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6.03 Market Efficiency - Answers
6.03 Market Efficiency - Answers
6.03 Market Efficiency - Answers
A. Cumulative
B. Convertible
C. Participating
Explanation
Noncumulative Does not accrue dividends that are undeclared and unpaid in past periods
Participating Allows for additional dividend payments if company profits exceed a certain threshold
Callable Allows issuer to buy back shares from investors for a specified price
Putable Allows investors to sell shares back to issuer for a specified price
Common shareholders may participate in a company's operating performance by sharing in its increasing (decreasing) profits, either through:
In contrast, preferred shareholders normally do not participate directly in the company's operating performance since the preferred dividend
is fixed at issuance, which in effect fixes the shares' value (based on discounted cash flows). Types of preferred shares include cumulative,
convertible, and participating.
For cumulative preferred shares, unpaid dividends accumulate and eventually must be paid. When the omitted dividends are paid, the "catch-
up" payment(s) may be larger than the usual periodic payment based on the stated fixed rate. However, there is no change to the rate itself,
which is fixed at issuance, so cumulative preferred shareholders do not share in the company's operating performance.
(Choice B) Convertible preferred shares are convertible to the company's common shares. If the value of the common shares increases
(decreases), based on company performance, the value of the preferred shares will also increase (decrease) as the option to convert to common
shares becomes more (less) valuable. In that way, holders of convertible preferred shares also share in the company's performance.
(Choice C) Participating preferred shares pay dividends that exceed the stated rate if the company's profits surpass levels specified at issuance,
allowing shareholders to share in the company's operating performance.
Things to remember:
Unlike common shareholders, preferred shareholders normally do not participate directly in a company's operating performance since the
preferred dividend (and thus share value) is fixed at issuance. Convertible and participating preferred stockholders share in a company's
operating performance through the possibility of converting to common shares or through expanded dividends.
Describe market efficiency and related concepts, including their importance to investment practitioners
LOS
A. increase.
B. decrease.
Explanation
In an efficient market, information is reflected quickly in asset prices. Factors that increase participants' speed and ease of access to information
facilitate faster price adjustments and increase market efficiency.
In over-the-counter (OTC) markets, dealers negotiate trades among themselves, and other market participants may not be informed of details.
Some dealers may choose to withdraw from trading altogether. These factors may limit data availability, increasing information cost and
decreasing market efficiency (Choice B).
Major exchanges, having many investors and listed companies, also have greater analyst coverage than OTC markets. Trade data is
immediately reported and easily obtained. Adding an exchange to a market increases trading volume and lowers information cost. These
changes cause market efficiency to rise (Choice C). OTC markets are not exchanges.
Things to remember:
Exchanges create greater market efficiency than over-the-counter markets. Efficient markets imply information quickly reflected in asset prices.
Data availability, the presence of many analysts and investors, low information-gathering cost, and exchanges tend to increase market efficiency.
Explanation
Market efficiency is determined based on how quickly and completely information is reflected in asset prices. The efficient market hypothesis
defines three forms of market efficiency:
The weak form assumes that asset prices reflect only historical market data (eg, price and volume data) (Choice C).
The semi-strong form assumes that asset prices reflect all historical market data plus all publicly available information (eg, financial
data). New public information is quickly assimilated into prices.
The strong form assumes that asset prices reflect all of the information assumed by the weak and semi-strong forms. In addition, it
assumes that prices reflect material, nonpublic information (eg, information known to management or other insiders) (Choice B).
In a semi-strong market, it is difficult, if not impossible, for investors to consistently achieve abnormal returns without nonpublic information.
Things to remember:
Market efficiency is determined based on how quickly and completely information is reflected in asset prices. The efficient market hypothesis
defines three forms of market efficiency: weak, semi-strong, and strong. The semi-strong form assumes that stock prices reflect all publicly
available information.
selling stocks whose total return over the past 3 years has outperformed the market and
buying stocks whose total return has underperformed the market over the same period.
This investor is most likely attempting to earn abnormal returns based which of the following market anomalies?
A. Value effect
B. Earnings surprise
C. Overreaction effect
Explanation
The overreaction effect is a type of momentum market anomaly. The premise of this anomaly is that investors overreact to the release of
unexpected public information and that abnormal returns can be earned by a strategy contrary to the overreaction.
