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THE UNIVERSITY OF HONG KONG

Faculty of Business and Economics
FINA2802_FINA2320_D– Investments and Portfolio Analysis
1st SEMESTER, 2017-2018

Chapter 11 The Efficient Market Hypothesis

 11.1 Random Walks and the Efficient Market Hypothesis

 Stock prices today should have reflected all available information.
 Future prices change must respond to new information immediately that is previously
unpredictable (new).
 Stock prices should follow a random walk, that is, price changes should be random and
unpredictable in a well-functioning and efficient market.
 Efficient Market Hypothesis (EMH) is the notion that stocks already reflect all
available information.
 Competition among different market participants ensures that stock prices should
reflect all available information.
 Versions of the Efficient Market Hypothesis
 Weak-form version:
- Stock prices already reflect all information that can be derived by examining
market trading data such as history of past prices, trading volume, trading
patterns, short interest, etc.
- Implications: Trend Analysis and Technical Analysis are wastes of time. Any
buy or sell signal should be already exploited by investors.

 Semistrong-form version:
- Stock prices already reflect all publicly available information regarding the
prospects of a firm.
- Such Information includes: history of past prices, trading volume, or short
interest. (weak form)
- Fundamental data includes: quality of management, quality of product line,
accounting practices and forecasts (from annual reports and analysts reports).
- Implications: Not only Trend Analysis and Technical Analysis are wastes of
time but also Fundamental Analysis is fruitless.

 Strong-form version:
- Stock prices already reflect all available information regarding the firm, even
including information available only to company insiders.
- Implications: All analysis including exploiting insider information is fruitless.

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 11.2 Implications of the EMH

 Active portfolio management strategy like Technical Analysis, Fundamental analysis,
and even using insider information are all time-wasting!
 Most investors should only earn a fair rate of return.
 Only serious analysis and uncommon techniques are likely to generate the differential
insights necessary to yield trading profits.
 Advocates passive investment strategy that makes no attempt to outsmart the market.
 Follows a buy-and-hold strategy by establishing a well-diversified portfolio.
 Frequent trading incurs large amount of trading costs without increasing expected
performance.
 Investing in index funds and ETFs are some of the recommended strategies.

 11.3 Event Studies

 An event study describes a technique of empirical financial research that enables an
observer to assess the impact of a particular event on a firm’s stock price.
 The abnormal return due to the event is the difference between the stock’s actual return
(e.g. ) and a benchmark return (e.g. ). The benchmark return can be estimated
using different models (SIM, CAPM, APT, etc.)

 A better indicator would be the Cumulative Abnormal Return (CAR), which is simply
the sum of all abnormal returns over the time period of interest.
 The main reason is because leakage of information may arise before announcement
date.CAR thus captures the total firm-specific stock movement for the entire period
when the market might be responding to new information.

 11.4 Are Markets Efficient?

 The Issues
 The Magnitude Issue
 The Selection Bias Issue
 The Lucky Event Issue
 Anomalies in Weak-Form Tests:
 Serial Correlation: the tendency for stock returns to be related to past returns
 Momentum Effect: recent good or poor performance continues over time.
 Reversal Effect: the tendency of poorly performing and well-performing stocks in
one period to experience reversals in following periods.
 Implications: They should not exist if weak-form efficient market holds.
 Anomalies in Semistrong-Form Tests:
 P/E Effect: low P/E stocks outperform high P/E stocks on average.
 The Small-Firm-in-January Effect: small firms stocks have higher average risk-
adjusted returns in January.
 Book-to-Market Ratios Effect: high book-to-market ratios stocks have higher
average annual returns.
 Post-Earnings-Announcement Price Drift Effect: positive (negative) earnings

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announcement stocks continue to rise (fall) after announcement date.

 Implications: They should not exist if semistrong-form efficient market holds.

 11.5 Mutual Fund and Analyst Performance

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PROBLEM SET 1
The semistrong form of the efficient market hypothesis asserts that stock prices:
a. Fully reflect all historical price information.
b. Fully reflect all publicly available information.
c. Fully reflect all relevant information, including insider information.
d. May be predictable.

