Deck 12: Market Efficiency

Question 1

An efficient market requires that:

A) all investors are rational and react quickly to new information.
B) information can be obtained at a considerable cost by investors.
C) new information does not have a significant effect on market prices.
D) investors react quickly and fully to new information.

Answer 1

D

Question 2

What is the most important determinant of stock price in an efficient market?

A) Information about past events and beliefs about future events
B) The trading system that connects buyers and sellers within the market
C) The number of traders participating in the market
D) The ability of investors to perfectly adjust prices based on new information

Answer 2

A

Question 3

Using technical analysis to consistently earn abnormal returns is consistent with which form of the Efficient Market Hypothesis?

A) None
B) Weak form
C) Semi-strong form
D) Strong form

Answer 3

A

Question 4

A characteristic of an efficient market is that:

A) prices adjust perfectly to new information.
B) announced information events tend to be dependent on one another.
C) investors are price takers.
D) individual investors have the ability to affect security prices.

Question 5

Research suggests company insiders earn abnormal returns on their stock transactions. What does this research mean for the efficient market hypothesis (EMH)?

A) Insider trading has nothing to do with the EMH.
B) Profitable insider trading contradicts all forms of the EMH.
C) Profitable insider trading contradicts only the weak form of the EMH.
D) Profitable insider trading contradicts only the strong form of the EMH

Question 6

Which of the following observations is most consistent with the EMH?

A) The January effect
B) The random walk
C) The low P/E effect
D) The success of the Value Line Investment Survey

Question 7

What is meant by the "disposition effect?"

A) Investors are more likely to sell winners than losers.
B) Investors are more likely to sell losers than winners.
C) Investors sell both winners and losers too soon.
D) Investors hold both winners and losers too long.

Question 8

Which of the following is the best definition of "behavioral finance?"

A) Behavioral finance studies how financial market participants behave.
B) Behavioral finance studies the ethical behavior of investors.
C) Behavioral finance studies what investors should do to optimize performance.
D) Behavioral finance studies how investor biases and emotions affect stock prices.

Question 9

What is meant by the expression stock prices follow a "random walk?"

A) The best prediction of next period's price change is last period's price change.
B) Stock price changes do not depend statistically on prior price changes.
C) Stock price changes tend to be positive.
D) Stock price changes do not reflect market information.

Question 10

According to the strong form of the efficient market hypothesis, which investors should expect to earn abnormal returns?

A) Investors with superior analytic ability
B) Investors with access to nonpublic information
C) Investors with access to public and nonpublic information
D) No investors

Question 11

Which of the following is an investment strategy that relies on the "overreaction hypothesis?"

A) Buy and hold
B) Value investing
C) Momentum
D) Contrarian

Question 12

What is meant by the statement that an efficient market prices securities correctly?

A) The prices reported by the securities exchanges accurately reflect real transactions.
B) Riskier securities are priced to yield higher returns.
C) The expected return on securities is equal to the risk-free return.
D) Both buyers and sellers agree that the prices are fair.

Question 13

The January effect can be largely attributed to the exceptional performance of:

A) low P/E stocks in January.
B) winner stocks in January.
C) loser stocks in January.
D) small stocks in January.

Question 14

A test which investigates whether publicly available financial accounting information can be used to generate abnormal returns is a direct test of:

A) weak form market efficiency.
B) semi-strong form market efficiency.
C) strong form market efficiency.
D) mean-variance market efficiency.

Question 15

Which statement regarding Warren Buffett's wager with Protege Funds is most accurate?

A) The index fund outperformed the hedge funds, thus supporting market efficiency.
B) The index fund outperformed the hedge funds, thus countering market efficiency.
C) The index fund underperformed the hedge funds, thus supporting market efficiency.
D) The index fund underperformed the hedge funds, thus countering market efficiency.

Question 16

The momentum effect indicates that stocks with the:

A) best long-term past performance will continue to perform well.
B) best short-term past performance will continue to perform well.
C) worst long-term past performance will reverse course and perform well.
D) worst short-term past performance will reverse course and perform well.

Question 17

In an efficient market, the expected abnormal return on a security is:

A) equal to zero.
B) equal to the risk-free return.
C) equal to the security's required return.
D) greater than the security's required return.

Question 18

Which of the following best describes the so-called size effect?

A) On average, small cap stocks return more than large cap stocks.
B) On average, large cap stocks return more than small cap stocks.
C) On average, small cap stocks earn abnormal returns.
D) Small cap stocks tend to perform exceptionally well during bull markets.

Question 19

Research suggests that low P/E stocks outperform high P/E stocks. Why is this finding an anomaly?

A) Low P/E stocks tend to have higher risk than high P/E stocks.
B) Low P/E stocks are temporarily out of favor but may have strong prospects.
C) The low P/E effect contradicts the Efficient Market Hypothesis.
D) Low P/E stocks are often weak companies.

