Market Efficiency and Behavioral Finance

Question 1

Which of the following is possible in a semi-strong-form efficient market?

I. An investor consistently earns abnormal profits by exploiting the trend in stock prices using technical analysis.
II. An executive consistently earns abnormal profits by selling shares of the company’s stock prior to the announcement of bad news.
III. Stocks with unexpectedly good earnings consistently generate positive alphas following the announcement date.
IV. An investor consistently beats the market by using difficult to acquire or expensive information.

Answer 1

II. An executive consistently earns abnormal profits by selling shares of the company’s stock prior to the announcement of bad news.

Question 2

Determine which of the following statements is most similar to the semi-strong version of the efficient markets hypothesis.

A
It should not be possible to consistently profit by selling winners and hanging on to losers.

B
It should not be possible to consistently profit by trading on information in past prices.

C
It should not be possible to consistently profit by trading on any public information, such as that found on the Internet or in the financial press.

D
It should not be possible to consistently profit by trading on private information, such as that obtained from a thorough analysis of the company and its industry.

E
It should not be possible to consistently profit by trading on inside information.

Answer 2

C

A is Weak
B is Weak
D is Strong
E is Strong

Question 3

Determine which version of the efficient markets hypotheses is contradicted by a momentum strategy whereby investors can use past stock returns to form a portfolio with positive alpha.

A
Weak form only

B
Weak form and semi-strong form only

C
Weak form, semi-strong form, and strong form

D
Strong form only

E
It does not contradict any of the three forms of the efficient markets hypothesis

Answer 3

C
Weak, semi-strong and strong

because when you contradict the weak form, you also contradict the semi-strong form and strong form.

Question 4

Which of the following demonstrates evidence for the semi-strong form of the efficient market hypothesis?

I. A fund manager is reliably able to make abnormal profits by trading based on historical patterns in stock prices.
II. A talented analyst routinely earns excess returns through analysis of corporate financial statements.
III. There is an instantaneous increase in stock price when a company announces unexpectedly good earnings but not significant abnormal returns afterwards.

Answer 4

III. There is an instantaneous increase in stock price when a company announces unexpectedly good earnings but not significant abnormal returns afterwards.

Question 5

Which of the following statements regarding market efficiency is/are TRUE?

I. If an investor believes in all three forms of market efficiency, the investor is likely to prefer passive investment strategies over active investment strategies.
II. If an investor does not believe in any of the three forms of market efficiency, the investor is likely to use more information to make decisions.
III. If the stronger form of market efficiency is violated, then the weaker forms are also violated.

A) I only 
B) II only 
C) I and II 
D) II and III
E) I, II and III

Answer 5

C) I and II

I. If an investor believes in all three forms of market efficiency, the investor is likely to prefer passive investment strategies over active investment strategies.

II. If an investor does not believe in any of the three forms of market efficiency, the investor is likely to use more information to make decisions.

Question 6

Determine which of the following statements regarding the efficient market hypothesis is FALSE:

A
If markets are efficient, the difference between the required return and expected return of a company’s security is zero.

B
Semi-strong-form inefficient markets are not necessarily weak-form inefficient.

C
Technical analysts who attempt to profit by looking at patterns of prices and trading volume assume that markets are weak-form inefficient.

D
Fundamental analysts who attempt to profit by using publicly available information to estimate a security’s intrinsic value to determine if the security is mispriced assume that markets are semi-strong-form efficient.

E
A company whose share price reacts gradually to the public release of its annual report most likely indicates that the market where the company trades is semi-strong-form inefficient.
Asset Pricing Models

Answer 6

D
Fundamental analysts who attempt to profit by using publicly available information to estimate a security’s intrinsic value to determine if the security is mispriced assume that markets are semi-strong-form efficient.

Question 7

Empirical Evidence Supporting the EMH

What are the three studies that support the weak form?

Answer 7

• Study #1: Kendall: random walk
• Study #2: Brealey, Meyers and Allan: scatter plot
• Study #3: Poterba and Summers: variance

Question 8

Empirical Evidence Supporting the EMH

What is the empirical evidence supporting Semi-Strong form?

Answer 8

Three months prior to the announcement, the stock price gradually increased, with a small positive abnormal return occurring throughout the period. This was caused by investor suspicion, and perhaps even leaked information. At the time of announcement, the stock price instantaneously jumped, providing a large positive abnormal return. Finally, after the announcement, the abnormal returns dropped to zero, and no further trend was present in the stock price. The diagram below illustrates the cumulative abnormal returns:

Question 9

Empirical Evidence Supporting the EMH

What is the empirical evidence supporting Strong form?

Answer 9

• Top performing fund managers in one year only have 50/50 chance to beat their reference index
• only beat 40% of the time

Question 10

Which of the following statements about market efficiency is/are TRUE?

I. If a market is not strong form efficient, then it is also not semi-strong form efficient.
II. If a market is strong form efficient, then it is also semi-strong form efficient.
III. In a semi-strong form efficient market, it is not possible for a company executive with insider information to consistently earn superior returns than any other investor in the market.
IV. In a strong form efficient market, stock price series should wander in no particular pattern.