PROBLEM SET 2
Assume that a company announces an unexpectedly large cash dividend to its shareholders.
In an efficient market without information leakage, one might expect:
a. An abnormal price change at the announcement.
b. An abnormal price increase before the announcement.
c. An abnormal price decrease after the announcement.
d. No abnormal price change before or after the announcement.
Note: There should be no any price change associated with the unexpected large cash
dividend before or after the announcement date as market should fully reflect that
information immediately at the announcement date. If there is any abnormal return
after the announcement date, then it contradicts against efficient market theory.

PROBLEM SET 3
Which one of the following would provide evidence against the semistrong form of the
efficient market theory?
a. About 50% of pension funds outperform the market in any year.
b. All investors have learned to exploit signals about future performance.
c. Trend analysis is worthless in determining stock prices.
d. Low P/E stocks tend to have positive abnormal returns over the long run.

PROBLEM SET 4
According to the efficient market hypothesis:
a. High-beta stocks are consistently overpriced.
b. Low-beta stocks are consistently overpriced.
c. Positive alphas on stocks will quickly disappear.
d. Negative alpha stocks consistently yield low returns for arbitrageurs.

PROBLEM SET 5
A “random walk” occurs when:
a. Stock price changes are random but predictable.
b. Stock prices respond slowly to both new and old information.
c. Future price changes are uncorrelated with past price changes.
d. Past information is useful in predicting future prices.

PROBLEM SET 6
Which of the following most appears to contradict the proposition that the stock market is
weakly efficient? Explain.
a. Over 25% of mutual funds outperform the market on average.

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b. Insiders earn abnormal trading profits.

c. Every January, the stock market earns abnormal returns.
c. This is a predictable pattern in returns which should not occur if the weak-form EMH is
valid.

PROBLEM SET 7
Suppose that, after conducting an analysis of past stock prices, you come up with the
following observations. Which would appear to contradict the weak form of the efficient
market hypothesis? Explain.
a. The average rate of return is significantly greater than zero.
b. The correlation between the return during a given week and the return during the
following week is zero.
c. One could have made superior returns by buying stock after a 10% rise in price and
selling after a 10% fall.
d. One could have made higher-than-average capital gains by holding stocks with low
dividend yields.

PROBLEM SET 8
Which of the following statements are true if the efficient market hypothesis holds?
a. It implies that future events can be forecast with perfect accuracy.
b. It implies that prices reflect all available information.
c. It implies that security prices change for no discernible reason.
d. It implies that prices do not fluctuate.

PROBLEM SET 9
Which of the following would be a viable way to earn abnormally high trading profits if
markets are semistrong-form efficient?
a. Buy shares in companies with low P/E ratios.
b. Buy shares in companies with recent above-average price changes.
c. Buy shares in companies with recent below-average price changes.
d. Buy shares in companies for which you have advance knowledge of an improvement in
the management team.
d. In a semistrong-form efficient market, it is not possible to earn abnormally high profits
by trading on publicly available information. Information about P/E ratios and recent price
changes is publicly known. On the other hand, an investor who has advance knowledge of
management improvements could earn abnormally high trading profits (unless the market is
also strong-form efficient).

PROBLEM SET 10
Which of the following phenomena would be either consistent with or a violation of the
efficient market hypothesis? Explain briefly.
a. Nearly half of all professionally managed mutual funds are able to outperform the S&P
500 in a typical year.
b. Money managers that outperform the market (on a risk-adjusted basis) in one year are
likely to outperform in the following year.

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c. Stock prices of companies that announce increased earnings in January tend to

outperform the market in February.
d. Stocks that perform well in one week perform poorly in the following week.
a. Consistent. Based on pure luck, half of all managers should beat the market in any
year.

b. Inconsistent. This would be the basis of an “easy money” rule: simply invest with last
year's best managers.

c. Inconsistent. The abnormal performance ought to occur in January when earnings are
announced.

d. Inconsistent. Reversals offer a means to earn easy money: just buy last week’s
losers.

