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Chapter 11 The Efficient Market Hypothesis: Answer Key
Chapter 11 The Efficient Market Hypothesis: Answer Key
1. If you believe in the ________ form of the EMH, you believe that stock prices reflect all
relevant information including historical stock prices and current public information about the
firm, but not information that is available only to insiders.
A. semistrong
B. strong
C. weak
D. semistrong, strong, and weak
E. hard
The semistrong form of the EMH maintains that stock prices immediately reflect all historical
and current public information, but not inside information.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Efficient Market Hypothesis
2. When Maurice Kendall examined the patterns of stock returns in 1953 he concluded that
the stock market was __________. Now, these random price movements are believed to be
_________.
A. inefficient; the effect of a well-functioning market
B. efficient; the effect of an inefficient market
C. inefficient; the effect of an inefficient market
D. efficient; the effect of a well-functioning market
E. irrational; even more irrational than before
Random price changes were originally thought to be driven by irrationality. Now, financial
economists believe random price changes occur because markets are informationally efficient.
AACSB: Analytic
Bloom's: Understand
Difficulty: Basic
Topic: Efficient Market Hypothesis
11-1
Chapter 11 - The Efficient Market Hypothesis
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Efficient Market Hypothesis
A hybrid strategy is one where the investor maintains a passive core and augments the
position with an actively managed portfolio.
AACSB: Analytic
Bloom's: Understand
Difficulty: Basic
Topic: Implications of the EMH
11-2
Chapter 11 - The Efficient Market Hypothesis
5. The difference between a random walk and a submartingale is the expected price change in
a random walk is ______ and the expected price change for a submartingale is ______.
A. positive; zero
B. positive; positive
C. positive; negative
D. zero; positive
E. zero; zero
A random walk has an expected price change of zero and a submartingale has a positive
expected price change.
AACSB: Analytic
Bloom's: Understand
Difficulty: Basic
Topic: Efficient Market Hypothesis
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Efficient Market Hypothesis
11-3
Chapter 11 - The Efficient Market Hypothesis
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Efficient Market Hypothesis
8. If you believe in the _______ form of the EMH, you believe that stock prices only reflect
all information that can be derived by examining market trading data such as the history of
past stock prices, trading volume or short interest.
A. semistrong
B. strong
C. weak
D. semistrong, strong, and weak
E. None of these are correct.
The information described above is market data, which is the data set for the weak form of
market efficiency. The semistrong form includes the above plus all other public information.
The strong form includes all public and private information.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Efficient Market Hypothesis
11-4
Chapter 11 - The Efficient Market Hypothesis
9. If you believe in the _________ form of the EMH, you believe that stock prices reflect all
available information, including information that is available only to insiders.
A. semistrong
B. strong
C. weak
D. semistrong, strong, and weak
E. None of these are correct.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Efficient Market Hypothesis
The reversal effect states that stocks that do well in one period tend to perform poorly in the
subsequent period, and vice versa.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Efficient Market Hypothesis
11-5
Chapter 11 - The Efficient Market Hypothesis
11. __________ focus more on past price movements of a firm's stock than on the underlying
determinants of future profitability.
A. Credit analysts
B. Fundamental analysts
C. Systems analysts
D. Technical analysts
E. Credit analysts, Fundamental analysts, Systems analysts, and Technical analysts
Technicians attempt to predict future stock prices based on historical stock prices.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Implications of the EMH
When stock prices have remained stable for a long period, these prices are termed resistance
levels; technicians believe it is difficult for the stock prices to penetrate these resistance
levels.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Implications of the EMH
11-6
Chapter 11 - The Efficient Market Hypothesis
When stock prices have remained stable for a long period, these prices are termed support
levels; technicians believe it is difficult for the stock prices to penetrate these support levels.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Implications of the EMH
14. ___________ the return on a stock beyond what would be predicted from market
movements alone.