For example, investors may form a consensus about a company's expected earnings per share (EPS). However, if EPS is lower than expected,
the investors are likely to sell the stock and to buy it when EPS is higher than expected (ie, earnings surprise anomaly) (Choice B). Investing
strategies based on earnings surprises tend to be short term and trend following.
The overreaction effect occurs because investors tend to overreact to unexpected news, not only selling (or buying) stock with disappointing (or
encouraging) earnings but also overselling (or overbuying) it.
In response, an investor could buy the stock that reported lower-than-expected EPS, which is now oversold and underpriced, and sell the stock of
the company that reported higher-than-expected EPS, which is now overbought and overpriced. This contrarian strategy, whereby investors buy
stocks that have underperformed over a 3- to 5-year period and sell stocks that have outperformed during the same period, assumes the
performance is based on investor overreactions.
(Choice A) The value effect anomaly refers to the concept that value stocks (eg, those with below-average P/E ratios and above-average
dividend yields) outperform growth stocks over a long period. It is unrelated to investor reactions to unexpected information.
Things to remember:
The overreaction effect is a market anomaly characterized by investor overreaction to the release of unexpected public information. The strategy
in response is to buy stocks that have underperformed the market and sell stocks that have outperformed the market.
Explanation
The efficient market hypothesis (EMH) sets forth three forms of market efficiency: weak, semi-strong, and strong. Under semi-strong-form EMH,
all publicly available information is reflected in asset market prices. Empirical evidence suggests that developed financial markets are semi-
strong-form efficient. Since regulations prevent the use of nonpublic information that would influence stock prices, markets are not strong-form
efficient.
Active portfolio management normally uses fundamental analysis as the basis for decisions to buy or sell securities. However, semi-strong-form
EMH implies active portfolio management would be futile since asset prices already reflect all publicly available information.
Active portfolio management incurs higher transaction and information acquisition costs than passive management, which instead seeks to
emulate the performance of an index. As a result, the semi-strong-form EMH implies that passive management will, on average, outperform
active portfolio management.
(Choice A) If a market is semi-strong-form efficient, all publicly available information is reflected in prices, including historical market data. Thus,
all markets that are semi-strong-form efficient are also said to be weak-form efficient.
(Choice C) The implication of semi-strong-form efficiency for actual markets is that active portfolio managers cannot beat the market on a
consistent basis. Passive managers generally try to replicate market index returns, not beat them. This answer is not an implication of semi-
strong-form EMH.
Things to remember:
Under the semi-strong-form efficient market hypothesis (EMH), all publicly available information is reflected in asset market prices. Active
management incurs higher transaction and information gathering costs than passive management. Semi-strong-form EMH implies that passive
portfolio management will, on average, outperform active portfolio management.
Explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive
portfolio management
LOS
A. survivorship.
B. mental accounting.
C. representativeness.
Explanation
Loss aversion Disliking losses more than one appreciates gains of equal magnitude
Mental accounting Separating wealth into different mental buckets with different risk and return expectations
Overconfidence Being overconfident in one's ability to estimate prices and select stocks
Making oversimplified assessments on new information based on conclusions drawn from past experiences (eg,
Representativeness
stereotypes)
Focusing on issues in isolation instead of considering the broader context in conjunction with other interrelated
Narrow framing
factors
Behavioral finance is the study of how behavioral biases often lead to irrational decision making. In this question, the investor exhibits the bias of
representativeness, which is characterized by making overly simplified associations based on past experiences. Due to poor past returns on
two small-cap stocks, the investor believes that small-cap stocks represent poor investment choices.
With investing, representativeness may lead to irrational decisions. Investors may apply quick judgments based on past associations instead of
analyzing information according to the proper context.
(Choice A) Survivorship is a statistical sampling bias, not a behavioral bias. This bias stems from excluding the performance of failed companies
in the calculation of fund returns. Survivorship often leads to overinflated reported fund performance.
(Choice B) Mental accounting refers to separating wealth into different mental buckets with different goals. There is no indication that the
investor is separating wealth into different buckets in this question.
Things to remember:
Representativeness is characterized by making overly simplistic associations based on past experience instead of analyzing situations according
to the proper context.