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PROBLEM SET 11
If markets are efficient, what should be the correlation coefficient between stock returns for
two non-overlapping time periods?
The correlation coefficient between stock returns for two non-overlapping periods should be
zero. If not, one could use returns from one period to predict returns in later periods and
make abnormal profits.

PROBLEM SET 12
A successful firm like Microsoft has consistently generated large profits for years. Is this a
violation of the EMH?
No. Microsoft’s continuing profitability does not imply that stock market investors who
purchased Microsoft shares after its success was already evident would have earned an
exceptionally high return on their investments.

PROBLEM SET 13
“If all securities are fairly priced, all must offer equal expected rates of return.” Comment.
Expected rates of return differ because of differential risk premiums.

PROBLEM SET 14
Steady Growth Industries has never missed a dividend payment in its 94-year history. Does
this make it more attractive to you as a possible purchase for your stock portfolio?
No. The value of dividend predictability would be already reflected in the stock price.

PROBLEM SET 15
At a cocktail party, your colleague tells you that he has beaten the market for each of the
last 3 years. Does this shake your belief in efficient markets?
No, markets can be efficient even if some investors earn returns above the market average.
Consider the Lucky Event issue: Ignoring transaction costs, about 50% of professional
investors, by definition, will “beat” the market in any given year. The probability of beating
it three years in a row, though small, is not insignificant. Beating the market in the past does
not predict future success as three years of returns make up too small a sample on which to
base correlation let alone causation.

PROBLEM SET 16
“Highly variable stock prices suggest that the market does not know how to price stocks.”
Comment.
Volatile stock prices could reflect volatile underlying economic conditions as large amounts
of information being incorporated into the price will cause variability in stock price. The
Efficient Market Hypothesis suggests that investors cannot earn excess risk-adjusted
rewards. The variability of the stock price is thus reflected in the expected returns as returns
and risk are positively correlated.

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PROBLEM SET 17
If prices are as likely to increase as decrease, why do investors earn positive returns from
the market on average?
Over the long haul, there is an expected upward drift in stock prices based on their fair
expected rates of return. The fair expected return over any single day is very small (e.g.,
12% per year is only about 0.03% per day), so that on any day the price is virtually equally
likely to rise or fall. Over longer periods, the small expected daily returns accumulate, and
upward moves are more likely than downward ones.

PROBLEM SET 18
“If the business cycle is predictable, and a stock has a positive beta, the stock’s returns also
must be predictable.” Respond.
While positive beta stocks respond well to favorable new information about the economy’s
progress through the business cycle, they should not show abnormal returns around already
anticipated events. If a recovery, for example, is already anticipated, the actual recovery is
not news. The stock price should already reflect the coming recovery.

PROBLEM SET 19
An index model regression applied to past monthly returns in General Motors’ stock price
produces the following estimates, which are believed to be stable over time:

rGM = 0.10%+1.1rM
If the market index subsequently rises by 8% and General Motors’ stock price rises by 7%,
what is the abnormal change in General Motors’ stock price?
The return on the market is 8%. Therefore, the forecast monthly return for Ford is:
0.10% + (1.1 × 8%) = 8.9%
Ford’s actual return was 7%, so the abnormal return was –1.9%.

PROBLEM SET 20
The monthly rate of return on T-bills is 1%. The market went up this month by 1.5%. In
addition, AmbChaser, Inc., which has an equity beta of 2, surprisingly just won a lawsuit
that awards it $1 million immediately.
a. If the original value of AmbChaser equity were $100 million, what would you guess was
the rate of return of its stock this month?
Based on broad market trends, the CAPM indicates that AmbChaser stock should have
increased by: 1.0% + 2.0 × (1.5% – 1.0%) = 2.0%
Its firm-specific (nonsystematic) return due to the lawsuit is $1 million per $100 million
initial equity, or 1%. Therefore, the total return should be (2% + 1%)= 3%.

b. What is your answer to (a) if the market had expected AmbChaser to win $2 million?
If the settlement was expected to be $2 million, then the actual settlement was a “$1
million disappointment,” and so the firm-specific return would be –1%, for a total return
of 2% (from CAPM) – 1% = 1%.