A. An irrational return is
B. An economic return is
C. An abnormal return is
D. An irrational return and an economic return are
E. An irrational return and an abnormal return are
An economic return is the expected return, based on the perceived level of risk and market
factors. When returns exceed these levels, the returns are called abnormal returns.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Event Studies
11-7
Chapter 11 - The Efficient Market Hypothesis
15. The debate over whether markets are efficient will probably never be resolved because of
________.
A. the lucky event issue
B. the magnitude issue
C. the selection bias issue
D. the lucky event issue, magnitude issue, and selection bias issue
E. None of these answers are correct.
The lucky event issue, magnitude issue, and selection bias issue all exist and make rigid
testing of market efficiency difficult or impossible.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Efficient Markets
The index fund is, by definition, passively managed. The other investment alternatives may or
may not be managed passively.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Implications of the EMH
11-8
Chapter 11 - The Efficient Market Hypothesis
Arbel divided firms into highly researched, moderately researched, and neglected groups
based on the number of institutions holding the stock.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Efficient Markets
18. Researchers have found that most of the small firm effect occurs
A. during the spring months.
B. during the summer months.
C. in December.
D. in January.
E. randomly.
Much of the so-called small firm effect simply may be the tax-effect as investors sell stocks
on which they have losses in December and reinvest the funds in January. As small firms are
especially volatile, these actions affect small firms in a more dramatic fashion.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Efficient Markets
11-9
Chapter 11 - The Efficient Market Hypothesis
19. Basu (1977, 1983) found that firms with low P/E ratios
A. earned higher average returns than firms with high P/E ratios.
B. earned the same average returns as firms with high P/E ratios.
C. earned lower average returns than firms with high P/E ratios.
D. had higher dividend yields than firms with high P/E ratios.
E. None of these are correct.
Firms with high P/E ratios already have an inflated price relative to earnings and thus tend to
have lower returns than low P/E ratio stocks. However, the P/E ratio may capture risk not
fully impounded in market betas so this may represent an appropriate risk adjustment rather
than a market anomaly.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Efficient Markets
20. Basu (1977, 1983) found that firms with high P/E ratios
A. earned higher average returns than firms with low P/E ratios.
B. earned the same average returns as firms with low P/E ratios.
C. earned lower average returns than firms with low P/E ratios.
D. had higher dividend yields than firms with low P/E ratios.
E. None of these are correct.
Firms with high P/E ratios already have an inflated price relative to earnings and thus tend to
have lower returns than low P/E ratio stocks. However, the P/E ratio may capture risk not
fully impounded in market betas so this may represent an appropriate risk adjustment rather
than a market anomaly.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Efficient Markets
11-10
Chapter 11 - The Efficient Market Hypothesis
21. Jaffe (1974) found that stock prices _________ after insiders intensively bought shares.
A. decreased
B. did not change
C. increased
D. became extremely volatile
E. became much less volatile
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Efficient Markets
22. Jaffe (1974) found that stock prices _________ after insiders intensively sold shares.
A. decreased
B. did not change
C. increased
D. became extremely volatile
E. became much less volatile
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Efficient Markets
11-11
Chapter 11 - The Efficient Market Hypothesis
23. Banz (1981) found that, on average, the risk-adjusted returns of small firms
A. were higher than the risk-adjusted returns of large firms.
B. were the same as the risk-adjusted returns of large firms.
C. were lower than the risk-adjusted returns of large firms.
D. were unrelated to the risk-adjusted returns of large firms.
E. were negative.
Banz found A to be true, although subsequent studies have attempted to explain the small firm
effect as the January effect, the neglected firm effect, etc.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Efficient Markets
24. Banz (1981) found that, on average, the risk-adjusted returns of large firms
A. were higher than the risk-adjusted returns of small firms.
B. were the same as the risk-adjusted returns of small firms.
C. were lower than the risk-adjusted returns of small firms.
D. were unrelated to the risk-adjusted returns of small firms.
E. were negative.
Banz found A to be true, although subsequent studies have attempted to explain the small firm
effect as the January effect, the neglected firm effect, etc.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Efficient Markets
11-12
Chapter 11 - The Efficient Market Hypothesis
Technical analysts attempt to predict future stock prices from historic stock prices; proponents
of EMH believe that stock price changes are random variables.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Implications of the EMH
The market appears to adjust to earnings information gradually, resulting in a sustained period
of abnormal returns.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Efficient Markets
11-13
Chapter 11 - The Efficient Market Hypothesis
The market appears to adjust to earnings information gradually, resulting in a sustained period
of abnormal returns.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Efficient Markets
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Event Studies
11-14
Chapter 11 - The Efficient Market Hypothesis
29. On November 22, 2009 the stock price of WalMart was $39.50 and the retailer stock
index was 600.30. On November 25, 2009 the stock price of WalMart was $40.25 and the
retailer stock index was 605.20. Consider the ratio of WalMart to the retailer index on
November 22 and November 25. WalMart is _______ the retail industry and technical
analysts who follow relative strength would advise _______ the stock.