Describe behavioral finance and its potential relevance to understanding market anomalies
LOS
Explanation
The theory of semi-strong form market efficiency holds that market prices contain all publicly available information. One consequence of this
theory is that investors cannot achieve abnormal returns without using material, nonpublic information. Market anomalies are persistent market
events that are inconsistent with semi-strong form efficiency, that is, price changes that cannot be explained by available or newly released
public information.
The earnings surprise anomaly is due to the lack of a complete and immediate price adjustment to unexpected news from an earnings report.
Since there is a lag between the release of the earnings report (which becomes public information) and the subsequent price adjustment, it is
possible to generate abnormal returns for a short time. This is inconsistent with semi-strong form market efficiency.
(Choice A) The initial public offering (IPO) anomaly indicates that, on average, investors purchasing shares through an IPO may be able to earn
short-term abnormal profits. IPOs are frequently underpriced, allowing investors to earn abnormal returns; however, market prices adjust quickly,
supporting semi-strong market efficiency.
(Choice C) A closed-end fund discount is the persistent 4–10% discount to net asset value (NAV) observed in these funds' prices. The discount
does not result in abnormal returns due to transaction costs, liquidity, and the potential for NAV miscalculations.
Things to remember:
A market anomaly is a market event that is inconsistent with efficient market theory. The earnings surprise anomaly is inconsistent with semi-
strong form market efficiency theory due to the short lag between the release of public information and the subsequent price adjustment.
A. herding.
B. loss aversion.
C. conservatism.
Explanation
Behavioral finance attempts to explain investment decision making by studying investors' behaviors. In part, it involves understanding various
biases that cause investors to act irrationally, which can lead to pricing anomalies. The herding bias suggests that investors may irrationally
ignore their own analysis and instead trade on the same side of the market and/or securities as other investors. This can lead to either
overreaction or under-reaction in the market.
In this scenario, the investor exhibits the herding bias. Based on research, the investor begins to believe that an invested stock is overvalued and
its price will decrease, and so intends to sell the stock. However, the investor instead decides to hold the stock after seeing that other investors
are buying or holding it.
(Choice B) Loss aversion refers to investors' tendencies to dislike losses more than they like gains of equal magnitude. Since this investor
believes the stock is overvalued, loss aversion would most likely drive the investor to sell the stock.
(Choice C) Conservatism refers to investors' tendencies to delay updating their views and forecasts based on new information and instead
maintain prior views and forecasts. This investor updated the proprietary model with new information, an action that does not exhibit
conservatism.
Things to remember:
Behavioral finance studies how investors behave to better understand their decision making, including biases that cause them to act irrationally.
The herding bias suggests that investors may irrationally ignore their own analysis and instead trade on the same side of the market and/or
securities as other investors.
Describe behavioral finance and its potential relevance to understanding market anomalies
LOS
A. Limiting arbitrage
Explanation
In an efficient market, new information is reflected quickly in asset prices. Factors that are likely to increase market efficiency increase the speed
at which participants receive new information, allow more rapid valuation and trading, and facilitate rapid price adjustments. Therefore arbitrage,
which tends to increase the speed that prices adjust to new information, ensures market efficiency.
Arbitrage is the riskless, simultaneous buying and selling of the same or equivalent instruments in one or more markets to exploit mispricing. As
arbitrage occurs, prices of equivalent financial instruments move toward the same price. The speed at which this occurs depends on arbitrage in
the market, so if arbitrage is constrained, market efficiency is reduced.
(Choice B) In fair and orderly markets, a greater number of participants have access to information used to perform valuations and make trades.
More trading means asset prices adjust to new information more quickly. As a result, promoting fair and orderly markets tends to increase, not
decrease, market efficiency.
(Choice C) If the number of investors is restricted, there will be less trading. Therefore, if the number of investors—or the number of a certain
type of investors (eg, foreigners)—is limited, market efficiency will decrease. Inversely, permitting foreign investment (ie, allowing a greater
number of investors) is likely to increase market efficiency.
Things to remember:
An efficient market is one in which new information is reflected quickly in asset prices. Arbitrage facilitates rapid price adjustments that increase
market efficiency. Enforcing fair and orderly markets, having many analysts and investors, and permitting investment by foreigners are factors that
tend to increase market efficiency.