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PROBLEM SET 21
In a recent closely contested lawsuit, Apex sued Bpex for patent infringement. The jury
came back today with its decision. The rate of return on Apex was rA = 3.1%. The rate of
return on Bpex was only rB = 2.5%. The market today responded to very encouraging news
about the unemployment rate, and rM = 3%. The historical relationship between returns on
these stocks and the market portfolio has been estimated from index model regressions as:

Based on these data, which company do you think won the lawsuit?
Given market performance, predicted returns on the two stocks would be:
Apex: 0.2% + (1.4 × 3%) = 4.4% > 3.1% (abnormal return is -1.3%)
Bpex: –0.1% + (0.6 × 3%) = 1.7% < 2.5% (abnormal return is 0.8%)
Apex underperformed this prediction; Bpex outperformed the prediction. We conclude that
Bpex won the lawsuit.

PROBLEM SET 22
Investors expect the market rate of return in the coming year to be 12%. The T-bill rate is
4%. Changing Fortunes Industries’ stock has a beta of 0.5. The market value of its
outstanding equity is $100 million.
a. What is your best guess currently as to the expected rate of return on Changing Fortunes’
stock? You believe that the stock is fairly priced.

Based on CAPM, the expected rate of return is:

4% + 0.5 × (12% – 4%) = 8%
If the stock is fairly priced, then E(r) = 8%.

b. If the market return in the coming year actually turns out to be 10%, what is your best
guess as to the rate of return that will be earned on Changing Fortunes’ stock?
If rM falls short of your expectation by 2% (that is, 10% – 12%) then you would expect
the return for Changing Fortunes Industries to fall short of your original expectation by: β
× 2% = 1%.
Therefore, you would forecast a “revised” expectation for Changing Fortunes of: 8% – 1%
= 7%

c. Suppose now that Changing Fortunes wins a major lawsuit during the year. The
settlement is $5 million. Changing Fortunes’ stock return during the year turns out to be
10%. What is your best guess as to the settlement the market previously expected
Changing Fortunes to receive from the lawsuit? (Continue to assume that the market
return in the year turned out to be 10%.). The magnitude of the settlement is the only
unexpected firm-specific event during the year.
Given a market return of 10%, you would forecast a return for Changing Fortunes of 7%.
The actual return is 10%. Therefore, the surprise due to firm-specific factors is 10% –

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7% = 3% which we attribute to the settlement. Because the firm is initially worth $100
million, the surprise amount of the settlement is 3% of $100 million, or $3 million,
implying that the prior expectation for the settlement was only $2 million.

PROBLEM SET 23
We know that the market should respond positively to good news and that good-news
events such as the coming end of a recession can be predicted with at least some accuracy.
Why, then, can we not predict that the market will go up as the economy recovers?
The market responds positively to new news. If the eventual recovery is anticipated, then
the recovery is already reflected in stock prices. Only a better-than-expected recovery
should affect stock prices.

PROBLEM SET 24
Good News, Inc., just announced an increase in its annual earnings, yet its stock price fell.
Is there a rational explanation for this phenomenon?
The market may have anticipated even greater earnings. Compared to prior expectations,
the announcement was a disappointment.

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PROBLEM SET 25
Your investment client asks for information concerning the benefits of active portfolio
management. She is particularly interested in the question of whether active managers can
be expected to consistently exploit inefficiencies in the capital markets to produce above-
average returns without assuming higher risk.
The semistrong form of the efficient market hypothesis asserts that all publicly available
information is rapidly and correctly reflected in securities prices. This implies that investors
cannot expect to derive above-average profits from purchases made after information has
become public because security prices already reflect the information’s full effects.
a. Identify and explain two examples of empirical evidence that tend to support the EMH
implication stated above.
b. Identify and explain two examples of empirical evidence that tend to refute the EMH
implication stated above.
a. Some empirical evidence that supports the EMH:
(i) professional money managers do not typically earn higher returns than comparable
risk, passive index strategies;
(ii) event studies typically show that stocks respond immediately to the public release of
relevant news;
(iii) most tests of technical analysis find that it is difficult to identify price trends that
can be exploited to earn superior risk-adjusted investment returns.

