CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS
PROBLEM SETS
1. 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.
2. 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.
3. Expected rates of return differ because of differential risk premiums.
4. No. The value of dividend predictability would be already reflected in the stock price.
5. 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.
6. 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.
7. The following effects seem to suggest predictability within equity markets and thus disprove the Efficient Market Hypothesis. However, consider the following:
a. Multiple studies suggest that “value” stocks (measured often by low P/E multiples) earn higher returns over time than “growth” stocks (high P/E multiples). This could suggest a strategy for earning higher
PROBLEM SETS
1. 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.
2. 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.
3. Expected rates of return differ because of differential risk premiums.
4. No. The value of dividend predictability would be already reflected in the stock price.
5. 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.
6. 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.
7. The following effects seem to suggest predictability within equity markets and thus disprove the Efficient Market Hypothesis. However, consider the following:
a. Multiple studies suggest that “value” stocks (measured often by low P/E multiples) earn higher returns over time than “growth” stocks (high P/E multiples). This could suggest a strategy for earning higher