A. inside information.
Explanation
The efficient market hypothesis (EMH) specifies three forms of market efficiency: weak, semi-strong, and strong. Under the weak-form efficient
market hypothesis, only historical market data is reflected in prices. Under the semi-strong form, all publicly available information is reflected
in prices, including both historical market data and other sources of publicly available information (eg, companies' financial statements). Strong-
form EMH states that all information, public and private, is reflected in prices.
Inside information is another name for material nonpublic information. Semi-strong EMH holds that all public information is included in prices.
However, because material, nonpublic information is not reflected in prices under this form, trading on it may in fact produce consistent, abnormal
returns. Trading on such information is illegal in most countries.
(Choice B) If all publicly available information is reflected in prices, then it is not possible for an investor to benefit from a change in price due to
the new public information. According to semi-strong EMH, earning consistent, abnormal returns based on publicly available information is not
possible.
(Choice C) The semi-strong EMH does not imply anything about nonmaterial nonpublic information. In addition, nonmaterial information is
defined as information that does not affect asset prices, so acting on nonmaterial information would not benefit an investor because it would not
change an asset's price.
Things to remember:
The efficient market hypothesis (EMH) specifies three forms of market efficiency: weak, semi-strong, and strong. Semi-strong EMH holds that
consistently earning abnormal returns based on publicly available information is not possible since asset prices in the market already reflect the
information.
A. conservatism.
B. loss aversion.
C. mental accounting.
Explanation
Loss aversion Disliking losses more than one appreciates gains of equal magnitude
Mental accounting Separating wealth into different mental buckets with different risk and return expectations
Overconfidence Being overconfident in one's ability to estimate prices and select stocks
Making oversimplified assessments on new information based on conclusions drawn from past experiences (eg,
Representativeness
stereotypes)
Focusing on issues in isolation instead of considering the broader context in conjunction with other interrelated
Narrow framing
factors
Behavioral finance is the area of study that examines how behavioral biases influence investment decisions. Often, biases lead to irrational
decision-making. Conservatism bias occurs when individuals are reluctant to accept new information and instead adhere strictly to past
information. In this scenario, the analyst refuses to revise the previous EPS forecast of $0.21 despite receiving updated information on supply
chain disruptions that will decrease earnings.
(Choice B) Loss aversion refers to investors' tendency to dislike losses more than they like gains of equal magnitude.
(Choice C) Mental accounting refers to investors separating wealth into different mental buckets to fulfill different goals.
Things to remember:
Conservatism bias occurs when investors are reluctant to accept new information and instead adhere strictly to past information.
Describe behavioral finance and its potential relevance to understanding market anomalies
LOS
A. herding.
B. risk aversion.
C. information cascades.
Explanation
Information cascades
Behavioral finance examines investor psychology to explain why and how investors do not always act rationally. Herding and information
cascades are behavioral theories that explore why investors often imitate other investors. Both theories are characterized by investors trading on
the same side of the market and/or in the same securities, as well as investors ignoring their own beliefs to act in concert with others.
While information cascades are premised on the initial actions of knowledgeable (ie, informed) participants, herding is not necessarily based on
information. In an information cascade, the actions of informed participants influence the decisions of subsequent actors.
In this scenario, the investor's decision to sell is based on the prior action of a portfolio manager perceived to be more knowledgeable, despite the
investor's belief in the stock's long-term prospects. The decision is also based on the imitating actions of others prior to the investor's decision.
These actions are more consistent with information cascades than with herding (Choice A).
(Choice B) Risk aversion describes investors wanting higher expected returns to compensate for assuming more risk. Nothing in this question
addresses the riskiness of the stock that the investor sells.
Things to remember:
Behavioral finance attempts to explain how and why investors do not always act rationally. Herding and information cascades are similar in that
investors trade on the same side of the market and/or in the same securities. However, information cascades presume that the initial actions of
knowledgeable participants influence the actions of others. Herding may or may not be based on information.
Describe behavioral finance and its potential relevance to understanding market anomalies
LOS
A. Risk aversion
B. Overconfidence
C. Mental accounting
Explanation
Behavioral finance is based on the idea that mental biases cause individuals to make recurring suboptimal investing decisions, which lead to
observed pricing anomalies. Overconfidence bias is rooted in the idea that investors overestimate their own research, analytical, and
selection abilities.
