Efficient capital markets and behavioral challenges

Chapter 14

Efficient Capital Markets and Behavioral Challenges

Multiple Choice Questions

1. An efficient capital market is one in which:

A. brokerage commissions are zero.

B. taxes are irrelevant.

C. securities always offer a positive rate of return to investors.

D. security prices are guaranteed by the U.S. Securities and Exchange Commission to be fair.

E. security prices reflect available information.

2. The notion that actual capital markets, such as the NYSE, are fairly priced is called the:

A. Efficient Markets Hypothesis (EMH).

B. Law of One Price.

C. Open Markets Theorem.

D. Laissez-Faire Axiom.

E. Monopoly Pricing Theorem.

3. The hypothesis that market prices reflect all available information of every kind is called _____

form efficiency.

A. open

B. strong

C. semistrong

D. weak

E. stable

4. The hypothesis that market prices reflect all publicly available information is called _____ form

efficiency.

A. open

B. strong

C. semistrong

D. weak

E. stable

5. The hypothesis that market prices reflect all historical information is called _____ form efficiency.

A. open

B. strong

C. semistrong

D. weak

E. stable

6. In an efficient market, the price of a security will:

A. always rise immediately upon the release of new information with no further price adjustments

related to that information.

B. react to new information over a two-day period after which time no further price adjustments

related to that information will occur.

C. rise sharply when new information is first released and then decline to a new stable level by the

following day.

D. react immediately to new information with no further price adjustments related to that

information.

E. be slow to react for the first few hours after new information is released allowing time for that

information to be reviewed and analyzed.

7. If the financial markets are efficient, then investors should expect their investments in those

markets to:

A. earn extraordinary returns on a routine basis.

B. generally have positive net present values.

C. generally have zero net present values.

D. produce arbitrage opportunities on a routine basis.

E. produce negative returns on a routine basis.

8. Which one of the following statements is correct concerning market efficiency?

A. Real asset markets are more efficient than financial markets.

B. If a market is efficient, arbitrage opportunities should be common.

C. In an efficient market, some market participants will have an advantage over others.

D. A firm will generally receive a fair price when it sells shares of stock.

E. New information will gradually be reflected in a stock's price to avoid any sudden change in the

price of the stock.

9. According to the efficient market hypothesis, financial markets fluctuate daily because they:

A. are inefficient.

B. slowly react to new information.

C. are continually reacting to new information.

D. offer tremendous arbitrage opportunities.

E. only reflect historical information.

10. Insider trading does not offer any advantages if the financial markets are:

A. weak form efficient.

B. semiweak form efficient.

C. semistrong form efficient.

D. strong form efficient.

E. inefficient.

11. According to theory, studying historical prices in order to identify mispriced stocks will not work in

markets that are _____ efficient.

I. weak form

II. semistrong form

III. strong form

A. I only

B. II only

C. I and II only

D. II and III only

E. I, II, and III

12. Which of the following tend to reinforce the argument that the financial markets are efficient?

I. Information spreads rapidly in today's world.

II. There is tremendous competition in the financial markets.

III. Market prices continually fluctuate.

IV. Market prices react suddenly to unexpected news announcements.

A. I and III only

B. II and IV only

C. I, II, and III only

D. II, III, and IV only

E. I, II, III, and IV

13. If you excel in analyzing the future outlook of firms, you would prefer that the financial markets be

____ form efficient so that you can have an advantage in the marketplace.

A. weak

B. semiweak

C. semistrong

D. strong

E. perfect

14. Your best friend works in the finance office of the Delta Corporation. You are aware that this friend

trades Delta stock based on information he overhears in the office. You know that this information

is not known to the general public. Your friend continually brags to you about the profits he earns

trading Delta stock. Based on this information, you would tend to argue that the financial markets

are at best _____ form efficient.

A. weak

B. semiweak

C. semistrong

D. strong

E. perfect

15. The U.S. Securities and Exchange Commission periodically charges individuals for insider trading

and claims those individuals have made unfair profits. Based on this fact, you would tend to argue

that the financial markets are at best _____ form efficient.