A. outperforming, buying
B. outperforming, selling
C. underperforming, buying
D. underperforming, selling
E. equally performing, neither buying nor selling
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Implications of the EMH
Lack of liquidity may affect the returns of small and neglected firms; however the theory does
not explain why the abnormal returns are concentrated in January.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Efficient Markets
11-15
Chapter 11 - The Efficient Market Hypothesis
31. Fama and French (1992) found that the stocks of firms within the highest decile of book-
to-market ratios had average monthly returns of _______ while the stocks of firms within the
lowest decile of book-to-market ratios had average monthly returns of________.
A. greater than 1%, greater than 1%
B. greater than 1%, less than 1%
C. less than 1%, greater than 1%
D. less than 1%, less than 1%
E. less than 0.5%, greater than 0.5%
This finding suggests either that low book-to-market ratio firms are relatively overpriced, or
that the book-to-market ratio is serving as a proxy for a risk factor that affects expected
equilibrium returns.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Efficient Markets
32. A market decline of 23% on a day when there is no significant macroeconomic event
______ consistent with the EMH because ________.
A. would be, it was a clear response to macroeconomic news
B. would be, it was not a clear response to macroeconomic news
C. would not be, it was a clear response to macroeconomic news
D. would not be, it was not a clear response to macroeconomic news
E. None of these are correct.
This happened on October 19, 1987. Although this specific event is not mentioned in this
edition of the book, it is an example of something that would be considered a violation of the
EMH.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Efficient Markets
11-16
Chapter 11 - The Efficient Market Hypothesis
Security prices react quickly to new information, security prices are seldom far above or
below their justified levels, and security analysis will not enable investors to realize superior
returns consistently; however, even in an efficient market one should be able to earn the
appropriate risk-adjusted rate of return.
AACSB: Analytic
Bloom's: Understand
Difficulty: Basic
Topic: Efficient Market Hypothesis
34. The weak form of the efficient market hypothesis asserts that
A. stock prices do not rapidly adjust to new information contained in past prices or past data.
B. future changes in stock prices cannot be predicted from past prices.
C. technicians cannot expect to outperform the market.
D. stock prices do not rapidly adjust to new information contained in past prices or past data
and future changes in stock prices cannot be predicted from past prices
E. future changes in stock prices cannot be predicted from past prices and technicians cannot
expect to outperform the market
The weak form of the efficient market hypothesis asserts that future changes in stock prices
cannot be predicted from past prices; therefore, technicians cannot expect to outperform the
market.
AACSB: Analytic
Bloom's: Understand
Difficulty: Basic
Topic: Efficient Market Hypothesis
11-17
Chapter 11 - The Efficient Market Hypothesis
35. A support level is the price range at which a technical analyst would expect the
A. supply of a stock to increase dramatically.
B. supply of a stock to decrease substantially.
C. demand for a stock to increase substantially.
D. demand for a stock to decrease substantially.
E. price of a stock to fall.
A support level is considered to be a level below that the price of the stock is unlikely to fall
and is believed to be determined by market psychology.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Implications of the EMH
36. A finding that _________ would provide evidence against the semistrong form of the
efficient market theory.
A. low P/E stocks tend to have positive abnormal returns
B. trend analysis is worthless in determining stock prices
C. one can consistently outperform the market by adopting the contrarian approach
exemplified by the reversals phenomenon
D. low P/E stocks tend to have positive abnormal returns and trend analysis is worthless in
determining stock prices
E. low P/E stocks tend to have positive abnormal returns and one can consistently outperform
the market by adopting the contrarian approach exemplified by the reversals phenomenon
Both low P/E stocks tending to have positive abnormal returns and the ability to consistently
outperform the market by adopting the contrarian approach exemplified by the reversals
phenomenon are inconsistent with the semistrong form of the EMH.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Efficient Market Hypothesis
11-18
Chapter 11 - The Efficient Market Hypothesis
The weak form of the efficient market hypothesis contradicts technical analysis, but is silent
on the possibility of successful fundamental analysis.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Efficient Market Hypothesis
38. Two basic assumptions of technical analysis are that security prices adjust
A. rapidly to new information and market prices are determined by the interaction of supply
and demand.
