CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS

1. If you believe in the ________ form of the EMH, you believe that stock prices reflect all relevant
information including historical stock prices and current public information about the firm, but not
information that is available only to insiders. A. semistrong

2. When Maurice Kendall examined the patterns of stock returns in 1953 he concluded that the stock
market was __________. Now, these random price movements are believed to be _________.
A. inefficient; the effect of a well-functioning market

3. The stock market follows a __________. B. submartingale

4. A hybrid strategy is one where the investor

D. maintains a passive core and augments the position with an actively managed portfolio.

5. The difference between a random walk and a submartingale is the expected price change in a random
walk is ______ and the expected price change for a submartingale is ______. D. zero; positive

6. The difference between a random walk and a submartingale is the expected price change in a random
walk is ______ and the expected price change for a submartingale is ______. D. zero; positive

7. Proponents of the EMH typically advocate

A. an active trading strategy.
B. investing in an index fund.
C. a passive investment strategy.
D. A and B
E. B and C

8. Proponents of the EMH typically advocate C. a passive investment strategy.

9. If you believe in the _______ form of the EMH, you believe that stock prices reflect all information
that can be derived by examining market trading data such as the history of past stock prices, trading
volume or short interest. C. weak

10. If you believe in the _________ form of the EMH, you believe that stock prices reflect all available
information, including information that is available only to insiders. B. strong

11. If you believe in the reversal effect, you should C. buy stocks this period that performed poorly
last period.

12. __________ focus more on past price movements of a firm's stock than on the underlying
determinants of future profitability.D. Technical analysts

13. _________ above which it is difficult for the market to rise. B. Resistance level is a value

14. _________ below which it is difficult for the market to fall. C. Support level is a value

15. ___________ the return on a stock beyond what would be predicted from market movements
alone.
A. An excess economic return is
B. An economic return is
C. An abnormal return is
D. A and B
E. A and C

16. The debate over whether markets are efficient will probably never be resolved because of
________.
A. the lucky event issue.
B. the magnitude issue.
C. the selection bias issue.
D. all of the above.

17. A common strategy for passive management is ____________. A. creating an index fund

18. Arbel (1985) found that A. the January effect was highest for neglected firms.

19. Researchers have found that most of the small firm effect occurs D. in January.

20. Basu (1977, 1983) found that firms with low P/E ratios
A. earned higher average returns than firms with high P/E ratios.

21. Jaffe (1974) found that stock prices _________ after insiders intensively bought shares.C. increased

22. Banz (1981) found that, on average, the risk-adjusted returns of small firms
A. were higher than the risk-adjusted returns of large firms.

23. Proponents of the EMH think technical analysts E. are wasting their time

24. Studies of positive earnings surprises have shown that there is D. both A and B are true.

25. Studies of negative earnings surprises have shown that there isD. both A and B are true.

26. Studies of stock price reactions to news are called B. event studies.

27. On November 22, 2005 the stock price of Walmart was $39.50 and the retailer stock index was
600.30. On November 25, 2005 the stock price of Walmart was $40.25 and the retailer stock index was
605.20. Consider the ratio of Walmart to the retailer index on November 22 and November 25. Walmart
is _______ the retail industry and technical analysts who follow relative strength would advise _______
the stock.
A. outperforming, buying
11/22: $39.50/600.30 = 0.0658; 11/25: $40.25/605.20 = 0.0665; Thus, K-Mart's relative strength is
improving and technicians using this technique would recommend buying.

28. Work by Amihud and Mendelson (1986,1991)

A. argues that investors will demand a rate of return premium to invest in less liquid stocks.
B. may help explain the small firm effect.
C. may be related to the neglected firm effect.
D. B and C.
E. A, B, and C.

29. Fama and French (1992) found that the stocks of firms within the highest decile of market/book
ratios had average monthly returns of _______ while the stocks of firms within the lowest decile of
market/book ratios had average monthly returns of ________. C. less than 1%, greater than 1%

30. A market decline of 23% on a day when there is no significant macroeconomic event ______
consistent with the EMH because ________.
D. would not be, it was not a clear response to macroeconomic news.

31. In an efficient market, __________.

A. security prices react quickly to new information
B. security prices are seldom far above or below their justified levels
C. security analysts will not enable investors to realize superior returns consistently
D. one cannot make money
E. A, B, and C

32. The weak form of the efficient market hypothesis asserts that
A. stock prices do not rapidly adjust to new information contained in past prices or past data.
B. future changes in stock prices cannot be predicted from past prices.
C. technicians cannot expect to outperform the market.
D. A and B
E. B and C

33. A support level is the price range at which a technical analyst would expect the
C. demand for a stock to increase substantially.

34. A finding that _________ would provide evidence against the semistrong form of the efficient
market theory.
A. low P/E stocks tend to have positive abnormal returns
B. trend analysis is worthless in determining stock prices
C. one can consistently outperform the market by adopting the contrarian approach exemplified by the
reversals phenomenon
D. A and B
E. A and C

35. The weak form of the efficient market hypothesis contradicts

D. technical analysis, but is silent on the possibility of successful fundamental analysis.

36. Two basic assumptions of technical analysis are that security prices adjust
C. Gradually to new information and market prices are determined by the interaction of supply
and demand.

37. Cumulative abnormal returns (CAR)

A. are used in event studies.
B. are better measures of security returns due to firm-specific events than are abnormal returns (AR).
C. are cumulated over the period prior to the firm-specific event.
D. A and B.
E. A and C.

38. Studies of mutual fund performance

A. indicate that one should not randomly select a mutual fund.
B. indicate that historical performance is not necessarily indicative of future performance.
C. indicate that the professional management of the fund insures above market returns.
D. A and B.
E. B and C.

39. The likelihood of an investment newsletter's successfully predicting the direction of the market for
three consecutive years by chance should be C. between 10% and 25%.

40. In an efficient market the correlation coefficient between stock returns for two non-overlapping time
periods should be C. zero.

41. The weather report says that a devastating and unexpected freeze is expected to hit Florida tonight,
during the peak of the citrus harvest. In an efficient market one would expect the price of Florida
Orange's stock to A. drop immediately.

42. Matthews Corporation has a beta of 1.2. The annualized market return yesterday was 13%, and the
risk-free rate is currently 5%. You observe that Matthews had an annualized return yesterday of 17%.
Assuming that markets are efficient, this suggests that
B. good news about Matthews was announced yesterday.
AR = 17% - (5% + 1.2 (8%)) = +2.4%. A positive abnormal return suggests that there was firm-specific
good news.

43. Nicholas Manufacturing just announced yesterday that its 4 th quarter earnings will be 10% higher
than last year's 4 th quarter. You observe that Nicholas had an abnormal return of -1.2% yesterday. This
suggests that
C. investors expected the earnings increase to be larger than what was actually announced.

44. When Maurice Kendall first examined stock price patterns in 1953, he found that
B. there were no predictable patterns in stock prices.

45. If stock prices follow a random walk D. price changes are random.

46. The main difference between the three forms of market efficiency is that
D. the definition of information differs.

47. Chartists practice A. technical analysis.

48. Which of the following are used by fundamental analysts to determine proper stock prices?
I) trendlines
II) earnings
III) dividend prospects
IV) expectations of future interest rates
V) resistance levels
A. I, IV, and V
B. I, II, and III
C. II, III, and IV
D. II, IV, and V
E. All of the items are used by fundamental analysts.

49. According to proponents of the efficient market hypothesis, the best strategy for a small investor with
a portfolio worth $40,000 is probably to E. invest in mutual funds.

50. Which of the following are investment superstars who have consistently shown superior
performance?
I) Warren Buffet
II) Phoebe Buffet
III) Peter Lynch
IV) Merrill Lynch
V) Jimmy Buffet
A. I, III, and IV
B. II, III, and IV
C. I and III
D. III and IV
E. I, III, IV, and V

51. Google has a beta of 1.0. The annualized market return yesterday was 11%, and the risk-free rate is
currently 5%. You observe that Google had an annualized return yesterday of 14%. Assuming that
markets are efficient, this suggests that
B. good news about Google was announced yesterday.
AR = 14% - (5% + 1.0 (6%)) = +3.0%. A positive abnormal return suggests that there was firm-specific
good news.

52. Music Doctors has a beta of 2.25. The annualized market return yesterday was 12%, and the
risk-free rate is currently 4%. You observe that Music Doctors had an annualized return yesterday of
15%. Assuming that markets are efficient, this suggests that
A. bad news about Music Doctors was announced yesterday.

53. QQAG has a beta of 1.7. The annualized market return yesterday was 13%, and the risk-free rate is
currently 3%. You observe that QQAG had an annualized return yesterday of 20%. Assuming that
markets are efficient, this suggests that
C. no significant news about QQAG was announced yesterday.

54. QQAG just announced yesterday that its 4th quarter earnings will be 35% higher than last year's 4th
quarter. You observe that QQAG had an abnormal return of -1.7% yesterday. This suggests that
C. investors expected the earnings increase to be larger than what was actually announced.

55. LJP Corporation just announced yesterday that it would undertake an international joint venture.
You observe that LJP had an abnormal return of 3% yesterday. This suggests that
D. investors view the international joint venture as good news.
56. Music Doctors just announced yesterday that its 1st quarter sales were 35% higher than last year's
1st quarter. You observe that Music Doctors had an abnormal return of -2% yesterday. This suggests that
C. investors expected the sales increase to be larger than what was actually announced.

57. The Food and Drug Administration (FDA) just announced yesterday that they would approve a new
cancer-fighting drug from King. You observe that King had an abnormal return of 0% yesterday. This
suggests that D. the approval was already anticipated by the market

58. Your professor finds a stock-trading rule that generates excess risk-adjusted returns. Instead of
publishing the results, she keeps the trading rule to herself. This is most closely associated with
________. B. selection bias

59. At freshman orientation, 1,500 students are asked to flip a coin 20 times. One student is crowned
the winner (tossed 20 heads). This is most closely associated with ________. D. the lucky event issue

60. Sehun (1986) finds that the practice of monitoring insider trade disclosures, and trading on that
information, would be ________. E. not sufficiently profitable to cover trading costs

61. If you believe in the reversal effect, you should

C. sell stocks this period that performed well last period.

62. Patell and Woflson (1984) report that most of the stock price response to corporate dividend or
earnings announcements occurs within ____________ of the announcement. C. 2 hours