analysis cannot produce superior returns. The semi-strong form of the EMF holds that both technical and fundamental analysis are ineffective for achieving superior returns. The strong form holds that, in addition to technical analysis and fundamental analysis not producing superior returns for investors, even inside information will not produce superior returns.

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7
Q

Asset A has a return of 12.5% and a standard deviation of 16.7%. Asset B has a return of 10.8% and a standard deviation of 11.4%. The correlation between Asset A and Asset B is +0.03. What is the required return and standard deviation if the portfolio rates are as follows:

Portfolio Weight of A Weight of B
20% 80%
Choose the best answer.

1) The expected return is 11.14% and the standard deviation is 9.76%

2) The expected return is 11.14% and the standard deviation is 9.81%

3) The expected return is 11.14% and the standard deviation is 9.62%

4) The expected return is 12.46% and the standard deviation is 9.76%

5) The expected return is 12.46% and the standard deviation is 9.81%

A

2) The expected return is 11.14% and the standard deviation is 9.81%

Expected return is (.20)(.125) + (.80)(.108) = .1114 or 11.14%. The standard deviation is [(.20)2 × (.167)2 + (.80)2 × (.114)2 + 2(.20)(.80)(.167)(.114)(.03)]½ = .0981 or 9.81%

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