In this scenario, the investor is confident of a company's valuation and investment prospects and emotionally invested in an outcome that confirms
the original analysis. When confronted with new facts (ie, substantial stock price decline) that undermine this confidence, the investor dismisses
the new facts as market irrationality.
High-growth stocks can encourage overconfidence bias since investors may become overly optimistic regarding a company's long-term
prospects. As collective overconfidence peaks, investors often have difficulty believing the stock is overvalued.
(Choice A) Risk aversion is not a specific behavioral finance bias; rather, it is an investor's general tendency to prefer less risk and require higher
expected returns to take on additional risk.
(Choice C) Mental accounting is observed when investors segregate different investments into separate mental "accounts," and treat them
differently as a result.
Things to remember:
Overconfidence bias is rooted in the idea that investors overestimate their own research and stock selection abilities and is most common with
high-growth stocks.
Describe behavioral finance and its potential relevance to understanding market anomalies
LOS
Explanation
The efficient market hypothesis (EMH) sets forth three forms of market efficiency: weak, semi-strong, and strong. Under weak-form EMH, only
historical market data is reflected in prices. The semi-strong form of EMH extends that data reflection in prices to include all publicly available
information. Under the strong-form EMH, all public and private information is reflected in market prices.
Since all public and private information is accounted for in market prices, it is impossible to consistently earn abnormal returns if strong-form EMH
applies. Abnormal returns are the portion of an asset's return that is not explained by the return of the market. If markets are strong-form efficient,
then they are also efficient in the semi-strong and weak forms. Likewise, if a market is efficient in the semi-strong form, then it is also weak-form
efficient.
(Choice A) All three forms (ie, weak, semi-strong, and strong) hold that historical market data is reflected in prices, so this statement is not unique
to strong-form EMH.
(Choice B) Under strong-form EMH, all public and private information is reflected in prices. This includes company financial reports. However,
this is also true under semi-strong-form EMH.
Things to remember:
Under the strong form of efficient market hypothesis (EMH), all public and private information is reflected in market prices. If strong-form EMH
holds, then it is not possible to obtain an abnormal return using either public or private information.
B. the price for which market participants can buy or sell the asset.
Explanation
An asset's intrinsic value is the true value it would be given by market participants if they had complete information on and understanding of
the asset. An asset's market value is the price that market participants can readily purchase or sell it for. (Choice B).
In an efficient market, all new relevant information about an asset's intrinsic value is reflected quickly and rationally in its market value. If
investors believe that a market is efficient, they will generally accept that an asset's market value correctly reflects its intrinsic value since all past
and present information has been processed.
In practice, an asset's intrinsic value cannot be known for certain, so analysts and investors must develop their own estimates to find assets with
market values that differ from the estimated intrinsic values.
(Choice A) If the intrinsic value of an asset is higher than its market value, the asset can be purchased at a lower price than its true worth, in
which case the asset is undervalued by the market.
Things to remember:
An asset's intrinsic value is the true value it would be given by market participants if they had complete understanding of and information on the
asset. An asset's market value is the price for which market participants currently buy and sell it. In an efficient market, all new information about
an asset is reflected quickly and rationally in its market value, and investors generally accept that the asset's market value reflects its intrinsic
value.
Explanation
Passive investment strategies attempt to match the returns on a benchmark index by holding all index securities or using statistical techniques
to replicate index returns. Active investment strategies attempt to outperform a benchmark index by overweighting and underweighting index
securities or by holding securities that are not in the index. Active strategies typically create more fees and expenses for the investor than
passive strategies.
Security prices in semi-strong-form efficient markets reflect all publicly available information. When this information is accurate, on average,
securities trade at prices that match or are close to their intrinsic value. Based on net returns, when securities trade at intrinsic value, active
strategies should underperform the market due to their fees and expenses. Passive strategies outperform active strategies by avoiding those
costs in semi-strong-form efficient markets (Choices B and C).
Things to remember:
Passive investment strategies attempt to replicate returns on a benchmark index. In semi-strong-form efficient markets, prices reflect all publicly
available information and securities trade at levels that match or are close to their intrinsic value. Active strategies that buy and sell securities at
intrinsic value will underperform the market due to the costs of this type of investing. Thus, passive strategies outperform active strategies if
markets are semi-strong-form efficient.
