CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
PROBLEM SETS
1. The correlation coefficient between stock returns for two nonoverlapping periods
should be zero. If not, returns from one period could be used to predict returns in later periods and make abnormal profits.
2. No. Microsoft’s continuing profitability does not imply that stock market investors
who purchased Microsoft shares after its success was already evident would have earned an exceptionally high return on their investments. It simply means that
Microsoft has made risky investments over the years that have paid off in the form of increased cash flows and profitability. Microsoft shareholders have benefited from the risk-expected return tradeoff, which is consistent with the EMH.
3. Expected rates of return differ because of differential risk premiums across all
securities.
4. No. The value of dividend predictability would be already reflected in the
stock price.
5. No, markets can be efficient even if some investors earn returns above the market
average. Consider the Lucky Event issue: Ignoring transaction costs, about 50% of professional investors, by definition, will “beat” the market in any given year. The probability of beating it three years in a row, though small, is not insignificant.
Beating the market in the past does not predict future success as three years of
returns make up too small a sample on which to base correlation let alone causation.
6. Volatile stock prices could reflect volatile underlying economic conditions as large
amounts of information being incorporated into the price will cause variability in stock price. The efficient market hypothesis suggests that investors cannot earn
excess risk-adjusted rewards. The variability of the stock price is thus reflected in the expected returns as returns and risk are positively correlated.
7. The following effects seem to suggest predictability within equity markets and thus
disprove the efficient market hypothesis. However, consider the following:
a. Multiple studies suggest that “value” stocks (measured often by low P/E
multiples) earn higher returns over time than “growth” stocks (high P/E multiples). This could suggest a strategy for earning higher returns over time. However, another rational argument may be that traditional forms of CAPM (such as Sharpe’s model) do not fully account for all risk factors that affect a firm’s price level. A firm viewed as riskier may have a lower price and thus P/E multiple.
b. The book-to-market effect suggests that an investor can earn excess returns by investing in companies with high book value (the value of a firm’s assets minus its liabilities divided by the number of shares outstanding) to market value. A study by Fama and French1 suggests that book-to-market value reflects a risk factor that is not accounted for by traditional one variable CAPM. For example, companies
experiencing financial distress see the ratio of book to market value increase. Thus a more complex CAPM that includes book-to-market value as an explanatory variable should be used to test market anomalies.
c. Stock price momentum can be positively correlated with past performance (short to intermediate horizon) or negatively correlated (long horizon). Historical data
seem to imply statistical significance to these patterns. Explanations for this include a bandwagon effect or the behaviorists’ (see Chapter 12) explanation that there is a tendency for investors to underreact to new information, thus producing a positive serial correlation. However, statistical significance does not imply economic
significance. Several studies that included transaction costs in the momentum
models discovered that momentum traders tended to not outperform the efficient market hypothesis strategy of buy and hold.
d. The small-firm effect states that smaller firms produce better returns than larger firms. Since 1926, returns from small firms outpace large firm stock returns by
about 1% per year. Do small cap investors earn excess risk-adjusted returns?
The measure of systematic risk according to Sharpe’s CAPM is the stock’s beta (or sensitivity of returns of the stock to market returns). If the stock’s beta is the best explanation of risk, then the small-firm effect does indicate an inefficient market. Dividing the market into deciles based on their betas shows an increasing
relationship between betas and returns. Fama and French2 show that the empirical relationship between beta and stock returns is flat over a fairly long horizon (1963–1990). Breaking the market into deciles based on sizes and then examining the
relationship between beta and stock returns within each size decile exhibits this flat relationship. This implies that firm size may be a better measure of risk than beta and the size-effect should not be viewed as an indicator that markets are inefficient. Heuristically this makes sense, as smaller firms are generally viewed as risky
compared to larger firms and perceived risk and return are positively correlated. 1 Fama, Eugene and Kenneth French, “Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Finance 33:1, pp. 3-56.
2 Ibid
In addition this effect seems to be endpoint and data sensitive. For example, smaller
stocks did not outperform larger stocks from the mid-1980s through the 1990s. In addition, databases contain stock returns from companies that have survived and do not include returns of those that went bankrupt. Thus small-firm data may exhibit survivorship bias.