A) I and II 
B) I and III 
C) II and III
D) II and IV 
E) II , III and IV

Answer 10

D) II and IV

II. If a market is strong form efficient, then it is also semi-strong form efficient.

IV. In a strong form efficient market, stock price series should wander in no particular pattern.

Question 11

Which of the following is evidence for the semi-strong form of the efficient market hypothesis?

I. In a scatter plot for prices changes of four stocks, the autocorrelation coefficients of the time series of percentage changes are close to 0.
II. There was a one-time increase in stock price at the time of the takeover announcement but no significant abnormal returns afterwards.
III. Professional managers cannot beat the market.

Answer 11

II
There was a one-time increase in stock price at the time of the takeover announcement but no significant abnormal returns afterwards.

Question 12

Which of the following are evidence against the efficient market hypothesis?

I. Lesser-known firms yield abnormally high returns.
II. New issues have high returns on the first day but underperform over the 3-5 year period after issue.
III. There was a one-time increase in the stock price at the time of takeover announcement but no significant abnormal returns afterwards. (Support EMH)

A) I only 
B) II only 
C) I and II 
D) I and III 
E) II and III

Answer 12

C) I and II

I. Lesser-known firms yield abnormally high returns.
II. New issues have high returns on the first day but underperform over the 3-5 year period after issue.

Question 13

Which of the following anomalies is an example of overreaction to information?

I. New-issue puzzle
II. Earnings announcement puzzle
III. Super Bowl effect
IV. Monday effect

Answer 13

I. New-issue puzzle

Question 14

Which of the following statements about calendar/time anomalies is/are true?

I. Stock returns have been observed to be lower in December than in other months.
II. Stock returns have been observed to be higher on Friday than on other days.
III. Stock returns have been observed to be more volatile during the middle of the trading day than toward either the beginning or the end of the trading day.

A) I only 
B) II only 
C) I and II 
D) II and IV 
E) None of these

Answer 14

E) None of these

I. Stock returns have been observed to be HIGHER in December than in other months.
II. Stock returns have been observed to be LOWER on Friday than on other days.
III. Stock returns have been observed to be more volatile during the START of the trading day than toward either the beginning or the end of the trading day.

Question 15

Which of the following may be possible in a semi-strong-form efficient market?

An investor consistently earns abnormal profits by exploiting the trend in stock prices using technical analysis.
An executive consistently earns abnormal profits by selling shares of the company’s stock prior to the announcement of bad news.
Stocks with unexpectedly good earnings consistently generate positive alphas following the announcement date.
A
I only

B
II only

C
III only

D
I and II only

E
I and III only

Answer 15

B
II only

Semi-strong-form EMH assumes that current security prices fully reflect all publicly available information, including past market trading data. Public information, such as those found on the Internet or in the financial press, is factored into market values. Prices will adjust immediately upon the release of any public announcements (earnings, mergers, etc). A semi-strong-form efficient market is also weak-form efficient.

Solution:

Statement I:

The investor consistently profits by trading on information on past prices. This violates even the weak form, which asserts that it should not be possible to profit by trading on information on past prices. Since it violates the weak form, it also violates the semi-strong form.

Thus, I is NOT possible in a semi-strong-form efficient market.

Statement II:

The executive has private information about the company and trades on that information before the information becomes publicly available. In a semi-strong-form efficient market, while it should not be possible for an investor to consistently profit by trading on any public information, it is still possible to consistently profit by trading on private information.

Thus, II is possible in a semi-strong-form efficient market.

Statement III:

After the announcement, earnings become public information. Statement III indicates that investors can consistently profit by trading on public information. This violates the semi-strong-form EMH.

Thus, III is NOT possible in a semi-strong-form efficient market.

Question 16

Which of the following would not support the weak form of the efficient market hypothesis?

A
Stock prices behave more like a random walk.

B
Stock returns exhibit positive serial correlation.

C
Prior to the takeover announcement, there was a gradual increase in the target’s stock price. At the time of the announcement, there was a one-time instantaneous price increase. After the announcement, there was no significant further price drift.

D
The top performing fund managers in one year only have a 50% chance to beat their reference index the following year.

E
(A), (B), (C), and (D) support the weak form of the efficient market hypothesis.

Answer 16

Statement A is an evidence supporting the weak form.

Statement B does not support the weak form. It illustrates the momentum effect, which asserts that there is a positive serial correlation in stock prices, meaning rising stock prices continue to rise and falling prices continue to fall. This is against the weak form EMH, which asserts that stock prices are purely random or unrelated to past data.

Statement C is an evidence supporting the semi-strong form. Since a semi-strong-form efficient market is also weak-form efficient, this statement also supports the weak form.

Statement D is an evidence supporting the strong form. Since a strong-form efficient market is also semi-strong and weak-form efficient, this statement also supports the weak form.

