Question 1

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:

Accepted Answer

A random walk means that the past prices hold no information about future prices, so there is no predictable amount based on the past prices (A). The expected return for the period is incorporated into the prior period price, so it cannot be due to (C) the security's risk or (D) the risk-free rate. Any difference between the actual return and the expected return must be due to new information unrelated to past prices (B). Therefore, choice B is correct.

Question 2

The abnormal return in an event study is described as:

Accepted Answer

The abnormal return in an event study is defined as the difference between the actual return and the expected return for a stock, given market conditions and other relevant factors. Therefore, it is not just the return earned on the day of announcement (option A) or the total return earned for the investment holding period (option C). Option D is incorrect because the abnormal return is not the same as the total return, but rather the excess return above what would be expected. Option E is incorrect because there is a clearly defined meaning for the term "abnormal return" in an event study.

Question 3

Which of the following is true?

Accepted Answer

The statement "If the stock market is weak form efficient, then stock prices follow a random walk" is true, while the other statements are false. A random walk implies that price changes are independent of each other and unpredictable, which is inconsistent with observed patterns in stock price changes. Additionally, high correlations between price changes would indicate a predictability that is not consistent with a random walk process. However, if the stock market is weak form efficient, then past price data cannot be used to predict future price movements, which is consistent with a random walk process.

Question 4

The semistrong form of the efficient market hypothesis states that:

Accepted Answer

The semistrong form of the efficient market hypothesis states that security prices reflect all publicly available information. It does not assert that all information is reflected in securities prices or that future prices are predictable.

Question 5

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

Accepted Answer

The semistrong form of the efficient market hypothesis states that stock prices adjust to new information quickly and efficiently. The fluctuation in stock prices on a daily basis is consistent with this form of the hypothesis as new information is constantly being incorporated into the price. The other choices are not applicable as they either contradict the hypothesis or are irrelevant.

Question 6

If the weak form of efficient markets holds,then:

Accepted Answer

If the weak form of efficient markets holds, it means that all past information, including past prices, is already reflected in current stock prices. Therefore, technical analysis (which relies on past prices to predict future price movements) would be useless. Stock prices would follow a random walk, as they would incorporate all available information and respond to new information as it becomes available. All of these statements are true if the weak form of efficient markets holds.

Question 7

Which of the following is not true about serial correlation?

Accepted Answer

Serial correlation measures the correlation between the current return on a security and its own past returns, not the returns on another security.

Question 8

Which of the following would be indicative of inefficient markets?

Accepted Answer

Inefficient markets are characterized by either overreaction and reversion or delayed response. Option A includes only overreaction and reversion, which may indicate inefficiency but not necessarily always. Option B includes only delayed response, which may also indicate inefficiency, but not exclusively. Option C, immediate and accurate response, indicates efficient markets. Thus, option D, which includes both overreaction and reversion, and delayed response, is the best choice for indicating inefficient markets.

Question 9

An investor discovers that stock prices change drastically as a result of certain events. This finding is a violation of the:

Accepted Answer

The answer of An investor discovers that stock prices change...

Question 10

Which form of the efficient market hypothesis implies that security prices reflect only information contained in past prices?

Accepted Answer

The weak form of the efficient market hypothesis states that security prices reflect all information contained in past prices, meaning that technical analysis and studying past price patterns cannot lead to abnormal returns.

Question 11

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

Accepted Answer

An investor who picks a portfolio by throwing darts at the financial pages believes in the efficient market hypothesis, which states that all available information is already reflected in stock prices. This means that any randomly chosen portfolio should theoretically perform just as well as a carefully selected one. Therefore, this investor believes that efficient markets will protect the portfolio from harm as all information is priced.

Question 12

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

Accepted Answer

A semistrong form efficient market incorporates all publicly available information in the price, while a weak form efficient market only incorporates past price data and technical analysis, and a strong form efficient market incorporates all information, including inside information. Therefore, answer choice B is correct as it distinguishes between a semistrong form efficient market and a weak form efficient market.

Question 13

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

Accepted Answer

In an efficient market, stock prices incorporate all available information and moves randomly without any predictable patterns. This means that the unexplained portion of price change in one period is unrelated to the unexplained portion of price change in any other period, which is known as a "random walk" in stock prices. Therefore, choice C is the correct answer. Option A is incorrect because while there may not be an easily identifiable driving force behind price changes, there are still many factors that affect stock prices. Option B is wrong because technical analysts cannot consistently predict future price movements in an efficient market. Similarly, option D is incorrect because the unexplained portion of price change in one period cannot be explained by a prior period's unexplained portion. Finally, option E is incorrect because choice C is the correct answer.

Question 14

Event studies attempt to measure:

Accepted Answer

Event studies attempt to measure the influence of information released to the market on returns in days surrounding its announcement, whether the market is at least semi-strong form efficient, and whether there is a significant reaction to public announcements. Therefore, option D is correct.

Question 15

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

Accepted Answer

Strong form efficiency implies that all information, public and private, is reflected in stock prices. Therefore, it encompasses both semistrong and weak form efficiencies, and also means that even insider information cannot be used to earn abnormal returns.

Question 16

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:

Accepted Answer

The weak form of the efficient market hypothesis states that past price movements and volume data do not affect stock prices. If large positive price changes are predictably followed by large negative price changes, it suggests that past price information can be used to predict future price movements, violating the weak form.

Question 17

Suppose that firms with unexpectedly high earnings earn abnormally high returns for several months after the announcement. This would be evidence of:

Accepted Answer

If firms with unexpectedly high earnings continue to earn abnormally high returns for several months after the announcement, it suggests that the market is not fully incorporating this information into stock prices immediately, indicating inefficiency in the semistrong form.

Question 18

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:

Accepted Answer

The semistrong form of the efficient market hypothesis states that all publicly available information, including historical price data and all public announcements, is already reflected in stock prices. If the predictions from the Farmer's Almanac, which are published years in advance and available to the public, are found to be accurate, then this information should already be reflected in stock prices, violating the semistrong form of the efficient market hypothesis.

Question 19

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:

Accepted Answer

The market may perceive the founding executive as a hindrance to the firm's progress, so their sudden death could be seen as an opportunity for positive change, leading to a rise in stock prices.

Question 20

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:

Accepted Answer

The information the lawyer has found is considered insider information and is not publicly available. The strong form of the efficient market hypothesis states that all information, both public and private, is reflected in stock prices, so the fact that the lawyer can "beat the market" by short-selling the stock suggests that the strong form of the efficient market hypothesis does not hold.

Quiz 14: Efficient Capital Markets and Behavioral Challenges