b. Some evidence that is difficult to reconcile with the EMH concerns simple portfolio
strategies that apparently would have provided high risk-adjusted returns in the past.
Some examples of portfolios with attractive historical returns:
(i) low P/E stocks;
(ii) high book-to-market ratio stocks;
(iii) small firms in January;
(iv) firms with very poor stock price performance in the last few months.
Other evidence concerns post-earnings-announcement stock price drift and
intermediate-term price momentum.

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PROBLEM SET 26
a. Briefly explain the concept of the efficient market hypothesis (EMH) and each of its
three forms—weak, semistrong, and strong—and briefly discuss the degree to which
existing empirical evidence supports each of the three forms of the EMH.
b. Briefly discuss the implications of the efficient market hypothesis for investment policy
as it applies to:
i. Technical analysis in the form of charting.
ii. Fundamental analysis.
c. Briefly explain the roles or responsibilities of portfolio managers in an efficient market
environment.
a. The efficient market hypothesis (EMH) states that a market is efficient if security prices
immediately and fully reflect all available relevant information. If the market fully
reflects information, the knowledge of that information would not allow an investor to
profit from the information because stock prices already incorporate the information.
The weak form of the EMH asserts that stock prices reflect all the information that can be
derived by examining market trading data such as the history of past prices and trading
volume. A strong body of evidence supports weak-form efficiency in the major U.S.
securities markets. For example, test results suggest that technical trading rules do not
produce superior returns after adjusting for transaction costs and taxes.
The semistrong form states that a firm’s stock price reflects all publicly available
information about a firm’s prospects. Examples of publicly available information are
company annual reports and investment advisory data. Evidence strongly supports the
notion of semistrong efficiency, but occasional studies (e.g., identifying market anomalies
such as the small-firm-in-January or book-to-market effects) and events (e.g. stock market
crash of October 19, 1987) are inconsistent with this form of market efficiency. There is a
question concerning the extent to which these “anomalies” result from data mining.
The strong form of the EMH holds that current market prices reflect all information
(whether publicly available or privately held) that can be relevant to the valuation of the
firm. Empirical evidence suggests that strong-form efficiency does not hold. If this form
were correct, prices would fully reflect all information. Therefore even insiders could
not earn excess returns. But the evidence is that corporate officers do have access to
pertinent information long enough before public release to enable them to profit from
trading on this information.

b. i. Technical analysis involves the search for recurrent and predictable patterns in stock
prices in order to enhance returns. The EMH implies that technical analysis is without
value. If past prices contain no useful information for predicting future prices, there is no
point in following any technical trading rule.
ii. Fundamental analysis uses earnings and dividend prospects of the firm, expectations of
future interest rates, and risk evaluation of the firm to determine proper stock prices. The
EMH predicts that most fundamental analysis is doomed to failure. According to
semistrong-form efficiency, no investor can earn excess returns from trading rules based on
publicly available information. Only analysts with unique insight achieve superior returns.
In summary, the EMH holds that the market appears to adjust so quickly to information

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about both individual stocks and the economy as a whole that no technique of selecting a
portfolio using either technical or fundamental analysis can consistently outperform a
strategy of simply buying and holding a diversified portfolio of securities, such as those
comprising the popular market indexes.

c. Portfolio managers have several roles and responsibilities even in perfectly efficient
markets. The most important responsibility is to identify the risk/return objectives for a
portfolio given the investor’s constraints. In an efficient market, portfolio managers are
responsible for tailoring the portfolio to meet the investor’s needs, rather than to beat the
market, which requires identifying the client’s return requirements and risk tolerance.
Rational portfolio management also requires examining the investor’s constraints,
including liquidity, time horizon, laws and regulations, taxes, and unique preferences and
circumstances such as age and employment.

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