Describe market efficiency and related concepts, including their importance to investment practitioners
LOS
Explanation
A market anomaly is a recurring market inefficiency that is inconsistent with efficient market theory. Semi-strong form market efficiency
theorizes that market prices contain all publicly available information. There are two well-known market anomalies that use publicly available
information to generate abnormal returns and therefore contradict semi-strong form market efficiency: the value effect and earnings surprise.
The value effect is the outperformance of value stocks versus growth stocks over long periods of time. Value stocks are defined as
having relatively low valuations (eg, price-to-earnings, price-to-book), or as stocks with relatively high dividend yields.
The earnings surprise anomaly is the lack of a complete and immediate price adjustment to the unexpected portion of reported earnings.
(Choice B) The January effect is market outperformance during the first few trading days of the year. Recent evidence implies that many time-
series anomalies such as the January effect are not persistent and have largely been arbitraged away. If these anomalies exist, they appear
inconsistently and are likely driven by seasonal factors such as tax-loss selling or window dressing, which both conclude by December 31.
(Choice C) The closed-end fund discount is the persistent 4–10% discount to net asset value (NAV) observed in the trading of these funds. The
efficacy of this anomaly is debated since transaction costs, liquidity, and the potential for NAV miscalculations make it unlikely that the discount
could be fully exploited.
Things to remember:
A market anomaly is a recurring market inefficiency that is inconsistent with efficient market theory. The value effect and earnings surprise are
inconsistent with semi-strong form market efficiency theory.
A. fair value.
B. market value.
Explanation
An asset is overvalued when its intrinsic value is less than its market value. An asset's intrinsic value is its estimated fair value based on equity
valuation models. Market value is the price at which an asset can be traded in a public market. Intrinsic value and market value can differ in
markets that are not fully efficient.
(Choice A) An asset's intrinsic value cannot be less than its fair value since the values are the same.
(Choice C) An asset's intrinsic value cannot be less than the present value of its expected future cash flows since the present value is an
estimate.
Things to remember:
When an asset's intrinsic value is less than its market value, the asset is overvalued. This can occur in markets that are not fully efficient.
Explanation
Markets are informationally efficient if security prices adjust rapidly and rationally to the release of new information. Informational efficiency
is fostered when information is widely available at low cost and there are numerous market participants adjusting their expectations of risk and
return as new information is released.
CFA Institute curriculum defines new information as the "surprise" or "unexpected" component of newly released information. For example, an
earnings report in line with expected earnings is not considered new information. In an informationally efficient market, prices adjust only when
information releases contain a surprise (ie, new information), such as when reported earnings fall short of expectations.
(Choice A) Security prices cannot accurately anticipate new information, since new information is defined as being unexpected, that is,
information that could not have been expected or anticipated.
(Choice B) Since most markets restrict trading on the basis of nonpublic (ie, private) information, informational efficiency is indicated by prices'
reaction to newly public information; it does not depend on security prices reflecting private information.
Things to remember:
Markets are informationally efficient if security prices adjust rapidly and rationally to the release of unexpected information. Informational efficiency
is fostered when information is widely available at low cost and there are numerous market participants adjusting their expectations of risk and
return as unexpected information is released.
Describe market efficiency and related concepts, including their importance to investment practitioners
LOS
Explanation
The efficient market hypothesis (EMH) stipulates that markets are efficient when asset prices fully reflect all relevant information. If a market is
efficient, abnormal returns cannot be consistently achieved in that market with information obtained from sources specified by the EMH.
In the semi-strong form of market efficiency, asset prices are assumed to reflect all historical market data plus all publicly available
information (eg, financial statements, earnings calls). Historical data and public information are both completely assimilated into prices, so an
investor cannot achieve abnormal returns using those resources. An investor could achieve abnormal returns only by using insider information.
Two analytical methods are used to estimate the relative value of investments and develop investment decisions:
Technical analysis (eg, charting techniques) uses a market's historical trading and volume data.
Fundamental analysis (eg, free cash flow valuation) uses publicly available data to derive an asset's intrinsic value.
Therefore, in a semi-strong form efficient market, neither technical nor fundamental analysis would be able to generate abnormal returns (Choices
A and B).