B. rapidly to new information and liquidity is provided by security dealers.
C. gradually to new information and market prices are determined by the interaction of supply
and demand.
D. gradually to new information and liquidity is provided by security dealers.
E. rapidly to information and to the actions of insiders.
Technicians follow market data such as price changes and volume of trading (as indicator of
supply and demand) believing that they can identify price trends as security prices adjust
gradually.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Implications of the EMH
11-19
Chapter 11 - The Efficient Market Hypothesis
As leakage of information occurs, the accumulated abnormal returns that are abnormal returns
summed over the period of interest (around the event date) are better measures of the effect of
firm-specific events.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Event Studies
Studies show that, in general, funds do not outperform the market and that historical
performance is not necessarily an indicator of future performance.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Mutual Fund/Analyst Performance
11-20
Chapter 11 - The Efficient Market Hypothesis
41. The likelihood of an investment newsletter's successfully predicting the direction of the
market for three consecutive years by chance should be
A. between 50% and 70%.
B. between 25% and 50%.
C. between 10% and 25%.
D. less than 10%.
E. greater than 70%.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Mutual Fund/Analyst Performance
42. In an efficient market the correlation coefficient between stock returns for two non-
overlapping time periods should be
A. positive and large.
B. positive and small.
C. zero.
D. negative and small.
E. negative and large.
In an efficient market there should be no serial correlation between returns from non-
overlapping periods.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Efficient Market Hypothesis
11-21
Chapter 11 - The Efficient Market Hypothesis
43. The weather report says that a devastating and unexpected freeze is expected to hit Florida
tonight, during the peak of the citrus harvest. In an efficient market one would expect the
price of Florida Orange's stock to
A. drop immediately.
B. remain unchanged.
C. increase immediately.
D. gradually decline for the next several weeks.
E. gradually increase for the next several weeks.
In an efficient market the price of the stock should drop immediately when the bad news is
announced. If later news changes the perceived impact to Florida Orange, the price may once
again adjust quickly to the new information. A gradual change is a violation of the EMH.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Event Studies
44. Matthews Corporation has a beta of 1.2. The annualized market return yesterday was
13%, and the risk-free rate is currently 5%. You observe that Matthews had an annualized
return yesterday of 17%. Assuming that markets are efficient, this suggests that
A. bad news about Matthews was announced yesterday.
B. good news about Matthews was announced yesterday.
C. no news about Matthews was announced yesterday.
D. interest rates rose yesterday.
E. interest rates fell yesterday.
AR = 17% - (5% + 1.2 (8%)) = +2.4%. A positive abnormal return suggests that there was
firm-specific good news.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Event Studies
11-22
Chapter 11 - The Efficient Market Hypothesis
45. Nicholas Manufacturing just announced yesterday that its fourth quarter earnings will be
10% higher than last year's fourth quarter. You observe that Nicholas had an abnormal return
of -1.2% yesterday. This suggests that
A. the market is not efficient.
B. Nicholas' stock will probably rise in value tomorrow.
C. investors expected the earnings increase to be larger than what was actually announced.
D. investors expected the earnings increase to be smaller than what was actually announced.
E. earnings are expected to decrease next quarter.
Anticipated earnings changes are impounded into a security's price as soon as expectations are
formed. Therefore a negative market response indicates that the earnings surprise was
negative, that is, the increase was less than anticipated.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Event Studies
46. When Maurice Kendall first examined stock price patterns in 1953, he found that
A. certain patterns tended to repeat within the business cycle.
B. there were no predictable patterns in stock prices.
C. stocks whose prices had increased consistently for one week tended to have a net decrease
the following week.
D. stocks whose prices had increased consistently for one week tended to have a net increase
the following week.