Over the long haul, there is an expected upward drift in stock prices based on their fair expected rates of return. The fair expected return over any single day is very small (e.g., 12% per year is only about 0.03% per day), so that on any day the price is virtually equally likely to rise or fall. Over longer periods, the small expected
daily returns accumulate, and upward moves are more likely than downward ones. Remember that economies tend to grow over time and stock prices tend to follow economic growth, so it is only natural that there is an upward drift in equity prices. c. This is a predictable pattern in returns that should not occur if the weak-form
EMH is valid.
Acute market inefficiencies are temporary in nature and are more easily
exploited than chronic inefficiencies. A temporary drop in a stock price due to
a large sale would be more easily exploited than the chronic inefficiencies
mentioned in the other responses.
This is a classic filter rule that should not produce superior returns in an
efficient market.
This is the definition of an efficient market.
Though stock prices follow a random walk and intraday price changes do
appear to be a random walk, over the long run there is compensation for
bearing market risk and for the time value of money. Investing differs from a
casino in that in the long-run, an investor is compensated for these risks, while
a player at a casino faces less than fair-game odds.
In an efficient market, any predictable future prospects of a company have
already been priced into the current value of the stock. Thus, a stock share
price can still follow a random walk.
While the random nature of dart board selection seems to follow naturally
from efficient markets, the role of rational portfolio management still exists. It 8. 9. 10. a. 11. c. 12. b. 13. a. b. c.
exists to ensure a well-diversified portfolio, to assess the risk-tolerance of the
investor, and to take into account tax code issues.
14. d. In a semistrong-form efficient market, it is not possible to earn abnormally
high profits by trading on publicly available information. Information about
P/E ratios and recent price changes is publicly known. On the other hand, an
investor who has advance knowledge of management improvements could
earn abnormally high trading profits (unless the market is also strong-form
efficient).
15. Market efficiency implies investors cannot earn excess risk-adjusted profits. If the
stock price run-up occurs when only insiders know of the coming dividend increase, then it is a violation of strong-form efficiency. If the public also knows of the
increase, then this violates semistrong-form efficiency.
16. While positive beta stocks respond well to favorable new information about the
economy’s progress through the business cycle, they should not show abnormal
returns around already anticipated events. If a recovery, for example, is already
anticipated, the actual recovery is not news. The stock price should already reflect the coming recovery.
17. a. Consistent. Based on pure luck, half of all managers should beat the market
in any year.
b. Inconsistent. This would be the basis of an “easy money” rule: simply invest
with last year's best managers.
c. Consistent. In contrast to predictable returns, predictable volatility does not
convey a means to earn abnormal returns.
d. Inconsistent. The abnormal performance ought to occur in January when
earnings are announced.
e. Inconsistent. Reversals offer a means to earn easy money: just buy last
week’s losers.
18. The return on the market is 8%. Therefore, the forecast monthly return for Ford is:
0.10% + (1.1 × 8%) = 8.9%
Ford ’s actual return was 7%, so the abnormal return was –1.9%.
19. a. Based on broad market trends, the CAPM indicates that AmbChaser stock
should have increased by: 1.0% + 2.0 × (1.5% – 1.0%) = 2.0%
Its firm-specific (nonsystematic) return due to the lawsuit is $1 million per
$100 million initial equity, or 1%. Therefore, the total return should be 3%. (It
is assumed here that the outcome of the lawsuit had a zero expected value.)
If the settlement was expected to be $2 million, then the actual settlement was
a “$1 million disappointment,” and so the firm-specific return would be –1%,
for a total return of 2% – 1% = 1%. b.
20. Given market performance, predicted returns on the two stocks would be:
Apex:
Bpex: 0.2% + (1.4 × 3%) = 4.4% –0.1% + (0.6 × 3%) = 1.7%
Apex underperformed this prediction; Bpex outperformed the prediction. We
conclude that Bpex won the lawsuit.
21. a. E (r M ) = 12%, r f = 4% and β = 0.5
Therefore, the expected rate of return is:
4% + 0.5 × (12% – 4%) = 8%
If the stock is fairly priced, then E (r ) = 8%.
b. If r M falls short of your expectation by 2% (that is, 10% – 12%) then you
would expect the return for Changing Fortunes Industries to fall short of your
original expectation by: β × 2% = 1%
Therefore, you would forecast a revised expectation for Changing Fortunes of:
8% – 1% = 7%
Given a market return of 10%, you would forecast a return for Changing
Fortunes of 7%. The actual return is 10%. Therefore, the surprise due to firm-
specific factors is 10% – 7% = 3%, which we attribute to the settlement.