Things to remember:
Under the semi-strong form efficient market hypothesis, all historical market data and publicly available information are reflected in asset prices.
To develop investment decisions, technical analysis uses historical market data while fundamental analysis uses publicly available data.
Therefore, in a market with semi-strong form efficiency, neither technical nor fundamental analysis would be able to generate abnormal returns.
Explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive
portfolio management
LOS
A. decrease.
C. increase.
Explanation
An efficient market is one in which new information is reflected quickly in asset prices. Market participants acquire market information from
company reports and use that data to make investment decisions. Factors that increase the speed at which participants have access to
information for valuation and trading facilitate faster price adjustments. This tends to increase market efficiency.
Less frequent financial reporting impedes valuation and investing and increases the cost of gathering information. More financial disclosure
contributes to a fairer and more orderly market, as well as broader availability of information to analysts and investors, both of which tend to
increase market efficiency. As a result of these factors, less frequent financial disclosure by companies decreases market efficiency (Choices
B and C).
Things to remember:
Factors that increase the speed at which participants receive new information tend to increase market efficiency. Company financial disclosure,
fair and orderly markets, many analysts and investors, and low cost of information gathering all contribute to increased market efficiency.
Explanation
A market anomaly is a recurring market inefficiency that is inconsistent with efficient market theory. Weak-form market efficiency holds that stock
prices contain all available past market data (ie, price and volume); therefore, an investor cannot earn abnormal profits by using only this
information.
However, considerable empirical evidence indicates that a momentum-based trading strategy using short-term historical stock price data can
earn abnormal returns in subsequent periods, thus contradicting weak-form market efficiency.
(Choice B) The earnings surprise anomaly is the lack of a complete and immediate price adjustment to the unexpected portion of reported
earnings (eg, fundamental public data). Due to this gradual price adjustment, stocks with a positive (negative) earnings surprise subsequently
outperform (underperform) without a release of new information, contradicting semi-strong form market efficiency.
(Choice C) The initial public offering (IPO) anomaly indicates that, on average, investors purchasing shares through an IPO may be able to earn
short-term abnormal profits. IPOs are frequently underpriced, allowing investors to earn abnormal returns; however, the excess return is fleeting
since market prices adjust quickly, supporting semi-strong market efficiency.
Things to remember:
The momentum anomaly contradicts weak-form market efficiency by earning abnormal returns using only historical price data.
A. technical analysis.
B. insider information.
C. fundamental analysis.
Explanation
The efficient market hypothesis (EMH) specifies three forms of market efficiency: weak, semi-strong, and strong. Weak-form EMH holds that
historical market data is reflected in market prices. Technical analysis involves using historical trading and volume data as the basis to buy and
sell. If historical market data has already influenced prices, then it is not possible to produce consistent, abnormal returns (ie, returns better
than expected returns) using technical analysis.
(Choices B and C) If markets are weak-form efficient, historical price and volume information are immediately reflected in market prices. Other
publicly available information (eg, company financial reports) and material nonpublic (insider) information may not be reflected in prices under
weak-form EMH. Therefore, it is possible for an investor to achieve consistent, abnormal returns by trading on publicly available information or
insider information.
Things to remember:
The three forms of the efficient market hypothesis (EMH) are weak, semi-strong, and strong. Weak-form EMH holds that historical market data is
reflected in asset market prices, implying that trading based on technical analysis will not produce consistent, abnormal returns.
Explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive
portfolio management
LOS
Explanation
The book value of equity is the amount of shareholders' equity reported on a company's balance sheet. It primarily consists of common stock
and retained earnings. On the balance sheet:
common stock reports the historical value of common equity issued, and
retained earnings (accumulated loss) reports the cumulative net profit (loss) since a company's inception, net of dividends.
All else equal, accumulated losses will reduce the book value of equity by reducing retained earnings. The book value of equity is also the
difference between total assets and total liabilities.
The market value of equity is the current value of the shareholders' equity (Shares outstanding × Current stock price). A change in the current
stock price will affect the equity's market value, not its book value (Choice C).
Since the stock price is based on investors' expectations of a company's future earnings or cash flows, the market value of equity is forward-
looking, whereas the book value of equity (based on share value at issuance) is backward-looking.