E. the direction of change in stock prices was unpredictable, but the amount of change
followed a distinct pattern.
The first studies in this area were made possible by the development of computer technology.
Kendall's study was the first to indicate that markets were efficient.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Implications of the EMH
11-23
Chapter 11 - The Efficient Market Hypothesis
A random walk means that the changes in prices are random and independent.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Efficient Market Hypothesis
48. The main difference between the three forms of market efficiency is that
A. the definition of efficiency differs.
B. the definition of excess return differs.
C. the definition of prices differs.
D. the definition of information differs.
E. they were discovered by different people.
The main difference is that weak form encompasses only historical data, semistrong form
encompasses historical data and current public information, and strong form encompasses
historical data, current public information, and inside information. All of the other definitions
remain the same.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Efficient Market Hypothesis
11-24
Chapter 11 - The Efficient Market Hypothesis
AACSB: Analytic
Bloom's: Understand
Difficulty: Basic
Topic: Implications of the EMH
50. Which of the following are used by fundamental analysts to determine proper stock
prices?
I) trendlines
II) earnings
III) dividend prospects
IV) expectations of future interest rates
V) resistance levels
A. I, IV, and V
B. I, II, and III
C. II, III, and IV
D. II, IV, and V
E. All five items are used by fundamental analysts.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Implications of the EMH
11-25
Chapter 11 - The Efficient Market Hypothesis
51. Which of the following are used by technical analysts to determine proper stock prices?
I) trendlines
II) earnings
III) dividend prospects
IV) expectations of future interest rates
V) resistance levels
A. I and V
B. I, II, and III
C. II, III, and IV
D. II, IV, and V
E. I and II
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Implications of the EMH
52. According to proponents of the efficient market hypothesis, the best strategy for a small
investor with a portfolio worth $40,000 is probably to
A. perform fundamental analysis.
B. exploit market anomalies.
C. invest in Treasury securities.
D. invest in derivative securities.
E. invest in mutual funds.
Individual investors tend to have relatively small portfolios and are usually unable to realize
economies of size. The best strategy is to pool funds with other small investors and allow
professional managers to invest the funds.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Mutual Fund/Analyst Performance
11-26
Chapter 11 - The Efficient Market Hypothesis
53. Which of the following are investment superstars who have consistently shown superior
performance?
I) Warren Buffet
II) Phoebe Buffet
III) Peter Lynch
IV) Merrill Lynch
V) Jimmy Buffet
A. I, III, and IV
B. II, III, and IV
C. I and III
D. III and IV
E. I, III, IV, and V
Warren Buffet manages Berkshire Hathaway and Peter Lynch managed Fidelity's Magellan
Fund. Phoebe Buffet is a character on NBC's "Friends" and Jimmy Buffet is "Wasting Away
in Margaritaville." Merrill Lynch isn't a person.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Mutual Fund/Analyst Performance
54. Google has a beta of 1.0. The annualized market return yesterday was 11%, and the risk-
free rate is currently 5%. You observe that Google had an annualized return yesterday of 14%.
Assuming that markets are efficient, this suggests that
A. bad news about Google was announced yesterday.
B. good news about Google was announced yesterday.
C. no news about Google was announced yesterday.
D. interest rates rose yesterday.
E. interest rates fell yesterday.
AR = 14% - (5% + 1.0 (6%)) = +3.0%. A positive abnormal return suggests that there was
firm-specific good news.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Efficient Markets
11-27
Chapter 11 - The Efficient Market Hypothesis
55. Music Doctors has a beta of 2.25. The annualized market return yesterday was 12%, and
the risk-free rate is currently 4%. You observe that Music Doctors had an annualized return
yesterday of 15%. Assuming that markets are efficient, this suggests that
A. bad news about Music Doctors was announced yesterday.
B. good news about Music Doctors was announced yesterday.
C. no news about Music Doctors was announced yesterday.
D. interest rates rose yesterday.
E. interest rates fell yesterday.
AR = 15% - (4% + 2.25 (8%)) = -7.0%. A negative abnormal return suggests that there was
firm-specific bad news.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Efficient Markets
56. QQAG has a beta of 1.7. The annualized market return yesterday was 13%, and the risk-
free rate is currently 3%. You observe that QQAG had an annualized return yesterday of 20%.