Because the firm is initially worth $100 million, the surprise amount of the
settlement is 3% of $100 million, or $3 million, implying that the prior
expectation for the settlement was only $2 million. c.
22. Implicit in the dollar-cost averaging strategy is the notion that stock prices
fluctuate around a “normal” level. Otherwise, there is no meaning to statements
such as: “when the price is high.” How do we know, for example, whether a price of $25 today will turn out to be viewed as high or low compared to the stock price six months from now?
23. The market responds positively to new news. If the eventual recovery is anticipated,
then the recovery is already reflected in stock prices. Only a better-than-expected recovery should affect stock prices.
24. Buy. In your view, the firm is not as bad as everyone else believes it to be.
Therefore, you view the firm as undervalued by the market. You are less pessimistic about the firm’s prospects than the beliefs built into the stock price.
25. Here we need a two-factor model relating Ford’s return to those of both the broad
market and the auto industry. If we call r I the industry return, then we would first estimate parameters α,βM ,βIND in the following regression:
r FORD =α+βM r M +βIND r IND +ε
Given these estimates we would calculate Ford’s firm-specific return as:
26. The market may have anticipated even greater earnings. Compared to prior
expectations, the announcement was a disappointment.
27. Thinly traded stocks will not have a considerable amount of market research
performed on the companies they represent. This neglected-firm effect implies a greater degree of uncertainty with respect to smaller companies. Thus positive
CAPM alphas among thinly traded stocks do not necessarily violate the efficient market hypothesis since these higher alphas are actually risk premiums, not market inefficiencies.
28. The negative abnormal returns (downward drift in CAR) just prior to stock
purchases suggest that insiders deferred their purchases until after bad news was released to the public. This is evidence of valuable inside information. The positive abnormal returns after purchase suggest insider purchases in anticipation of good news. The analysis is symmetric for insider sales.
29. a. The market risk premium moves countercyclical to the economy, peaking in
recessions. A violation of the efficient market hypothesis would imply that investors could take advantage of this predictability and earn excess risk adjusted returns. However, several studies, including Siegel,3 show that successfully timing the 3 Jeremy Siegel, Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies, 2002, New York: McGraw-Hill.
r FORD -[α+βM r M +βIND r IND +ε] This estimate of firm-specific news would measure the market’s assessment of the potential profitability of Ford’s new model.
b. changes have eluded professional investors thus far. Moreover a changing risk premium implies changing required rates of return for stocks rather than an inefficiency with the market. As the market risk premium increases during a recession, stocks prices tend to fall.
As the economy recovers, the market risk premium falls, and stock prices tend to rise. These changes could give investors the impression that markets overreact,
especially if the underlying changes in the market risk premium are small but
cumulative. For example, the October Crash of 1987 is commonly viewed as an
example of market overreaction. However, in the weeks running up to mid-October, several underlying changes to the market risk premium occurred (in addition to
changes in the yields on long-term Treasury Bonds). Congress threatened investors with a “merger tax” that would have truncated the booming merger industry and loosened the discipline that the threat of mergers provides to a firm’s management. In addition, the Secretary of Treasury threatened further depreciation in the value of the dollar, frightening foreign investors. These events may have increased the
market risk premium and lowered stock prices in a seeming overreaction.
CFA PROBLEMS
1. b. Semistrong form efficiency implies that market prices reflect all publicly
available information concerning past trading history as well as fundamental
aspects of the firm.
2. a. The full price adjustment should occur just as the news about the dividend
becomes publicly available.
3. d. If low P/E stocks tend to have positive abnormal returns, this would represent
an unexploited profit opportunity that would provide evidence that investors
are not using all available information to make profitable investments.
4. c. In an efficient market, no securities are consistently overpriced or underpriced.
While some securities will turn out after any investment period to have
provided positive alphas (i.e., risk-adjusted abnormal returns) and some
negative alphas, these past returns are not predictive of future returns.
5. c. A random walk implies that stock price changes are unpredictable, using past
price changes or any other data.
6.
7.