(Choice A) All else equal, halting dividends increases retained earnings and, thus, book value of equity since the company keeps more earnings,
instead of paying them as dividends.
Things to remember:
The book value of equity is reported on a company's balance sheet as the historical value of common equity issued (ie, common stock) and
cumulative net profit (loss) since a company's inception, net of dividends (ie, retained earnings). The equity's market value is based on current
share price, which is based on investors' current expectations of future earnings.
Describe behavioral finance and its potential relevance to understanding market anomalies
LOS
Explanation
The Efficient Market Hypothesis (EMH) specifies three forms of market efficiency: weak, semi-strong, and strong. Market efficiency is determined
by how quickly and completely information is reflected in asset prices. If a market is truly efficient, abnormal returns cannot be achieved on a
consistent basis with the information available.
The semi-strong form of efficiency assumes that asset prices reflect all historical market data plus all publicly available information (eg,
financial statement information). New public information is quickly assimilated into prices, so an investment manager cannot capitalize on events
such as earnings surprises to achieve abnormal returns.
Active portfolio management normally uses more frequent trading to exploit perceived inefficiencies. Active management therefore incurs higher
trading and information acquisition costs than passive management, which instead seeks to replicate the performance of the market or an index.
As a result, when a market is truly semi-strong form efficient, net-of-fees returns from passive management will, on average, outperform active
portfolio management with its higher costs (Choices B and C).
Things to remember:
Under the semi-strong form of the Efficient Market Hypothesis (EMH), all publicly available information is reflected in asset market prices. Semi-
strong form EMH implies that since active management incurs higher transaction costs, passive management will outperform net of fees.
Explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive
portfolio management
LOS
Explanation
The efficient market hypothesis (EMH) defines market efficiency based on how quickly and completely information is reflected in asset prices. If
markets are truly efficient, then abnormal returns cannot be achieved on a consistent basis. The EMH defines three forms of market efficiency:
The weak form assumes that asset prices reflect only historical market data (eg, price and volume data). In a weak form efficient market,
the market achieves only limited efficiency since it reflects limited information (ie, only historical data). An investment manager using active
management and all publicly available information could achieve abnormal returns to consistently outperform the market.
The semi-strong form assumes that asset prices reflect all historical market data plus all publicly available information (eg, financial
statement information). New public information is quickly assimilated into prices, so an investment manager cannot capitalize on events
such as earnings surprises to achieve abnormal returns, making active management strategies ineffective, without using nonpublic
information (Choice B).
The strong form assumes that asset prices reflect all public information as well as material, nonpublic information (ie, information known
to management or other insiders). In this case, it is impossible for an investment manager to consistently outperform the market even on a
short-term basis since asset prices reflect all available information (Choice C).
Things to remember:
The efficient market hypothesis (EMH) defines market efficiency based on how quickly and completely information is reflected in asset prices. The
EMH defines three forms of market efficiency: weak, semi-strong, and strong. Only in a weak form efficient market can an investment manager
use active management to consistently outperform the market, since the market achieves only limited efficiency and reflects limited information.
Explanation
Passive investment strategies attempt to match the returns on a benchmark index. Active management strategies attempt to earn higher risk-
adjusted returns by overweighting undervalued securities and underweighting overvalued securities. Successful active management
requires markets that are both:
Informationally inefficient: new information is not rapidly reflected in market prices, enabling research to identify securities trading above
or below intrinsic value, and
Operationally efficient: trading-related costs are less than the additional returns earned by buying undervalued and selling overvalued
securities
(Choices A and B) If markets are informationally efficient, all publicly available information is reflected in security prices, so market prices are
close to intrinsic value. If securities always trade at intrinsic value, active strategies underperform passive strategies by the costs of trading. This
is true in operationally efficient markets where trading costs are low. In operationally inefficient markets, active strategies are at an even greater
disadvantage.
Things to remember:
Active management strategies attempt to earn higher returns by overweighting undervalued securities and underweighting overvalued securities.
Successful active management requires markets that are informationally inefficient so mispriced securities can be discovered through research.
Additionally, markets must be operationally efficient so that trading costs are less than the additional returns earned through trading mispriced
securities.
Describe market efficiency and related concepts, including their importance to investment practitioners
LOS