Market Efficiency (Reading 48)

Exercise Problems:

1.      According to behavioral finance, observed overreaction in securities markets most likely occurs due to:

A. loss aversion.

B. gambler’s fallacy.

C. disposition effect.

A is correct. According to loss aversion related arguments in behavioral theories, investors dislike losses more than they like comparable gains. Thus, such a behavioral bias can explain observed overreaction in markets.

2.      Arbitrage activity will most likely be higher in securities markets:

A. that are efficient.

B. with no restrictions on short selling.

C. with high information-acquisition costs.

 Ans: B;

B is correct. Short selling helps in price discovery. Arbitrageurs benefit from pricing discrepancies (inefficiencies); therefore, arbitrage activity will be higher in markets with no restrictions on short selling.

3.      An observation that stocks with above average price-to-earnings ratios have consistently underperformed those with below average price-to-earnings ratios least likely contradicts which form of the market efficiency?

A. Weak form

B. Strong form

C. Semi-strong form

B is correct. The observation that stocks with high above-average price-to-earnings ratios have consistently underperformed those with below-average price-to-earnings ratios is a cross-sectional anomaly. It is a contradiction to the semi-strong form of market efficiency and weak-form market efficiency because all the information used to categorize stocks by their price-to-earnings ratios is publicly available.

4.      Which of the following is the most accurate characterization of momentum anomalies? Momentum anomalies:

A. relate to long-term price patterns.

B. relate to short-term price patterns.

C. are consistent with weak-form market efficiency.

Ans: B;

Momentum anomalies relate to short-term price patterns, typically resulting from investor overreaction in response to the release of unexpected public information.

5.      If a securities market is efficient, it is most likely that:

A. security prices would react only to the “unexpected” elements of information.

B. investors would prefer active investment strategies to passive investment strategies.

C. the time frame for price adjustment allows many traders to earn profits with little risk.

Ans: A;

In an efficient market, prices should be expected to react only to the “unexpected” or “surprise” element of information releases. Investors process the unexpected information and revise expectations accordingly.

6.      A financial analyst utilizing his analytical expertise and up-to-date information buys a company’s stock. His close friends, who lack information or expertise, imitate the financial analyst’s action and buy the stock. Which of the following statements concerning this behavioral bias is most accurate?

A. It improves market efficiency.

B. It is identical to representativeness.

C. It is inconsistent with rational behavior.

This behavioral bias is an example of an information cascade wherein the transmission of information is from those participants who act first and whose decisions influence the decisions of others. The behavior of informed traders acting first and uninformed traders imitating the informed traders is consistent with rationality. The imitation trading by the uninformed traders helps the market incorporate relevant information and improves market efficiency.

7.      In an efficient market, fundamental analysis most likely requires that the analyst must:

A. extrapolate historical data to estimate future values and take investment decisions.

B. do a superior job of estimating the relevant variables and predict earnings surprises.

C. use trading rules for detecting the price movements that lead to new equilibrium prices.

To take advantage of the long-run price movements in an efficient capital market the analyst must do a superior job of estimating the relevant variables and predict earnings surprises.

8.      Which of the following statements most accurately describes the weak-form Efficient Market Hypothesis (EMH)? The weak-form EMH assumes that current security prices:

A. fully reflect all information from public and private sources.

B. fully reflect all security market information, including transactions by exchange specialists.

C. adjust rapidly to the release of all public information; that is, security prices fully reflect all public information.

The weak-form EMH assumes that current stock prices fully reflect all security market information, including transactions by exchange specialists.

9.      Capital market efficiency is desirable, but there are limitations to achieving full market efficiency. Which of the following is least likely to be a limitation to achieving full capital market efficiency?

A. Survivorship bias

B. Limits of arbitrage

C. Cost of information

The three limitations for achieving full capital market efficiency are: 1) cost of information, 2) cost of trading, and 3) limits of arbitrage. Survivorship bias is not one of them.

10.  Assuming efficient markets and a lack of access to superior analysts, which of the following is the least important activity in managing portfolios?

A. Minimizing total transaction costs.

B. Diversifying completely on a global basis.

C. Paying close attention to the monetary policy environment

Ans: C;

In efficient markets and without access to superior analysts, portfolio management calls for minimizing the transaction costs and diversifying completely on a global basis. Paying attention to the monetary policy and evaluating its implications for portfolio management is appropriate for portfolio managers with access to superior analysts.

11.  Which of the following is least likely included in the assumptions of an informationally efficient securities market?

A. A large number of profit-maximizing participants analyze and value securities.

B. New information regarding securities comes to the market in a predictable manner.

C. Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information.

The assumption that the new information comes to the market in a predictable manner is an inaccurate statement. The correct assumption is that the new information comes to the market in a random fashion.

12.  The behavior of investors who put more money into a failure that they feel responsible for, rather than into a success, is most accurately described as:

A. escalation bias.

B. confirmation bias.

C. overconfidence bias.

Escalation bias refers to the investor behavior of putting more money into a failure that they feel responsible for rather than into a success. This leads to the practice of “averaging down” by viewing the additional purchase as a “bargain” rather than considering the initial purchase as a mistake and selling the stock.

13.  The best characterization of the strong-form of efficient market hypothesis (EMH) with respect to the information set is that it encompasses:

A. both weak-form and semistrong-form hypotheses.

B. neither weak-form nor semistrong-form hypothesis.

C. the semistrong-form but not the weak-form hypothesis.

Ans: A;

The difference among the three forms of the EMH revolves around the information set included in each. The weak form includes public market information, the semistrong form includes all public information, and the strong form includes all public and private information. The strong form EMH encompasses both the weak-from and the semistrong form EMH.

14.  An equity analyst working for a growth oriented mutual fund has a tendency to misvalue the stocks of popular companies that she has previously recommended and the fund already owns. Her behavior is most likely consistent with which of the following biases?

A. Escalation bias

B. Prospect theory

C. Confirmation bias

Ans: C;

Confirmation bias refers to the bias of looking for information that supports prior opinions and decisions, which leads to a tendency to misvalue the stocks of generally popular companies.