A. weak

B. semiweak

C. semistrong

D. strong

E. perfect

16. Individuals that continually monitor the financial markets seeking mispriced securities:

A. tend to make substantial profits on a daily basis.

B. tend to make the markets more efficient.

C. are never able to find a security that is temporarily mispriced.

D. are always quite successful using only well-known public information as their basis of

evaluation.

E. are always quite successful using only historical price information as their basis of evaluation.

17. Efficient capital markets are financial markets:

A. in which current market prices reflect available information.

B. in which current market prices reflect the present value of securities.

C. in which there is no excess profit from using available information.

D. All of these.

E. None of these.

18. If the efficient market hypothesis holds, investors should expect:

A. to earn only a normal return.

B. to receive a fair price for their securities.

C. to always be able to pick stocks that will outperform the market averages.

D. Both to earn only a normal return; and to receive a fair price for their securities.

E. Both to receive a fair price for their securities; and to always be able to pick stocks that will

outperform the market averages.

19. Financial managers can create value through financing decisions that:

A. reduce costs or increase subsidies.

B. increase the product prices.

C. create a new security.

D. Both reduce costs or increase subsidies; and increase the product prices.

E. Both reduce costs or increase subsidies; and create a new security.

20. In an efficient market when a firm makes an announcement of a new product or product

enhancement with superior technology providing positive NPV, the price of the stock will:

A. rise gradually over the next few days.

B. decline gradually over the next few days.

C. rise on the same day to the new price.

D. stay at the same price, with no net effect.

E. drop on the same day to the new price.

21. An investor discovers that for a certain group of stocks, large positive price changes are always

followed by large negative price changes. This finding is a violation of the:

A. moderate form of the efficient market hypothesis.

B. semistrong form of the efficient market hypothesis.

C. strong form of the efficient market hypothesis.

D. weak form of the efficient market hypothesis.

E. None of these.

22. Which of the following would be indicative of inefficient markets?

A. Overreaction and reversion

B. Delayed response

C. Immediate and accurate response

D. Both Overreaction and reversion; and Delayed response

E. Both Overreaction and reversion; and Immediate and accurate response

23. When the stock price follows a random walk, the price today is said to be equal to the prior period

price plus the expected return for the period with any remaining difference to the actual return due

to:

A. a predictable amount based on the past prices.

B. a component based on new information unrelated to past prices.

C. the security's risk.

D. the risk free rate.

E. None of these.

24. Which form of the efficient market hypothesis implies that security prices reflect only information

contained in past prices?

A. Weak form

B. Semistrong form

C. Strong form

D. Hard form

E. Past form

25. If the weak form of efficient markets holds, then:

A. technical analysis is useless.

B. stock prices reflect all information contained in past prices.

C. stock prices follow a random walk.

D. All of these.

E. None of these.

26. Under the concept of an efficient market, a random walk in stock prices means that:

A. there is no driving force behind price changes.

B. technical analysts can predict future price movements to earn excess returns.

C. the unexplained portion of price change in one period is unrelated to the unexplained portion of

price change in any other period.

D. the unexplained portion of price change in one period that cannot be explained by expected

return can only be explained by the unexplained portion of price change in a prior period.

E. None of these.

27. A semistrong form efficient market is distinct from a weak form efficient market by:

A. incorporating only random movements in the price.

B. incorporating all publicly available information in the price.

C. incorporating inside information in the price.

D. All of these.

E. None of these.

28. If a market is strong form efficient, it also implies that:

A. semistrong form efficiency holds.

B. weak form efficiency holds.

C. one cannot earn abnormal returns with inside information.

D. Both semistrong form efficiency holds; and one cannot earn abnormal returns with inside

information.

E. semistrong form efficiency holds; and weak form efficiency holds; and one cannot earn

abnormal returns with inside information.