8. d. A gradual adjustment to fundamental values would allow for the use of strategies based on past price movements in order to generate abnormal profits. a. a. Some empirical evidence that supports the EMH:
(i) Professional money managers do not typically earn higher returns than
comparable risk, passive index strategies.
(ii) Event studies typically show that stocks respond immediately to the
public release of relevant news.
(iii) Most tests of technical analysis find that it is difficult to identify price
trends that can be exploited to earn superior risk-adjusted investment
returns.
Some evidence that is difficult to reconcile with the EMH concerns simple
portfolio strategies that apparently would have provided high risk-adjusted
returns in the past. Some examples of portfolios with attractive historical returns: (i) Low P/E stocks.
(ii) High book-to-market ratio stocks.
(iii) Small firms in January.
(iv) Firms with very poor stock price performance in the last few months.
Other evidence concerns post-earnings-announcement stock price drift and
intermediate-term price momentum.
An investor might choose not to index even if markets are efficient because he
or she may want to tailor a portfolio to specific tax considerations or to specific risk management issues, for example, the need to hedge (or at least not add to)
exposure to a particular source of risk (e.g., industry exposure).
The efficient market hypothesis (EMH) states that a market is efficient if
security prices immediately and fully reflect all available relevant information.
If the market fully reflects information, the knowledge of that information
would not allow an investor to profit from the information because stock
prices already incorporate the information.
i. The weak form of the EMH asserts that stock prices reflect all the information that can be derived by examining market trading data such as the history of past prices and trading volume.
A strong body of evidence supports weak-form efficiency in the major U.S.
securities markets. For example, test results suggest that technical trading rules do not produce superior returns after adjusting for transaction costs and taxes. b. c. 9. a.
ii. The semistrong form states that a firm’s stock price reflects all publicly
available information about a firm’s prospects. Examples of publicly available
information are company annual reports and investment advisory data.
Evidence strongly supports the notion of semistrong efficiency, but occasional
studies (e.g., identifying market anomalies such as the small-firm-in-January or book-to-market effects) and events (e.g. stock market crash of October 19, 1987) are inconsistent with this form of market efficiency. There is a question
concerning the extent to which these “anomalies” result from data mining.
iii. The strong form of the EMH holds that current market prices reflect all
information (whether publicly available or privately held) that can be relevant
to the valuation of the firm.
Empirical evidence suggests that strong-form efficiency does not hold. If this
form were correct, prices would fully reflect all information. Therefore even
insiders could not earn excess returns. But the evidence is that corporate
officers do have access to pertinent information long enough before public
release to enable them to profit from trading on this information.
b. i. Technical analysis involves the search for recurrent and predictable patterns in
stock prices in order to enhance returns. The EMH implies that technical analysis is without value. If past prices contain no useful information for predicting future prices, there is no point in following any technical trading rule.
ii. Fundamental analysis uses earnings and dividend prospects of the firm,
expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. The EMH predicts that most fundamental analysis is doomed to failure. According to semistrong-form efficiency, no investor can earn excess returns from trading rules based on publicly available information. Only analysts with unique insight achieve superior returns.
In summary, the EMH holds that the market appears to adjust so quickly to
information about both individual stocks and the economy as a whole that no
technique of selecting a portfolio using either technical or fundamental analysis can consistently outperform a strategy of simply buying and holding a diversified
portfolio of securities, such as those comprising the popular market indexes.
c. Portfolio managers have several roles and responsibilities even in perfectly
efficient markets. The most important responsibility is to identify the risk/return objectives for a portfolio given the investor’s constraints. In an efficient market, portfolio managers are responsible for tailoring the portfolio to meet the investor’s needs, rather than to beat the market, which requires identifying the client’s return requirements and risk tolerance. Rational portfolio management also requires
examining the investor’s constraints, including liquidity, time horizon, laws and regulations, taxes, and unique preferences and circumstances such as age and
employment.
10. a. The earnings (and dividend) growth rate of growth stocks may be consistently
overestimated by investors. Investors may extrapolate recent growth too far into the future and thereby downplay the inevitable slowdown. At any given time,
growth stocks are likely to revert to (lower) mean returns and value stocks are
likely to revert to (higher) mean returns, often over an extended future time
horizon.
In efficient markets, the current prices of stocks already reflect all known relevant information. In this situation, growth stocks and value stocks provide the same
risk-adjusted expected return. b.
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
PROBLEM SETS
1. The correlation coefficient between stock returns for two nonoverlapping periods
should be zero. If not, returns from one period could be used to predict returns in later periods and make abnormal profits.
2. No. Microsoft’s continuing profitability does not imply that stock market investors
who purchased Microsoft shares after its success was already evident would have earned an exceptionally high return on their investments. It simply means that
Microsoft has made risky investments over the years that have paid off in the form of increased cash flows and profitability. Microsoft shareholders have benefited from the risk-expected return tradeoff, which is consistent with the EMH.
3. Expected rates of return differ because of differential risk premiums across all
securities.
4. No. The value of dividend predictability would be already reflected in the
stock price.
5. No, markets can be efficient even if some investors earn returns above the market
average. Consider the Lucky Event issue: Ignoring transaction costs, about 50% of professional investors, by definition, will “beat” the market in any given year. The probability of beating it three years in a row, though small, is not insignificant.
Beating the market in the past does not predict future success as three years of
returns make up too small a sample on which to base correlation let alone causation.
6. Volatile stock prices could reflect volatile underlying economic conditions as large
amounts of information being incorporated into the price will cause variability in stock price. The efficient market hypothesis suggests that investors cannot earn
excess risk-adjusted rewards. The variability of the stock price is thus reflected in the expected returns as returns and risk are positively correlated.
7. The following effects seem to suggest predictability within equity markets and thus
disprove the efficient market hypothesis. However, consider the following:
a. Multiple studies suggest that “value” stocks (measured often by low P/E
multiples) earn higher returns over time than “growth” stocks (high P/E multiples). This could suggest a strategy for earning higher returns over time. However, another rational argument may be that traditional forms of CAPM (such as Sharpe’s model) do not fully account for all risk factors that affect a firm’s price level. A firm viewed as riskier may have a lower price and thus P/E multiple.
b. The book-to-market effect suggests that an investor can earn excess returns by investing in companies with high book value (the value of a firm’s assets minus its liabilities divided by the number of shares outstanding) to market value. A study by Fama and French1 suggests that book-to-market value reflects a risk factor that is not accounted for by traditional one variable CAPM. For example, companies
experiencing financial distress see the ratio of book to market value increase. Thus a more complex CAPM that includes book-to-market value as an explanatory variable should be used to test market anomalies.
c. Stock price momentum can be positively correlated with past performance (short to intermediate horizon) or negatively correlated (long horizon). Historical data
seem to imply statistical significance to these patterns. Explanations for this include a bandwagon effect or the behaviorists’ (see Chapter 12) explanation that there is a tendency for investors to underreact to new information, thus producing a positive serial correlation. However, statistical significance does not imply economic
significance. Several studies that included transaction costs in the momentum
models discovered that momentum traders tended to not outperform the efficient market hypothesis strategy of buy and hold.
d. The small-firm effect states that smaller firms produce better returns than larger firms. Since 1926, returns from small firms outpace large firm stock returns by
about 1% per year. Do small cap investors earn excess risk-adjusted returns?
The measure of systematic risk according to Sharpe’s CAPM is the stock’s beta (or sensitivity of returns of the stock to market returns). If the stock’s beta is the best explanation of risk, then the small-firm effect does indicate an inefficient market. Dividing the market into deciles based on their betas shows an increasing
relationship between betas and returns. Fama and French2 show that the empirical relationship between beta and stock returns is flat over a fairly long horizon (1963–1990). Breaking the market into deciles based on sizes and then examining the
relationship between beta and stock returns within each size decile exhibits this flat relationship. This implies that firm size may be a better measure of risk than beta and the size-effect should not be viewed as an indicator that markets are inefficient. Heuristically this makes sense, as smaller firms are generally viewed as risky
compared to larger firms and perceived risk and return are positively correlated. 1 Fama, Eugene and Kenneth French, “Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Finance 33:1, pp. 3-56.
2 Ibid
In addition this effect seems to be endpoint and data sensitive. For example, smaller
stocks did not outperform larger stocks from the mid-1980s through the 1990s. In addition, databases contain stock returns from companies that have survived and do not include returns of those that went bankrupt. Thus small-firm data may exhibit survivorship bias.
Over the long haul, there is an expected upward drift in stock prices based on their fair expected rates of return. The fair expected return over any single day is very small (e.g., 12% per year is only about 0.03% per day), so that on any day the price is virtually equally likely to rise or fall. Over longer periods, the small expected
daily returns accumulate, and upward moves are more likely than downward ones. Remember that economies tend to grow over time and stock prices tend to follow economic growth, so it is only natural that there is an upward drift in equity prices. c. This is a predictable pattern in returns that should not occur if the weak-form
EMH is valid.
Acute market inefficiencies are temporary in nature and are more easily
exploited than chronic inefficiencies. A temporary drop in a stock price due to
a large sale would be more easily exploited than the chronic inefficiencies
mentioned in the other responses.
This is a classic filter rule that should not produce superior returns in an
efficient market.
This is the definition of an efficient market.
Though stock prices follow a random walk and intraday price changes do
appear to be a random walk, over the long run there is compensation for
bearing market risk and for the time value of money. Investing differs from a
casino in that in the long-run, an investor is compensated for these risks, while
a player at a casino faces less than fair-game odds.
In an efficient market, any predictable future prospects of a company have
already been priced into the current value of the stock. Thus, a stock share
price can still follow a random walk.
While the random nature of dart board selection seems to follow naturally
from efficient markets, the role of rational portfolio management still exists. It 8. 9. 10. a. 11. c. 12. b. 13. a. b. c.
exists to ensure a well-diversified portfolio, to assess the risk-tolerance of the
investor, and to take into account tax code issues.
14. d. In a semistrong-form efficient market, it is not possible to earn abnormally
high profits by trading on publicly available information. Information about
P/E ratios and recent price changes is publicly known. On the other hand, an
investor who has advance knowledge of management improvements could
earn abnormally high trading profits (unless the market is also strong-form
efficient).
15. Market efficiency implies investors cannot earn excess risk-adjusted profits. If the
stock price run-up occurs when only insiders know of the coming dividend increase, then it is a violation of strong-form efficiency. If the public also knows of the
increase, then this violates semistrong-form efficiency.
16. While positive beta stocks respond well to favorable new information about the
economy’s progress through the business cycle, they should not show abnormal
returns around already anticipated events. If a recovery, for example, is already
anticipated, the actual recovery is not news. The stock price should already reflect the coming recovery.
17. a. Consistent. Based on pure luck, half of all managers should beat the market
in any year.
b. Inconsistent. This would be the basis of an “easy money” rule: simply invest
with last year's best managers.
c. Consistent. In contrast to predictable returns, predictable volatility does not
convey a means to earn abnormal returns.
d. Inconsistent. The abnormal performance ought to occur in January when
earnings are announced.
e. Inconsistent. Reversals offer a means to earn easy money: just buy last
week’s losers.
18. The return on the market is 8%. Therefore, the forecast monthly return for Ford is:
0.10% + (1.1 × 8%) = 8.9%
Ford ’s actual return was 7%, so the abnormal return was –1.9%.
19. a. Based on broad market trends, the CAPM indicates that AmbChaser stock
should have increased by: 1.0% + 2.0 × (1.5% – 1.0%) = 2.0%
Its firm-specific (nonsystematic) return due to the lawsuit is $1 million per
$100 million initial equity, or 1%. Therefore, the total return should be 3%. (It
is assumed here that the outcome of the lawsuit had a zero expected value.)
If the settlement was expected to be $2 million, then the actual settlement was
a “$1 million disappointment,” and so the firm-specific return would be –1%,
for a total return of 2% – 1% = 1%. b.
20. Given market performance, predicted returns on the two stocks would be:
Apex:
Bpex: 0.2% + (1.4 × 3%) = 4.4% –0.1% + (0.6 × 3%) = 1.7%
Apex underperformed this prediction; Bpex outperformed the prediction. We
conclude that Bpex won the lawsuit.
21. a. E (r M ) = 12%, r f = 4% and β = 0.5
Therefore, the expected rate of return is:
4% + 0.5 × (12% – 4%) = 8%
If the stock is fairly priced, then E (r ) = 8%.
b. If r M falls short of your expectation by 2% (that is, 10% – 12%) then you
would expect the return for Changing Fortunes Industries to fall short of your
original expectation by: β × 2% = 1%
Therefore, you would forecast a revised expectation for Changing Fortunes of:
8% – 1% = 7%
Given a market return of 10%, you would forecast a return for Changing
Fortunes of 7%. The actual return is 10%. Therefore, the surprise due to firm-
specific factors is 10% – 7% = 3%, which we attribute to the settlement.
Because the firm is initially worth $100 million, the surprise amount of the
settlement is 3% of $100 million, or $3 million, implying that the prior
expectation for the settlement was only $2 million. c.
22. Implicit in the dollar-cost averaging strategy is the notion that stock prices
fluctuate around a “normal” level. Otherwise, there is no meaning to statements
such as: “when the price is high.” How do we know, for example, whether a price of $25 today will turn out to be viewed as high or low compared to the stock price six months from now?
23. The market responds positively to new news. If the eventual recovery is anticipated,
then the recovery is already reflected in stock prices. Only a better-than-expected recovery should affect stock prices.
24. Buy. In your view, the firm is not as bad as everyone else believes it to be.
Therefore, you view the firm as undervalued by the market. You are less pessimistic about the firm’s prospects than the beliefs built into the stock price.
25. Here we need a two-factor model relating Ford’s return to those of both the broad
market and the auto industry. If we call r I the industry return, then we would first estimate parameters α,βM ,βIND in the following regression:
r FORD =α+βM r M +βIND r IND +ε
Given these estimates we would calculate Ford’s firm-specific return as:
26. The market may have anticipated even greater earnings. Compared to prior
expectations, the announcement was a disappointment.
27. Thinly traded stocks will not have a considerable amount of market research
performed on the companies they represent. This neglected-firm effect implies a greater degree of uncertainty with respect to smaller companies. Thus positive
CAPM alphas among thinly traded stocks do not necessarily violate the efficient market hypothesis since these higher alphas are actually risk premiums, not market inefficiencies.
28. The negative abnormal returns (downward drift in CAR) just prior to stock
purchases suggest that insiders deferred their purchases until after bad news was released to the public. This is evidence of valuable inside information. The positive abnormal returns after purchase suggest insider purchases in anticipation of good news. The analysis is symmetric for insider sales.
29. a. The market risk premium moves countercyclical to the economy, peaking in
recessions. A violation of the efficient market hypothesis would imply that investors could take advantage of this predictability and earn excess risk adjusted returns. However, several studies, including Siegel,3 show that successfully timing the 3 Jeremy Siegel, Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies, 2002, New York: McGraw-Hill.
r FORD -[α+βM r M +βIND r IND +ε] This estimate of firm-specific news would measure the market’s assessment of the potential profitability of Ford’s new model.
b. changes have eluded professional investors thus far. Moreover a changing risk premium implies changing required rates of return for stocks rather than an inefficiency with the market. As the market risk premium increases during a recession, stocks prices tend to fall.
As the economy recovers, the market risk premium falls, and stock prices tend to rise. These changes could give investors the impression that markets overreact,
especially if the underlying changes in the market risk premium are small but
cumulative. For example, the October Crash of 1987 is commonly viewed as an
example of market overreaction. However, in the weeks running up to mid-October, several underlying changes to the market risk premium occurred (in addition to
changes in the yields on long-term Treasury Bonds). Congress threatened investors with a “merger tax” that would have truncated the booming merger industry and loosened the discipline that the threat of mergers provides to a firm’s management. In addition, the Secretary of Treasury threatened further depreciation in the value of the dollar, frightening foreign investors. These events may have increased the
market risk premium and lowered stock prices in a seeming overreaction.
CFA PROBLEMS
1. b. Semistrong form efficiency implies that market prices reflect all publicly
available information concerning past trading history as well as fundamental
aspects of the firm.
2. a. The full price adjustment should occur just as the news about the dividend
becomes publicly available.
3. d. If low P/E stocks tend to have positive abnormal returns, this would represent
an unexploited profit opportunity that would provide evidence that investors
are not using all available information to make profitable investments.
4. c. In an efficient market, no securities are consistently overpriced or underpriced.
While some securities will turn out after any investment period to have
provided positive alphas (i.e., risk-adjusted abnormal returns) and some
negative alphas, these past returns are not predictive of future returns.
5. c. A random walk implies that stock price changes are unpredictable, using past
price changes or any other data.
6.
7.