Assuming that markets are efficient, this suggests that
A. bad news about QQAG was announced yesterday.
B. good news about QQAG was announced yesterday.
C. no significant news about QQAG was announced yesterday.
D. interest rates rose yesterday.
E. interest rates fell yesterday.
AR = 20% - (3% + 1.7 (10%)) = 0.0%. A positive abnormal return suggests that there was
firm-specific good news and a negative abnormal return suggests that there was firm-specific
bad news.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Efficient Markets
11-28
Chapter 11 - The Efficient Market Hypothesis
57. QQAG just announced yesterday that its fourth quarter earnings will be 35% higher than
last year's fourth quarter. You observe that QQAG had an abnormal return of -1.7%
yesterday. This suggests that
A. the market is not efficient.
B. QQAG stock will probably rise in value tomorrow.
C. investors expected the earnings increase to be larger than what was actually announced.
D. investors expected the earnings increase to be smaller than what was actually announced.
E. earnings are expected to decrease next quarter.
Anticipated earnings changes are impounded into a security's price as soon as expectations are
formed. Therefore a negative market response indicates that the earnings surprise was
negative, that is, the increase was less than anticipated.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Efficient Markets
58. LJP Corporation just announced yesterday that it would undertake an international joint
venture. You observe that LJP had an abnormal return of 3% yesterday. This suggests that
A. the market is not efficient.
B. LJP stock will probably rise in value again tomorrow.
C. investors view the international joint venture as bad news.
D. investors view the international joint venture as good news.
E. earnings are expected to decrease next quarter.
The positive abnormal return suggests that investors view the international joint venture as
good news.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Efficient Markets
11-29
Chapter 11 - The Efficient Market Hypothesis
59. Music Doctors just announced yesterday that its first quarter sales were 35% higher than
last year's first quarter. You observe that Music Doctors had an abnormal return of -2%
yesterday. This suggests that
A. the market is not efficient.
B. Music Doctors stock will probably rise in value tomorrow.
C. investors expected the sales increase to be larger than what was actually announced.
D. investors expected the sales increase to be smaller than what was actually announced.
E. earnings are expected to decrease next quarter.
The negative abnormal return suggests that investors expected the sales increase to be larger
than what was actually announced.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Efficient Markets
60. The Food and Drug Administration (FDA) just announced yesterday that they would
approve a new cancer-fighting drug from King. You observe that King had an abnormal
return of 0% yesterday. This suggests that
A. the market is not efficient.
B. King stock will probably rise in value tomorrow.
C. King stock will probably fall in value tomorrow.
D. the approval was already anticipated by the market.
E. None of these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Event Studies
11-30
Chapter 11 - The Efficient Market Hypothesis
61. Your professor finds a stock-trading rule that generates excess risk-adjusted returns.
Instead of publishing the results, she keeps the trading rule to herself. This is most closely
associated with ________.
A. regret avoidance
B. selection bias
C. framing
D. insider trading
E. None of these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Efficient Markets
62. At freshman orientation, 1,500 students are asked to flip a coin 20 times. One student is
crowned the winner (tossed 20 heads). This is most closely associated with ________.
A. regret avoidance
B. selection bias
C. overconfidence
D. the lucky event issue
E. None of these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Efficient Markets
11-31
Chapter 11 - The Efficient Market Hypothesis
63. Sehun (1986) finds that the practice of monitoring insider trade disclosures, and trading on
that information, would be ________.
A. extremely profitable for long-term traders
B. extremely profitable for short-term traders
C. marginally profitable for long-term traders
D. marginally profitable for short-term traders
E. not sufficiently profitable to cover trading costs
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Efficient Markets
The reversal effect states that stocks that do well in one period tend to perform poorly in the
subsequent period, and vice versa.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic
Topic: Efficient Markets
11-32
Chapter 11 - The Efficient Market Hypothesis
65. Patell and Woflson (1984) report that most of the stock price response to corporate
dividend or earnings announcements occurs within ____________ of the announcement.
A. 10 minutes
B. 45 minutes
C. 2 hours
D. 4 hours
E. 2 trading days
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