29. An investor discovers that predictions about weather patterns published years in advance and

found in the Farmer's Almanac are amazingly accurate. In fact, these predictions enable the

investor to predict the health of the farm economy and therefore certain security prices. This

finding is a violation of the:

A. moderate form of the efficient market hypothesis.

B. semistrong form of the efficient market hypothesis.

C. strong form of the efficient market hypothesis.

D. weak form of the efficient market hypothesis.

E. None of these.

30. A lawyer works for a firm that advises corporate firms planning to sue other corporations for

antitrust damages. He finds that he can "beat the market" by short-selling the stock of the firm that

will be sued. This finding is a violation of the:

A. moderate form of the efficient market hypothesis.

B. semistrong form of the efficient market hypothesis.

C. strong form of the efficient market hypothesis.

D. weak form of the efficient market hypothesis.

E. None of these.

31. An investor discovers that stock prices change drastically as a result of certain events. This finding

is a violation of the:

A. moderate form of the efficient market hypothesis.

B. semistrong form of the efficient market hypothesis.

C. strong form of the efficient market hypothesis.

D. weak form of the efficient market hypothesis.

E. None of these.

32. The semistrong form of the efficient market hypothesis states that:

A. all information is reflected in the price of securities.

B. security prices reflect all publicly available information.

C. future prices are predictable.

D. Both all information is reflected in the price of securities; and future prices are predictable.

E. None of these.

33. The market price of a stock moves or fluctuates daily. This fluctuation is:

A. inconsistent with the semistrong efficient market hypothesis because prices should be stable.

B. inconsistent with the weak form efficient market hypothesis because all past information should

be priced in.

C. consistent with the semistrong form of the efficient market hypothesis because as new

information arrives daily prices will adjust to it.

D. consistent with the strong form because prices are controlled by insiders.

E. None of these.

34. An investor who picks a portfolio by throwing darts at the financial pages:

A. believes that efficient markets will protect the portfolio from harm as all information is priced.

B. believes that riskier portfolios earn the same as less risky portfolios.

C. does so because stock prices do not matter; only cash flow generated matters.

D. Both believes that efficient markets will protect the portfolio from harm as all information is

priced; and does so because stock prices do not matter; and only cash flow generated matters.

E. Both believes that riskier portfolios earn the same as less risky portfolios; and does so because

stock prices do not matter; and only cash flow generated matters.

35. Suppose that firms with unexpectedly high earnings earn abnormally high returns for several

months after the announcement. This would be evidence of:

A. efficient markets in the weak form.

B. inefficient markets in the weak form.

C. efficient markets in the semistrong form.

D. inefficient markets in the semistrong form.

E. inefficient markets in the strong form.

36. Which of the following is not true about serial correlation?

A. It measures the correlation between the current return on a security and the current return on

another security.

B. It involves only one security.

C. Positive serial correlation indicates a tendency for continuation.

D. Negative serial correlation indicates a tendency toward reversal.

E. Significant positive or negative serial correlation coefficients are indicative of market inefficiency

in the weak form.

37. Which of the following is true?

A. A random walk for stock price changes is inconsistent with observed patterns in price changes.

B. If the stock market follows a random walk, price changes should be highly correlated.

C. If the stock market is weak form efficient, then stock prices follow a random walk.

D. All of these.

E. Both If the stock market follows a random walk, price changes should be highly correlated; and

If the stock market is weak form efficient, then stock prices follow a random walk.

38. Event studies attempt to measure:

A. the influence of information released to the market on returns in days surrounding its

announcement.

B. if the market is at least semistrong form efficient.

C. whether there is a significant reaction to public announcements.

D. All of these.

E. None of these.

39. The abnormal return in an event study is described as:

A. the return earned on the day of announcement for the stock.

B. the excess return earned on the day of announcement for the stock.

C. the total return earned for the investment holding period.

D. All of these.

E. None of these.

40. Evidence on stock prices finds that the sudden death of a chief executive officer causes stock

prices to fall and the sudden death of an active founding chief executive officer causes stock price

to rise. This contrary evidence happens because:

A. markets are inefficient and unsure of the real value of the events.

B. death is inevitable and market prices are random.

C. things simply happen.

D. the value of the founding executive was a negative to the firm.

E. None of these.

41. Studies of the performance of professionally managed mutual funds find that these funds:

A. do not outperform a market index. Assuming mutual fund managers rely primarily on public

information, this finding refutes the semistrong form of the efficient market hypothesis.

