Question 1

According to the Efficient Market Hypothesis (EMH), a market is said to be efficient if prices in that market reflect all available information. Is this following statement true or false?"It is possible to consistently outperform the market by taking advantage of all the information that the market already knows"

True

Accepted Answer

According to the Efficient Market Hypothesis (EMH) prices on traded assets already reflect all known information and they instantly change to reflect new information. Therefore, it is impossible to consistently outperform the market by using any information that the market already knows.
Key takeaway: With automated training, the market is very near the "efficient market" that Eugene Fama dreamed up. When Warren Buffett was starting out in 1950, the market was full of inefficiency. Today, computerized trading bots snap up slightly undervalued assets in an instant.

Question 2

The Efficient Markets Hypothesis (EMH) states that a stock's current price correctly predicts the underlying company's future results.

Accepted Answer

EMH make no such statement. The model uses publicly available information to make the best possible estimate of future performance and does not require a stock price to reflect a company's future performance.
Key Takeaway: Many people blamed the EMH model for the current crisis in 2008 because high stock market prices caused financial leaders to underestimate the severity of the financial bubble. The forecast can be wrong without violating EMH. In short, it appears that the market at large misunderstood the risk profile of many firms, thus overvaluing them.

Question 3

A portfolio is a collection of investments made by individuals or institutions. The market portfolio then is:&#10;A)A collection of investments into a specific market.&#10;B)A collection of all securities where the amount invested in each security is proportional to its relative market value.&#10;C)A collection of all securities available in a specific market and the amount invested is the same for every security.&#10;D)A collection of all investments in a whole economy.

Accepted Answer

A collection of all securities where the amount invested in each security is proportional to its relative market value.
Key Takeaway: Index funds are examples of market portfolios that are highly efficient for investing.

Question 4

The covariance of two risky assets measures how two returns of two assets move in relation to each other. What happens to the relation between the two returns if the covariance is negative?&#10;A)Two returns move in the same direction.&#10;B)Two returns move in opposite directions.&#10;C)Two returns are equal.&#10;D)Two returns do not have any relation.

Accepted Answer

When the covariance of two risky assets is negative, two returns of these two assets move in opposite directions. When the covariance of two risky assets is negative, two returns of these two assets move in the same direction.
Key Takeaway: Covariance can be positive, negative or zero.

Question 5

Tom has decided to invest in different assets simultaneously in order to reduce risks. What is this strategy called?&#10;A)Multiple investments.&#10;B)Diversification.&#10;C)Risk reduction.&#10;D)Shared partnership.

Accepted Answer

This strategy is called diversification. The power of diversification means that when Tom diversifies his portfolio into different assets (i.e. investing in different assets at the same time), he reduces his risk dramatically.
Key Takeaway: Diversification helps prevent the risk of investing into a single asset whose price can fluctuate and be unpredictable. By spreading out the investment into various assets, the risk from fluctuations can be reduced.

Question 6

In the random walk hypothesis, rates of return must meet which of the following conditions?&#10;A)Independent over time.&#10;B)Identically distributed.&#10;C)Uncorrelated.&#10;D)Independently and identically distributed.

Accepted Answer

Key Takeaway: The Random Walk hypothesis is a model in which asset prices are unpredictable. This model requires the rates of returns to be independently and identically distributed (iid) for statistical reference.

Deck 8: The Efficient Market Hypothesis, the Mean Variance Portfolio Theory, and the Random Walk Model