Question 17

Determine which of following is an example of a behavioral bias that might cause the market portfolio not to be efficient.

A
Investors are attracted to large growth stocks that receive greater news coverage.

B
Investors are attracted to investments with skewed distributions that have a small probability of an extremely high payoff.

C
The true market portfolio may be efficient, but the proxy an investor uses to mimic the market portfolio may be inaccurate.

D
Investors are exposed to significant non-tradeable risks outside their portfolio, such as human capital.

E
Investors systematically ignore positive-NPV investment opportunities.

Answer 17

There are several reasons why the market portfolio might not be efficient:

Proxy Error. Even though the true market portfolio may be efficient, the market proxy that the investors used may be inaccurate. The true market portfolio consists of all traded wealth, which includes bonds, real estate, art, and so on. Unfortunately, it is not possible to include most of these investments in the market proxy because not all price data is available. As a result, standard proxies such as the S&P 500 may be inefficient compared with the true market.
Behavioral Biases. While some sophisticated investors hold efficient portfolios, some other investors may be subject to behavioral biases. For example, some investors may be attracted to large growth stocks that receive greater news coverage, or sell winners and hang on to losers, following a contrarian strategy. As a result, they hold inefficient portfolios. Since the market portfolio is the combined holdings of the biased and sophisticated investors, the resulting market portfolio might not be inefficient.
Alternative risk preferences. Some investors focus on risk characteristics other than the volatility of their portfolio. As a result, they may choose inefficient portfolios. For example, some investors may choose investments with skewed distributions that have a small probability of an extremely high payoff.
Non-tradable Wealth. Investors are exposed to other significant non-tradable risks outside their portfolio. For example, an investment banker is exposed to financial sector risk, while a computer programmer is exposed to tech sector risk. These risks are due to their work (human capital) and are not tradable. As the banker and the programmer select their portfolios, they may choose to invest more or less in these sectors. They deviate from the market portfolio to offset the inherent exposures.
Thus, A is correct.

Question 18

Since the development of the CAPM model, it is not uncommon that practitioners use market capitalization, book-to-market ratio and past returns to form portfolios that have a positive alpha.

Thus, the market portfolio may not be efficient, and therefore a stock’s beta is not an adequate measure of systematic risk.

Determine which of the following is NOT a reason why a market portfolio may not be efficient.

A
Alternative Risk Preferences

B
Non-Tradable Wealth

C
Proxy Error

D
Behavioral Biases

E
No portfolios are efficient

Answer 18

There are several reasons why the market portfolio might not be efficient:

Proxy Error. Even though the true market portfolio may be efficient, the market proxy that the investors used may be inaccurate. The true market portfolio consists of all traded wealth, which includes bonds, real estate, art, and so on. Unfortunately, it is not possible to include most of these investments in the market proxy because not all price data is available. As a result, standard proxies such as the S&P 500 may be inefficient compared with the true market.
Behavioral Biases. While some sophisticated investors hold efficient portfolios, some other investors may be subject to behavioral biases. As a result, they hold inefficient portfolios. Since the market portfolio is the combined holdings of the biased and sophisticated investors, the resulting market portfolio might not be inefficient.
Alternative risk preferences. Some investors focus on risk characteristics other than the volatility of their portfolio. As a result, they may choose inefficient portfolios. For example, some investors may choose investments with skewed distributions that have a small probability of an extremely high payoff.
Non-tradable Wealth. Investors are exposed to other significant non-tradable risks outside their portfolio. For example, an investment banker is exposed to financial sector risk, while a computer programmer is exposed to tech sector risk. These risks are due to their work (human capital) and are not tradable. As the banker and the programmer select their portfolios, they may choose to invest more or less in these sectors. They deviate from the market portfolio to offset the inherent exposures.
Thus, (A), (B), (C), and (D) are reasons why a market portfolio may not be efficient.

Question 19

You are given the following scenarios regarding investor behavior:

I
A significant number of uninformed investors hold an inefficient portfolio because they are overconfident in their ability to manage a portfolio.
II
Investors hold inefficient portfolios because they care about other factors other than expected return and volatility.
III
Investors do not have rational expectations, thus misinterpret information to believe they are earning a positive alpha when they are actually holding a negative alpha.
Determine which of the scenarios above would cause the market portfolio to become inefficient.

A
I only

B
III only

C
I and II only

D
II and III only

E
I, II, and III

Answer 19

I does not cause the market portfolio to be inefficient.
Overconfidence bias is a non-systematic trading bias, meaning it does not impact market efficiency.

II causes the market portfolio to be inefficient.
Investors with alternative risk preferences cause the market portfolio to be inefficient, as investors will not hold the market portfolio in aggregate. They care about about aspects of their portfolio other than expected return and volatility (thus they are willing to hold portfolios that are mean-variance inefficient).

III causes the market portfolio to be inefficient.
The market portfolio can be inefficient (and thus it is possible to beat the market) if a significant number of investors do not have rational expectations (thus information is misinterpreted).