Deck 11: Efficient Markets, Classical Finance, and Behavioral Finance

Question 1

An advantage of efficient markets is that

A)an investor can expect fair prices.
B)an investor can expect to find a number of arbitrage opportunities.
C)everyone should be able to borrow and lend at the same interest rate.
D)an investor can expect to find a reasonable number of "great bets" in which to invest.

Answer 1

an investor can expect fair prices.

Question 2

Which of the following markets is least likely to be efficient?

A)corporate bond market
B)Treasury bond market
C)stock market
D)real estate market

Answer 2

real estate market

Question 3

If an investor believes that the stock market is efficient at only the weak level, which of the following activities would he consider to be a waste of time and effort?

A)plotting the historical prices of a stock to look for a trend that will suggest when it is a good time to buy or sell that stock.
B)studying a firm's financial statements in an attempt to forecast the future cash flows of the firm.
C)analyzing current information about a firm as it is made public.
D)reading a column in the Wall Street Journal that he believes often hints at insider information.

Answer 3

plotting the historical prices of a stock to look for a trend that will suggest when it is a good time to buy or sell that stock.

Question 4

If a market is efficient, then

A)it may be perfect or imperfect.
B)all investments will offer the same return.
C)there is no reason to invest in it since you can't expect to earn any excess returns.
D)it must also be perfect.

Question 5

Some studies of the stock market have concluded that a "weekend effect" exists. These
studies found that, on average, the stock market tends to fall on Mondays, relative to
the preceding Friday's close price.
Is this a violation of the concept of efficient markets? Explain.

Question 6

An efficient market is defined as one in which

A)the current prices reflect all available information.
B)there are no taxes.
C)there are no transaction costs.
D)All of the above are necessary conditions for an efficient market.

Question 7

If the stock market is semistrong efficient, then

A)an investor will never earn any excess return on his stock investment if he is privy only to publicly available information.
B)investors can expect stocks to be fairly priced according to their risk most of the time.
C)investors can expect new information about a firm to be rapidly reflected in its stock price.
D)Both B and C are correct statements.

Question 8

"Anyone willing to devote the time and effort can find mispriced securities and enjoy abnormally high returns on a regular basis." This statement would be attributed to an investor
In which of the fundamentals-based classes?

A)non believer
B)mild believer
C)firm believer
D)true believer

Question 9

Which of the following is not one of the fundamentals-based classifications of market efficiency?

A)moderate believer
B)true believer
C)non believer
D)mild believer

Question 10

Which of the following statements about market efficiency is most correct?

A)If you earn a return greater than what the market suggests it should be, then the market is necessarily inefficient.
B)The concept of market efficiency is most powerful over long time horizons.
C)If a market is efficient, then you should not expect to earn returns greater than what the market suggests the return should be.
D)All of the above are true statements.

Question 11

How do you think the introduction of internet brokers affected the
efficiency of U.S. financial markets? Why?

Question 12

If a market is perfect, then

A)it may be either efficient or inefficient.
B)there will be higher bid-ask spreads.
C)there may be arbitrage opportunities available, but no great bets.
D)it must also be efficient.

Question 13

If a market is efficient, then

A)only professional money managers will be able to earn profits.
B)there are an abundance of arbitrage opportunities available.
C)the only way to earn profits is by investing in highly speculative investments.
D)None of the above is a true statement.

Question 14

If the stock market is at least semistrong efficient then,

A)trading on information that you read in The Wall Street Journal or on the internet is unlikely to allow you to purchase stocks that are significantly underpriced.
B)you cannot expect to find underpriced or overpriced stocks even if you have inside information.
C)you are likely to find underpriced and overpriced securities by conducting a thorough analysis of a firm's financial statements.
D)you should be able to determine when to buy or to sell a stock by studying the pattern of its historical prices.

Question 15

Which of the following is an implication of efficient markets?

A)An investor should employ a buy-and-hold strategy when investing to minimize transaction costs.
B)The only way an investor can expect to increase his expected return is to increase the risk of his portfolio.
C)Only institutional investors or very wealthy individuals can expect to earn excess returns.
D)Both A and B are true statements.

Question 16

"Stock prices always reflect the best estimate of the present value of the expected future cash flows of a firm. Therefore, stock prices will change only when new information enters the
Market." This statement would be attributed to an investor in which of the
Fundamentals-based classes?

A)firm believer
B)mild believer
C)true believer
D)non believer

Question 17

Which of the following statements correctly describes a strong form efficient market?

A)Only those privy to insider information can expect to earn abnormally high returns.
B)No one can earn a return over and above a fair return that would compensate him for his risk, except for the occasional lucky fool.
C)The use of technical analysis can be used to find mispriced securities.
D)Both A and C are correct statements.

Question 18

Which of the following is inconsistent with the concept of semistrong efficient markets?

A)An investor hears a financial analyst on television claim that investors can earn unusually high returns by buying stocks near the end of December and selling them in early January.
By following this advice, the investor does earn an abnormally high return on his portfolio.
B)An investor observes that the bonds of an airline that has filed for bankruptcy are selling for an extremely low price and decides to purchase some of the bonds. Fortunately, the
Airline overcomes its financial difficulties, the bond payments are made as promised, and
The investor earns an extraordinarily high return on this investment.
C)A diner in a New York City restaurant overhears two men at the next table talking about a merger between their two firms and earns high profits by purchasing stock based on this
Information.
D)All of the above are inconsistent with the concept of semistrong efficient markets.

Question 19

"Financial prices sometimes deviate from their fair prices based on expected future cash flows, and even the existence of transaction costs will not prevent investors from earning returns over
And above what they should expect, given the risk of the investment." This statement would
Be attributed to an investor in which of the fundamentals-based classes?

A)firm believer
B)non believer
C)true believer
D)mild believer

Question 20

"Although stock prices sometimes deviate from their fair prices based on expected future cash flows, transaction costs make it impossible for investors to find unusually good bets." This
Statement would be attributed to an investor in which of the fundamentals-based classes?

A)non believer
B)true believer
C)firm believer
D)mild believer

Question 21

What does it mean to say, "Stock prices follow a random walk?"

A)Stock prices move haphazardly and, thus, are unpredictable.
B)Differing transaction costs result in different signals for investors, so excess returns to investors are random.
C)The stock market is both imperfect and inefficient.
D)Stock prices move in response to new information, but new information enters the market randomly.

Question 22

Jason has just attended a seminar in which he learned about the concept of efficient
markets. He tells you what he has learned and his conclusion: "The U.S. financial
markets are largely semistrong efficient, which means that I can't expect to earn any
excess returns on my investments, no matter how much risk I take, since I don't have
any insider information. Therefore, I should just keep my money in a savings account
or invest in a risk-free asset like a Treasury bond." Comment on Jason's conclusion.

Question 23

If stock prices follow a "random walk," does this mean that they move haphazardly,
with no rhyme nor reason?

Question 24

As a "true believer" in market efficiency, what investment strategy would you adopt?
How would this differ from the strategy that a "mild believer" might take? Explain.

Question 25

Which of the fundamentals-based classes is most closely aligned with the tenets of behavioral finance?

A)firm believer
B)mild believer
C)non believer
D)true believer

Question 26

It is difficult to conclude that a particular trading strategy has resulted in excess returns because of the

A)the low signal-to-noise ratio.
B)the high signal-to-noise ratio.
C)transaction costs involved, which blur results.
D)large amount of daily drift.

Question 27

What is the typical range for the noise in U.S. stocks?

A)100 to 500 basis points per day
B)300 to 500 basis points per day
C)5 to 10 basis points per day
D)1 to 3 basis points per day

Question 28

What are the traditional classifications of efficient markets and what does each level
imply?

Question 29

In the random walk equation, is called the

A)noise
B)drift
C)error term
D)transaction cost variable

Question 30

Which of the fundamentals-based classes is most closely aligned with the tenets of classical finance?

A)mild believer
B)true believer
C)firm believer
D)non believer

Question 31

In order to conclude that a particular trading strategy truly leads to excess returns on individual stocks or if the results are just due to noise, you would need about how many years
Worth of daily return data?

A)about 150 or more years
B)60 - 100 years
C)35- 50 years
D)10 - 20 years

Question 32

The difference between an arbitrage and a great bet is

A)great bets are much easier to find in our financial markets than are arbitrage opportunities.
B)an arbitrage does not require a cash outflow whereas a great bet usually does, at least in some scenarios.
C)arbitrage opportunities are easier to find in our financial markets than are great bets.
D)the great bet is expected to offer a much higher return than any arbitrage would.

Question 33

What feature(s)do both great bets and arbitrage have in common?

A)Both are ex-ante concepts.
B)Both are very rare unless the market is very imperfect.
C)Neither should ever require an initial cash outflow.
D)Both A and B are correct answers.

Question 34

Which of the following is an example of a "great bet?"

A)You placed a bet on the underdog horse to "Win," and the horse came in first place.
B)You went to Las Vegas, put a quarter in a slot machine, and won $1,200.
C)You play a game in which you will win $100,000 if you draw any card but an ace out of a 52-card deck. If you draw an ace, however, you pay only $1.00.
D)You bought the stock of Amazon. com when it was selling for $7 a share, and it increased in value to over $40 a share in less than 6 months.

Question 35

Suppose you observe a vendor selling peanuts just outside the ballpark for $1.00 a bag.
Inside the ballpark, vendors are selling peanuts for $3.50 a bag. You take orders from
those sitting around you, quoting a price of $2.00 a bag and collecting the money in
advance. You then go out to the street vendor and purchase enough bags for $1.00 to
fulfill the orders and use your ticket stub to re-enter the ballpark. Is this an example of
an arbitrage or is it just a "great bet"?

Question 36

What is a reasonable range for daily expected returns on stocks?

A)between 1 and 3 basis points per day
B)between 0 and 1 percent a day
C)between 1 and 3 percent a day
D)between 5 and 10 basis points per day

Question 37

What is meant by the "noise" in the Signal-To-Noise ratio?

A)the stock price momentum
B)externalities, such as which party wins an election
C)the day-to-day price volatility
D)the level of insider trading associated with a particular security

Question 38

The "filter rule" is a technical analysis tool that says, "Wait until a stock increases by a certain percentage (i.e., the filter)after it has hit a recent all-time low and then buy the stock. Wait
Until it decreases by that percentage after it has hit a recent all-time high to sell the stock."
Proponents of the rule indicate that abnormal profits can be made by following it. If this is the
Case, then

A)markets are semistrong efficient.
B)markets are weakly efficient.
C)markets are strongly efficient.
D)None of the above. Markets are not even weakly efficient if this rule works.

Question 39

Which of the following is an example of an arbitrage opportunity?

A)You can play a game in which you will win $100,000 if you draw any card but an ace out of a 52-card deck. If you draw an ace, however, you pay only $1.00.
B)You have found an investment that is guaranteed to offer you a 100% return on your investment in one year.
C)You are able to borrow money today for one year at 3% and simultaneously invest the proceeds in a project that is guaranteed to return 15% at the end of the year. There are no
Transaction costs associated with either the loan or the investment.
D)None of the above is an arbitrage opportunity.

Question 40

Which of the following statements is most correct in an efficient perfect market?

A)The best predictor of tomorrow's stock price is its price today plus a tiny drift.
B)The best predictor of tomorrow's stock price is its price today plus or minus about 1%.
C)The best predictor of tomorrow's stock price is its price today.
D)The best predictor of tomorrow's stock price is its price today minus any transaction costs.

Question 41

If the markets are not perfect, but only efficient, in which of the following scenarios would a merger of two companies be most likely to create value?

A)Although Company B is in an unrelated industry, the CFO of Company A has done a thorough analysis and has identified Company B as an extremely undervalued company.
B)Company A is in a completely different industry from Company B, so the merger would provide diversification benefits.
C)Company B is one of Company A's suppliers, and the merger would allow Company A to obtain supplies more cheaply than Company A's competitors can.
D)A merger of the two companies would create value in all of the above scenarios.

Question 42

If you are the CEO of a corporation, and the market is at least semistrong efficient, then

A)you can create value for your own firm by merging with other firms even if they are correctly priced since this provides diversification benefits for your shareholders.
B)it is unlikely that your valuation of your company's worth should differ from what the market says it's worth unless you have information that the market does not.
C)you can expect to create value for your firm by taking over other companies that you identify are selling at too low a price.
D)Both B and C are correct answers.

Question 43

"Survivorship Bias" refers to the fact that

A)those analysts who manage to become highly visible--e.g., by getting interviews on talk shows--are more likely to survive and thrive in the industry.
B)it is more likely that a company will remain in existence if it has a large bankroll to support it through economic downturns.
C)the investments industry is high-stress, and few investment managers last more than 10 to 15 years.
D)poorer performing mutual funds disappear, so that when average returns are calculated, they are based on the funds that remain, which causes the results to be upward-biased.

Question 44

The bulk of empirical evidence on mutual fund returns suggests that

A)there are some proven superior fund managers, and investors should try to invest in funds that have produced superior results over the last three years.
B)superior performance is due more to luck than to the superior analytical ability of a fund manager.
C)the past performance of a fund cannot be used to predict how it will perform in the future.
D)Both B and C are true statements.

Question 45

What is "technical analysis"? Does it mostly support or refute the random walk
theory?