B. do not outperform a market index. Assuming mutual fund managers rely primarily on public

information, this finding supports the semistrong form of the efficient market hypothesis.

C. outperform a market index. Assuming mutual fund managers rely primarily on public

information, this finding refutes the semistrong form of the efficient market hypothesis.

D. outperform a market index. Assuming mutual fund managers rely primarily on public

information, this finding supports the semistrong form of the efficient market hypothesis.

E. Both outperform a market index. Assuming mutual fund managers rely primarily on public

information, this finding refutes the semistrong form of the efficient market hypothesis; and

outperform a market index. Assuming mutual fund managers rely primarily on public

information, this finding supports the semistrong form of the efficient market hypothesis.

42. Which of the following statements is true?

A. In efficient markets, a stock's price should change with the arrival of new information.

B. Average stock returns are higher in January than other months.

C. Studies by Fama and French and others find that returns of high book to market stocks are

much higher than low book to market value stocks to be consistent with the efficient market

hypothesis.

D. All of these.

E. None of these.

43. Which of the following is true?

A. Most empirical evidence is consistent with strong form efficiency.

B. Most empirical evidence is inconsistent with weak form efficiency.

C. Strong form market efficiency is not supported by the empirical evidence.

D. Both Most empirical evidence is consistent with strong form efficiency; and Strong form market

efficiency is not supported by the empirical evidence.

E. Both Most empirical evidence is inconsistent with weak form efficiency; and Strong form market

efficiency is not supported by the empirical evidence.

44. In examining the issue of whether the choice of accounting methods affects stock prices, studies

have found that:

A. accounting depreciation methods can significantly affect stock prices.

B. switching depreciation methods can significantly affect stock prices.

C. accounting changes that increase accounting earnings also increases stock prices.

D. accounting changes can affect stock prices if the company were either to withhold information

or provide incorrect information.

E. All of these.

45. Market efficiency says:

A. prices may not reflect underlying value.

B. a good financial manager can time stock sales.

C. managers may profitably speculate in foreign currency.

D. managers cannot boost stock prices through creative accounting.

E. None of these.

46. The abnormal returns for initial public offerings over longer time periods seem to call market

efficiency into question because:

A. the average returns at announcement are large and positive while the long-term results are

much lower than the returns for seasoned equity offerings.

B. the average returns at announcement are small and negative while the long-term results are

much lower than the returns for seasoned equity offerings.

C. the average returns at announcement are zero while the long-term results are much higher

than the returns for seasoned equity offerings.

D. the average returns at announcement are large and positive while the long-term results are

much higher than the returns for seasoned equity offerings.

E. the average returns at announcement are insignificant while the long-term results are much

lower than the returns for seasoned equity offerings.

47. An example of financially irrational behavior is:

A. gambling in Las Vegas.

B. when a firm announces an increase in earnings and the stock price enjoys three days of large

abnormal returns.

C. when a firm announces an increase in earnings and the stock price enjoys an immediate surge

in value which is captured in one day.

D. Both gambling in Las Vegas; and when a firm announces an increase in earnings and the stock

price enjoys three days of large abnormal returns.

E. Both gambling in Las Vegas; and when a firm announces an increase in earnings and the stock

price enjoys an immediate surge in value which is captured in one day.

48. Ritter's study of Initial Public Offerings (IPOs) showed that the post offering stock performance

was:

A. less than the control group by about 2% in the five years following the IPO.

B. incorrectly priced at issuance because over the next five years the abnormal returns were

greater than zero on average.

C. immaterial to the pricing of the IPO because future market performance is unknown at

issuance.

D. equal across IPOs, irrespective of risk or which year they were issued.

E. All of these.

49. If the securities market is efficient, an investor need only throw darts at the stock pages to pick

securities and be just as well off.

A. This is true because there are no differences in risk and return.

B. This is true because in an efficient stock market prices do not fluctuate.

C. This is false because professional portfolio managers prefer to generate commissions by active

trading.

D. This is false because investors may not hold a desirable risk-return combination in their

portfolio.

E. This is false because the markets are controlled by the institutional investors.

50. Financial managers must be cognizant of market efficiency because: