Chapter 11, The Efficient Market Hypothesis Video Solutions, Investments

Problem 1

If markets are efficient, what should be the correlation coefficient between stock returns for two nonoverlapping time periods?

Rashmi Sinha

Numerade Educator

Problem 2

A successful firm like Microsoft has consistently generated large profits for years. Is this at violation of the EMH?

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Problem 3

"If all securities are fairly priced, all must offer equal expected rates of return." Comment.

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Problem 4

Steady Growth Industries has never missed a dividend payment in its 94 -year history. Does this make it more attractive to you as a possible purchase for your stock portfolio?

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Problem 5

At a cocktail party, your co-worker tells you that he has beaten the market for each of the last three years. Suppose you believe him. Does this shake your belief in efficient markets?

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01:22

Problem 6

"Constanly fluctuating stock prices suggest that the market does not know how to price stocks." Comment.

Jennifer Stoner

Numerade Educator

Why are the following "effects" considered efficient market anomalies? Are there rational explanations for any of these effects?
a. P/E effect.
b. Book-to-market effect.
c. Momentum effect.
d. Small-firm effect.

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01:41

Problem 8

If prices are as likely to increase as decrease, why do investors earn positive returns from the market on average?

Narayan Hari

Numerade Educator

Problem 9

Which of the following (hypothetical) observations would most contradict the proposition that the stock market is weakly efficient? Explain.
a. Over $25 \%$ of mutual funds outperform the market on average.
b. Insiders earn abnormal trading profits.
c. Every January, the stock market earns abnormal returns.

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Problem 10

Which of the following sources of market incfficiency would be most casily exploited?
a. A stock price drops suddenly due to a large sale by an institution.
b. A stock is overpriced because traders are restricted from short sales.
c. Stocks are overvalued because investors are exuberant over increased productivity in the cconomy.

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Problem 11

Suppose that, after conducting an analysis of past stock prices, you come up with the following observations. Which would appear to contradict the weak form of the efficient market hypothesis? Explain.
a. The average rate of return is significantly greater than zero,
b. The correlation between the return during a given week and the return during the following week is zero.
c. One could have made superior returns by buying stock after a $10 \%$ rise in price and selling after a $10 \%$ fall.
d. One could have made higher-than-average capital gains by holding stocks with low dividend yields.

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Problem 12

Which of the following statements are true if the efficient market bypothesis holds?
a. It implies that future events can be forecast with perfect accuracy.
b. It implies that prices reflect all available information.
c. It implies that security prices change for no discernible reason.
d. It implies that prices do not fluctuate.

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Problem 13

Respond to each of the following comments.
a. If stock prices follow a random walk, then capital markets are little different from a casino.
b. A good part of a company's future prospects is predictable. Given this fact, stock prices can't possibly follow a random walk.
c. If markets are efficient, you might as well select your portfolio by throwing darts at the stock listings in The Wall Street Journal.

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Problem 14

Which of the following would be a viable way to earn abnormally high trading profits if markets are semistrong-form efficient?
a. Buy shares in companies with low P/E ratios.
b. Buy shares in companies with recent above-average price changes.
c. Buy shares in companies with recent below-average price changes.
d. Buy shares in companies for which you have advance knowledge of an improvement in the management team.

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Problem 15

Suppose you find that prices of stocks before large dividend increases show on average consistently positive abnormal returns. Is this a violation of the EMH?

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Problem 16

"If the business cycle is predictable, and a stock has a positive beta, the stock's returns also must be predictable." Respond.

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Problem 17

Which of the following hypothetical phenomena would be either consistent with or a violation of the efficient market hypothesis? Explain briefly.
a. Nearly half of all professionally managed mutual funds are able to outperform the S\&P 500 in a typical year.
b. Money managers who outperform the market (on a risk-adjusted basis) in one year are likely to outperform the market in the following year.
c. Stock prices tend to be predictably more volatile in January than in other months.
d. Stock prices of companies that announce increased carnings in January tend to outperform the market in February.

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Problem 18

An index model regression applied to past monthly returns in Ford's stock price produces the following estimates, which are believed to be stable over time:
$$
r_F=.10 \%+1.1 r_M
$$
If the market index subsequently rises by $8 \%$ and Ford's stock price rises by $7 \%$, what is the aboormal change in Ford's stock price?

Rashmi Sinha

Numerade Educator

Problem 19

The monthly rate of return on T-bills is $1 \%$. The market went up this month by $1.5 \%$. In addition. AmbChaser, Inc.. which has an equity beta of 2 , surprisingly just won a lawsuit that awurds it $$\$ 1$$ million immediately.
a. If the original value of AmbChaser equity were $$\$ 100$$ million, what would you guess was the rate of return of its stock this month?
b. What is your answer to (a) if the market had expected AmbChaser to win $$\$ 2$$ million?

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Problem 20

In a recent closely contested lawsuir, Apex sued Bpex for patent infringement. The jury came back today with its decision. The rate of return on Apex was $r_A=3.1 \%$. The rate of return on Bpex was only $r_3=2.5 \%$. The market today responded to very encouraging news about the unemployment rate, and $r_M=3 \%$. The historical relationship between returns on these stocks and the market portfolio has been estimated from index model regressions as:
$$
\begin{aligned}
& \text { Apex: } r_A=.2 \%+1.4 r_M \\
& \text { Bpex: } r_B=-.1 \%+.6 r_M
\end{aligned}
$$
On the basis of these data, which company do you think won the lawsuit?

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Problem 21

Investors expect the market rate of return in the coming year to be $12 \%$. The T-bill rate is $4 \%$. Changing Fortunes Industries' stock has a beta of .5 . The market value of its outstanding equity is $$\$ 100$$ million.
a. Using the CAPM, what is your best guess currently as to the expected rate of return on Changing Fortunes's stock? You believe that the stock is fairly priced.
b. If the market return in the coming year actually turns out to be $10 \%$, what is your best guess as to the rate of return that will be earned on Changing Fortunes's stock?
c. Suppose now that Changing Fortunes wins a major lawsuit during the year. The settlement is $$\$ 5$$ million, Changing Fortunes's stock return during the year turns out to be $10 \%$. What is your best guess as to the settlement the market previously expected Changing Fortunes to receive from the lawsuit? (Continue to assume that the market return in the year turned out to be 10%.) The magnitude of the settlement is the oaly unexpected firm-specific event during the year.

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02:15

Problem 22

Dollar-cost averaging means that you buy equal dollar amounts of a stock every period, for example, $\$ 500$ per month. The strategy is based on the idea that when the stock price is low, your fixed monthly purchase will buy more shares, and when the price is high, fewer shares. Averaging over time, you will end up buying more shares when the slock is cheaper and fewer when it is relatively expensive. Therefore, by design, you will exhibit good market timing. Evaluate this strategy.

Nick Johnson

Numerade Educator

01:46

Problem 23

We know that the market should respond positively to good news and that good-news events such as the coming end of a recession can be predicted with at Ieast some accuracy. Why, then. can we not predict that the market will go up as the economy recovers?

Mihir Nayar

Numerade Educator

Problem 24

You know that firm XYZ is very poorly run. On a scale of 1 (worst) to 10 (best), you would give it a score of 3 . The market consensus evaluation is that the management score is only 2 . Should you buy or sell the stock?

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12:06

Problem 25

Suppose that during a certain week the Fed announces a new monetary growth policy, Congress surprisingly passes legislation restricting imports of foreign automobiles, and Ford comes out with a new car model that it believes will increase profits substantially. How might you go about measuring the market's assessment of Ford's new model?

Md.Daniyal Arshad

Numerade Educator

Problem 26

Good News, Inc., just announced an increase in its annual carnings, yet its stock price fell. Is there a rational explanation for this phenomenon?

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Problem 27

Shares of small firms with thinly traded stocks tend to show positive CAPM alphas. Is this a violation of the efficient market hypothesis?

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Problem 28

Examine the accompanying figure, which presents cumulative abnormal returns both before and after dates on which insiders buy or sell shares in their firms. How do you interpret this figure? What are we to make of the pattern of CARs before and after the event date?

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03:08

Problem 29

Suppose that as the economy moves through a business cycle, risk premiums also change For example, in a recession, when people are concerned about their jobs, risk tolerance might be lower and risk premiums might be higher. In a booming economy, tolerance for risk might be higher and premiums lower.
a. Would a predictably shifting risk premium such as described here be a violation of the efficient market bypothesis?
b. How might a cycle of increasing and decreasing risk premiums create an appearance that stock prices "overreact," first falling excessively and then seeming to recover?

Rashmi Sinha

Numerade Educator

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