Question 46

Assume your current projects will return $560 tomorrow although your investors believe they will return only $300. A new project will cost $600 and will return $800 tomorrow, but your
Investors believe it will return only $700. If you have no cash and can use only equity
Financing, what will the value of the combined firm be to the existing shareholders if the new
Project is undertaken?

A)$ 544
B)$1,000
C)$ 760
D)None of the above answers is correct.

Question 47

In which of the following situations is an event study most likely to be useful?

A)a study designed to determine the effect that recessionary fears have had on charitable contributions during a period when the CEO of one of the largest charities has been
Indicted for fraud
B)a study designed to determine what effect the completion of a merger agreement that was announced at least 18 months prior would have on the price of the acquiring firm today
C)a study designed to determine what effect the announcement of a new patent has on the stock price of a firm
D)a study designed to determine what effect the arrest of a famous actress or actor will have on the aggregate value of the stock market

Question 48

A certain analyst boasts that she earned 30% on her stock picks this year while the 500 returned only 15%. She claims that this is proof that she has developed a superior trading
Strategy. What are other possible reasons for the results she has reported? (Assume she is not
Lying to you)

A)She had a lucky year.
B)She invested in a portfolio of high beta stocks.
C)She neglected to factor in her transaction costs.
D)All of the above are possible reasons for her extraordinary year.

Question 49

Given the efficiency of the U.S. financial markets, what useful information can
corporate managers
derive by observing current stock prices?

Question 50

If a firm employs 5,000 analysts, how many of them are likely to issue forecasts that beat the market eight years in a row, assuming none of them has any superior ability and that there are
No transaction costs?

A)about 20
B)about 50
C)about 300
D)less than 10

Question 51

If you, as the CEO of a corporation, truly believe that the stock of your corporation is undervalued, then you should

A)do a reverse split of your stock.
B)repurchase some of your shares since your cost of equity capital is so high.
C)issue preferred stock if you need to raise more funds for a project.
D)issue more stock since your cost of equity capital is so low.

Question 52

The common industry standard for evaluating a mutual fund's performance is to use how many years of data?

A)three
B)ten
C)five
D)one

Question 53

If the markets are semistrong efficient, and a firm is known to have been having financial difficulties for the last six months, what effect would you expect an announcement by the firm
That it will cut dividends have on the day that the announcement is made, all else equal?

A)a significant decrease in price since investors will not be getting as much in cash payments
B)little to no effect on the price since the cut has probably been anticipated by the markets
C)a significant increase in the price of a competitor firm that has not had to cut its dividends
D)a moderate increase in price since investors will consider this a step in the right direction

Question 54

Assume a zero percent discount rate for simplicity. Your current projects cost $200, and you know they will return $800 next year. There is a new project that will cost $300 and will return
$500. Your investors believe, however, that both the current projects and the new projects will
Return only 50%. If you have no cash and can use only equity financing, what will the value of
The combined firm be to the existing shareholders if the new project is undertaken?

A)$780
B)$520
C)$750
D)$800

Question 55

What level of market efficiency best describes the U.S. financial markets?

A)strongly efficient
B)perfectly efficient
C)weakly efficient
D)semistrong efficient

Question 56

Which of the following events have resulted in increases in firm value, on average, when the event is announced?

A)management's successful defense against a hostile takeover of the firm
B)the death of the founding CEO
C)the sale of new shares of stock of a firm that is already publicly held
D)The announcement of all of the above events results, on average, in an increase in firm value.

Question 57

Suppose you discover a mutual fund that has consistently earned higher returns than
the market, on a risk-adjusted basis, and believe that the fund manager is truly a
superior analyst. Should you expect to earn excess returns by investing in this fund?
Explain.

Question 58

Which of the following events have resulted in decreases in firm value, on average, when the event is announced?

A)the death of the founding CEO
B)management's successful defense against a hostile takeover of the firm
C)the announcement of a stock split
D)the acquisition of a firm by another firm

Question 59

Assuming a perfect market, a corporation can create value only by

A)paying out dividends to its shareholders
B)making changes to its capital structure
C)splitting its stock
D)None of the above actions will create value.

Question 60

If a firm employs 50 analysts, how many of them are likely to issue forecasts that beat the market five years in a row, assuming none of them has any superior ability and that there are
No transaction costs?

A)about 10
B)fewer than 2
C)25
D)about 5

Question 61

Assume you live (or invest)in a country in which the election results are known with
certainty because the elections are known to be "fixed." What would you expect to
happen to the market prices of stocks in that country upon the announcement of the
results?