The question of whether markets are efficient will always be a provocative one, given the implications that efficient markets have for investment management and research. If an efficient market is defined as one where the market price is an unbiased estimate of the true value, it is quite clear that some markets will always be more efficient than others and that markets will always be more efficient to some investors than to others. The capacity of a market to correct inefficiencies quickly will depend, in part, on the ease of trading, the transactions cost and the vigilance of profit-seeking investors in that market.

While market efficiency can be tested in a number of different ways, the two most widely used tests to test efficiency are 'event studies' which examine market reactions to information events and 'portfolio studies' which evaluate the returns of portfolios created on the basis of observable characteristics. It does make sense to be vigilant, because bias can enter these studies, intentionally or otherwise, in a number of different ways and can lead to unwarranted conclusions, and, worse still, wasteful investment strategies.

There is substantial evidence of irregularities in market behavior, related to systematic factors such as size, price-earnings ratios and price book value ratios, as well as to time - the January and the weekend effects. While these irregularities may be inefficiencies, there is also the sobering evidence that professional money managers, who are in a position to exploit these inefficiencies, have a very difficult time consistently beating financial markets. Read together, the persistence of the irregularities and the inability of money managers to beat the market is testimony to the gap between empirical tests on paper and real world money management in some cases, and the failure of the models of risk and return in others.

1. Which of the following is an implication of market efficiency? (There may be more than one right answer)

(a) Resources are allocated among firms efficiently (i.e. put to best use)

(b) No investor will do better than the market in any time period

(c) No investor will do better than the market consistently

(d) No investor will do better than the market consistently after adjusting for risk

(e) No investor will do better than the market consistently after adjusting for risk and transactions costs

(f) No group of investors will do better than the market consistently after adjusting for risk and transactions costs.

2. Suppose you are following a retailing stock which has a strong seasonal pattern to sales. Would you expect to see a seasonal pattern in the stock price as well?

3. Tests of market efficiency are often referred to as joint tests of two hypotheses - the hypothesis that the market is efficient and an expected returns model. Explain. Is it ever possible to test market efficiency alone? (i.e. without jointly testing an asset pricing model)

4. You are in a violent argument with a chartist. He claims that you are violating the fundamental laws of economics by trying to find intrinsic value. "Price is determined by demand and supply... not by some intrinsic value'. Is finding an intrinsic value inconsistent with demand and supply?

5. You are testing the effect of merger announcements on stock prices. (This is an event study.). Your procedure goes through the following steps.

Step 1: You choose the twenty biggest mergers of the year

Step 2: You isolate the date the merger became effective as the key day around which you will examine the data

Step 3: You look at the returns for the five days after the effective merger date

By looking at these returns (.13%) you conclude that you could not have made money on merger announcements. Are there any flaws that you can detect in this test? How would you correct for them? Can you devise a stronger test?

6. In an efficient market, the market price is defined to be an 'unbiased estimate' of the true value. This implies that

(a) the market price is always equal to true value.

(b) the market price has nothing to do with true value

(c) markets make mistakes about true value, and investors can exploit these mistakes to make money

(d) market prices contain errors, but the errors are random and therefore cannot be exploited by investors.

(e) no one can beat the market.

7. Evaluate whether the following actions are likely to increase stock market efficiency, decrease it or leave it unchanged, and explain why.

a. The government imposes a transaction tax of 1% on all stock transactions. Increase Efficiency_ Decrease Efficiency__Leave unchanged__

b. The securities exchange regulators impose a restriction on all short sales to prevent rampant speculation.

Increase Efficiency_ Decrease Efficiency__Leave unchanged__

c. An options market, trading call and put options, is opened up, with options traded on many of the stocks listed on the exchange.

Increase Efficiency_ Decrease Efficiency__Leave unchanged__

d. The stock market removes all restrictions on foreign investors acquiring and holding stock in companies.

Increase Efficiency_ Decrease Efficiency__Leave unchanged__

8. The following is a graph of cumulative abnormal returns around the announcement of asset divestitures by major corporations.

Cumulative Abnormal Returns

How best would you explain the

(a) market behavior before the announcement?

(b) market reaction to the announcement ?

(c) market reaction after the announcement?

9. What is the phenomenon of the size effect in stock performance? How does it relate to the 'turn-of-the-year' effect? Can you suggest any good reasons why small stocks, after adjusting for beta, still do

better than large stocks? What strategy would you follow to exploit this anomaly? What factors do you have to keep in mind?

10. A study examining market reactions to earnings surprises found that prices tend to drift after earnings surprises. What does this tell you market's capacity to learn from events and new information? What cross-sectional differences would you expect to find in this learning behavior? (i.e. Would you expect to see a greater price drift in some types of firms than in others? Why?) How would you try to exploit this anomaly? What possible costs would you have to keep in mind?

11. One explanation of the turn-of-the-year or January effect has to do with sales and purchases related to the tax year.

(a) Present the tax effect hypothesis

(b) Studies have shown that the January effect occurs internationally, even in countries where the tax year does not start in January. Speculate on a good reason for this.

12. The following are the expected price appreciation and dividend yield components of returns on two portfolios - a 'high dividend yield' portfolio and a 'low dividend yield' portfolio.

Portfolio Expected Price Appreciation Expected Dividend Yield

You are a taxable investor who faces a tax rate of 40% on dividends. What would your tax rate on capital gains need to be for you to be indifferent between these two portfolios?

13. Answer true or false to the following questions -

a. Low price-earnings stocks, on average, earn returns in excess of expectations, while high price-earnings stocks earn less than expected. This is primarily because lower P/E ratio stocks have lower risk. TRUE FALSE

b. The small firm effect, which refers the positive excess returns earned, on average, by small firms, is primarily caused by a few small firms that make very high positive returns.


c. Investors generally cannot make money on analyst recommendations, because stock prices are not affected by these recommendations. TRUE FALSE

14. You are examining the performance of two mutual funds. AD VALUE Fund has been in existence since January 1, 1988 and invests primarily in low Price Earnings Ratio stocks, with high dividend yields. AD GROWTH Fund has also been in existence since January 1, 1988 but it invests primarily in high growth stocks, with high PE ratios and low or no dividends. The performance of these funds over the last five years is summarized below:

Average from 1988-1992 Price Appreciation Dividend Yield Beta


The average riskfree rate during the period was 6%. The current riskfree rate is 3%.

a. How well or badly did these funds perform after adjusting for risk?

b. Assume that the front-end load on each of these funds is 5% (i.e. if you put $1000 in each of these funds today, you would only be investing $950 after the initial commission). Assume also that the excess returns you have calculated in part (a) will continue into the future and that you choose to invest in the fund that outperformed the market. How many years would you have to hold this fund to break even?

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  • Celendine
    Is finding an intrinsic value inconsistent with demand and supply?
    7 years ago

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