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Chapter13: Efficient Markets and Behavioral Finance

Problem Sets

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Select problems are available in McGraw-Hill Connect. Please see the preface for more information.

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Which (if any) of these statements are true? Stock prices appear to behave as though successive values (a) are random numbers, (b) follow regular cycles, (c) differ by a random number.



Supply the missing words:

   “There are three forms of the efficient-market hypothesis. Tests of randomness in stock returns provide evidence for the ________________ form of the hypothesis. Tests of stock price reaction to well-publicized news provide evidence for the ________________ form, and tests of the performance of professionally managed funds provide evidence for the ________________ form. Market efficiency results from competition between investors. Many investors search for new information about the company's business that would help them to value the stock more accurately. Such research helps to ensure that prices reflect all available information; in other words, it helps to keep the market efficient in the ________________ form. Other investors study past stock prices for recurrent patterns that would allow them to make superior profits. Such research helps to ensure that prices reflect all the information contained in past stock prices; in other words, it helps to keep the market efficient in the ________________ form.”



True or false? The efficient-market hypothesis assumes that



There are no taxes.



There is perfect foresight.



Successive price changes are independent.



Investors are irrational.



There are no transaction costs.



Forecasts are unbiased.



True or false?



Financing decisions are less easily reversed than investment decisions.



Tests have shown that there is almost perfect negative correlation between successive price changes.



The semistrong form of the efficient-market hypothesis states that prices reflect all publicly available information.



In efficient markets the expected return on each stock is the same.



Analysis of 60 monthly rates of return on United Futon common stock indicates a beta of 1.45 and an alpha of −.2% per month. A month later, the market is up by 5%, and United Futon is up by 6%. What is Futon's abnormal rate of return?



True or false?



Analysis by security analysts and investors helps keep markets efficient.



Psychologists have found that, once people have suffered a loss, they are more relaxed about the possibility of incurring further losses.



Psychologists have observed that people tend to put too much weight on recent events when forecasting.



If the efficient-market hypothesis is correct, managers will not be able to increase stock prices by creative accounting that boosts reported earnings.



Geothermal Corporation has just received good news: its earnings increased by 20% from last year's value. Most investors are anticipating an increase of 25%. Will Geothermal's stock price increase or decrease when the announcement is made?

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Here again are the six lessons of market efficiency. For each lesson give an example showing the lesson's relevance to financial managers.



Markets have no memory.



Trust market prices.



Read the entrails.



There are no financial illusions.



The do-it-yourself alternative.



Seen one stock, seen them all.



Give two or three examples of research results or events that raise doubts about market efficiency. Briefly explain why.




How would you respond to the following comments?



“Efficient market, my eye! I know lots of investors who do crazy things.”



“Efficient market? Balderdash! I know at least a dozen people who have made a bundle in the stock market.”



“The trouble with the efficient-market theory is that it ignores investors' psychology.”



“Despite all the limitations, the best guide to a company's value is its written-down book value. It is much more stable than market value, which depends on temporary fashions.”



Respond to the following comments:



“The random-walk theory, with its implication that investing in stocks is like playing roulette, is a powerful indictment of our capital markets.”



“If everyone believes you can make money by charting stock prices, then price changes won't be random.”



“The random-walk theory implies that events are random, but many events are not random. If it rains today, there's a fair bet that it will rain again tomorrow.”



Which of the following observations appear to indicate market inefficiency? Explain whether the observation appears to contradict the weak, semistrong, or strong form of the efficient-market hypothesis.



Tax-exempt municipal bonds offer lower pretax returns than taxable government bonds.



Managers make superior returns on their purchases of their company's stock.



There is a positive relationship between the return on the market in one quarter and the change in aggregate profits in the next quarter.



There is disputed evidence that stocks that have appreciated unusually in the recent past continue to do so in the future.



The stock of an acquired firm tends to appreciate in the period before the merger announcement.



Stocks of companies with unexpectedly high earnings appear to offer high returns for several months after the earnings announcement.



Very risky stocks on average give higher returns than safe stocks.



Here are alphas and betas for Intel and Conagra for the 60 months ending April 2009. Alpha is expressed as a percent per month.

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Explain how these estimates would be used to calculate an abnormal return.

p. 339



“If the efficient-market hypothesis is true, the pension fund manager might as well select a portfolio with a pin.” Explain why this is not so.



Two financial managers, Alpha and Beta, are contemplating a chart showing the actual performance of the Standard and Poor's Composite Index over a five-year period. Each manager's company needs to issue new shares of common stock sometime in the next year.


Alpha Measure of portfolio return adjusted for effect of market.: My company's going to issue right away. The stock market cycle has obviously topped out, and the next move is almost surely down. Better to issue now and get a decent price for the shares.


Beta Measure of market risk: You're too nervous; we're waiting. It's true that the market's been going nowhere for the past year or so, but the figure clearly shows a basic upward trend. The market's on the way up to a new plateau.


What would you say to Alpha and Beta?




What does the efficient-market hypothesis have to say about these two statements?



“I notice that short-term interest rates are about 1% below long-term rates. We should borrow short-term.”



“I notice that interest rates in Japan are lower than rates in the United States. We would do better to borrow Japanese yen rather than U.S. dollars.”



Fama and French show that average stock returns on firms with small market capitalizations have been significantly higher than average returns for “large-cap” firms. What are the possible explanations for this result? Does the result disprove market efficiency? Explain briefly.



Column (A) in Table 13.1 on the following page shows the monthly return on the British FTSE 100 index from May 2007 through February 2009. Columns (B) and (C) show returns on the stocks of two firms—Executive Cheese and Paddington Beer. Both firms announced their earnings in February 2009. Calculate the average abnormal return of the two stocks during the month of the earnings announcement.

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Visit us at



On May 15, 1997, the government of Kuwait offered to sell 170 million BP shares, worth about $2 billion. Goldman Sachs was contacted after the stock market closed in London and given one hour to decide whether to bid on the stock. They decided to offer 710.5 pence ($11.59) per share, and Kuwait accepted. Then Goldman Sachs went looking for buyers. They lined up 500 institutional and individual investors worldwide, and resold all the shares at 716 pence ($11.70). The resale was complete before the London Stock Exchange opened the next morning. Goldman Sachs made $15 million overnight.36

   What does this deal say about market efficiency? Discuss.



Explain how incentive and agency problems can contribute to mispricing of securities or to bubbles. Give examples.



Many commentators have blamed the subprime crisis on “irrational exuberance.” What is your view? Explain briefly.




“The strong-form of the efficient-market hypothesis is nonsense. Look at mutual fund X; it has had superior performance for each of the last 10 years.” Does the speaker have a point? Suppose that there is a 50% probability that X will obtain superior performance in any year simply by chance.



If X is the only fund, calculate the probability that it will have achieved superior performance for each of the past 10 years.



Now recognize that there are over 10,000 mutual funds in the United States. What is the probability that by chance there is at least 1 out of 10,000 funds that obtained 10 successive years of superior performance?

p. 340

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See Problem 18. Rates of return in percent per month:

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Some extreme bubbles are obvious with hindsight, after they burst. But how would you define a bubble? There are many examples of good news and rising stock prices, followed by bad news and falling stock prices. Can you set out rules and procedures to distinguish bubbles from the normal ups and downs of stock prices?

36“Goldman Sachs Earns a Quick $15 Million Sale of BP Shares,” The Wall Street Journal, May 16, 1997, p. A4.

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