8. d. A gradual adjustment to fundamental values would allow for the use of strategies based on past price movements in order to generate abnormal profits. a. a. Some empirical evidence that supports the EMH:
(i) Professional money managers do not typically earn higher returns than
comparable risk, passive index strategies.
(ii) Event studies typically show that stocks respond immediately to the
public release of relevant news.
(iii) Most tests of technical analysis find that it is difficult to identify price
trends that can be exploited to earn superior risk-adjusted investment
returns.
Some evidence that is difficult to reconcile with the EMH concerns simple
portfolio strategies that apparently would have provided high risk-adjusted
returns in the past. Some examples of portfolios with attractive historical returns: (i) Low P/E stocks.
(ii) High book-to-market ratio stocks.
(iii) Small firms in January.
(iv) Firms with very poor stock price performance in the last few months.
Other evidence concerns post-earnings-announcement stock price drift and
intermediate-term price momentum.
An investor might choose not to index even if markets are efficient because he
or she may want to tailor a portfolio to specific tax considerations or to specific risk management issues, for example, the need to hedge (or at least not add to)
exposure to a particular source of risk (e.g., industry exposure).
The efficient market hypothesis (EMH) states that a market is efficient if
security prices immediately and fully reflect all available relevant information.
If the market fully reflects information, the knowledge of that information
would not allow an investor to profit from the information because stock
prices already incorporate the information.
i. The weak form of the EMH asserts that stock prices reflect all the information that can be derived by examining market trading data such as the history of past prices and trading volume.
A strong body of evidence supports weak-form efficiency in the major U.S.
securities markets. For example, test results suggest that technical trading rules do not produce superior returns after adjusting for transaction costs and taxes. b. c. 9. a.
ii. The semistrong form states that a firm’s stock price reflects all publicly
available information about a firm’s prospects. Examples of publicly available
information are company annual reports and investment advisory data.
Evidence strongly supports the notion of semistrong efficiency, but occasional
studies (e.g., identifying market anomalies such as the small-firm-in-January or book-to-market effects) and events (e.g. stock market crash of October 19, 1987) are inconsistent with this form of market efficiency. There is a question
concerning the extent to which these “anomalies” result from data mining.
iii. The strong form of the EMH holds that current market prices reflect all
information (whether publicly available or privately held) that can be relevant
to the valuation of the firm.
Empirical evidence suggests that strong-form efficiency does not hold. If this
form were correct, prices would fully reflect all information. Therefore even
insiders could not earn excess returns. But the evidence is that corporate
officers do have access to pertinent information long enough before public
release to enable them to profit from trading on this information.
b. i. Technical analysis involves the search for recurrent and predictable patterns in
stock prices in order to enhance returns. The EMH implies that technical analysis is without value. If past prices contain no useful information for predicting future prices, there is no point in following any technical trading rule.
ii. Fundamental analysis uses earnings and dividend prospects of the firm,
expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. The EMH predicts that most fundamental analysis is doomed to failure. According to semistrong-form efficiency, no investor can earn excess returns from trading rules based on publicly available information. Only analysts with unique insight achieve superior returns.
In summary, the EMH holds that the market appears to adjust so quickly to
information about both individual stocks and the economy as a whole that no
technique of selecting a portfolio using either technical or fundamental analysis can consistently outperform a strategy of simply buying and holding a diversified
portfolio of securities, such as those comprising the popular market indexes.
c. Portfolio managers have several roles and responsibilities even in perfectly
efficient markets. The most important responsibility is to identify the risk/return objectives for a portfolio given the investor’s constraints. In an efficient market, portfolio managers are responsible for tailoring the portfolio to meet the investor’s needs, rather than to beat the market, which requires identifying the client’s return requirements and risk tolerance. Rational portfolio management also requires
examining the investor’s constraints, including liquidity, time horizon, laws and regulations, taxes, and unique preferences and circumstances such as age and
employment.
10. a. The earnings (and dividend) growth rate of growth stocks may be consistently
overestimated by investors. Investors may extrapolate recent growth too far into the future and thereby downplay the inevitable slowdown. At any given time,
growth stocks are likely to revert to (lower) mean returns and value stocks are
likely to revert to (higher) mean returns, often over an extended future time
horizon.
In efficient markets, the current prices of stocks already reflect all known relevant information. In this situation, growth stocks and value stocks provide the same
risk-adjusted expected return. b.