Question 20

Which of the following is not an investor trading bias?

A) Loss aversion
B) Framing
C) Overconfidence
D) Mean reversion

Question 21

The financial markets in the U.S. are less efficient than financial markets in less developed countries.

Question 22

Gordon has conducted a test to determine whether he could have earned abnormal returns by purchasing stocks after their price increased by 2% and selling stocks after their price fell by 2%. This is an example of:

A) a runs test.
B) a filter rule test.
C) an event study.
E) a test of strong form efficiency.

Question 23

Which of the following best illustrates the overconfidence bias?

A) Investors sell winners too early.
B) Investors avoid stocks with recent poor performance.
C) Investors hold losers too long.
D) Investors trade securities too frequently.

Question 24

Which of the following statements is true for an efficient market?

A) The expected return in the market is 0.
B) Information arrives randomly and independently.
C) Mutual fund managers outperform the aggregate market.
D) Stock prices respond gradually to information as it spreads across the country.

Question 25

Real estate prices have dropped substantially in Stan's home town. Stan recently got transferred and needs to sell his house, but he informs his real estate agent that he won't sell for less than the original purchase price of the house. Which bias is most consistent with Stan's statement?

A) House-money effect
B) Mental accounting
C) Anchoring and reference points
D) Hindsight bias

Question 26

Your frugal friend tells you he found $100 in the parking lot and he plans to bet it on the Super Bowl game. What behavior is your friend most likely exhibiting?

A) naïve diversification
B) loss aversion
C) money allusion
D) house-money effect

Question 27

The semi-strong form of the EMH:

A) suggests that technical trading rules can be used advantageously.
B) encompasses the strong form of the EMH.
C) states that publicly available information can be used to earn abnormal returns.
D) encompasses the weak form of the EMH.

Question 28

Carl holds a large position in Stock X that was recently downgraded. Carl's advisor recommends he sell X and take his gain, which was accumulated over the past several years. However, Carl decides not to sell X. Carl's behavior best represents:

A) the house-money effect.
B) representativeness bias.
C) loss aversion.
D) the endowment effect.

Question 29

Carl owns stock in XYZ, which has dropped by 20% over the last month. Carl decides to purchase additional shares of XYZ. Which bias is most consistent with Carl's decision?

A) Representativeness
B) Overconfidence
C) Naïve diversification
D) Status quo bias

Question 30

When Enron failed, many Enron employees lost their retirements because they had invested their retirement funds in Enron stock. Which behavioral bias is most consistent with this observation?

A) House-money effect
B) Over-confidence
C) Loss aversion
D) Familiarity

Question 31

The SUE effect suggests that superior performance is associated with stocks:

A) exhibiting strong recent price performance.
B) exhibiting weak long-term past price performance.
C) that have beat their earnings estimate.
D) that have low price multiples.

Question 32

The value effect suggests that investors can earn abnormal returns by holding stocks with:

A) low price multiples.
B) high price multiples.
C) small size and strong recent performance.
D) large size and strong recent performance.

Question 33

Data mining refers to the search for security return patterns by:

A) regressing firm stock returns against firm price multiples.
B) calculating CARs relative to firm earnings announcements.
C) applying various investment techniques to a set of return data.
D) applying filter tests to very large samples of return data.

Question 34

The overconfidence bias tends to encourage investors to:

A) trade too much.
B) trade too infrequently.
C) sell winners to early.
D) hold losers to long.

Question 35

In tests of market efficiency, CAR refers to:

A) cumulative average return.
B) compound average return.
C) compound annual return.
D) cumulative abnormal return.

Question 36

An investor trying to take advantage of the firm quality anomaly would most likely target firms with high:

A) profitability.
B) price multiples.
C) recent stock performance.
D) long-term stock performance.

Question 37

The asset growth anomaly finds that abnormal performance is particularly poor for:

A) large firms with high asset growth.
B) large firms with low asset growth.
C) small firms with high asset growth.
D) small firms with low asset growth.

Question 38

The endowment bias suggests that investors:

A) with larger portfolios tend to be more aggressive.
B) with smaller portfolios tend to be more aggressive.
C) develop an attachment to securities in their portfolio.
D) tend to value future cash flows higher than current cash flows.

Question 39

For statistical tests of stock returns over time to support the efficient markets hypothesis (EMH), the resulting correlations should be:

A) positive.
C) approximately 1.
D) approximately -1.
E) approximately 0.

Question 40

The behavioral bias of mental accounting indicates that individuals tend to:

A) follow what other individuals are doing.
B) avoid investments that have worked out poorly in the past.
C) separate assets into noninterchangeable accounts.
D) spread investments evenly across investment options.

Question 41

Historically, stock returns for companies with low P/E ratios have been better than returns for stocks with high P/E ratios.

Question 42

Evidence indicates that the majority of actively-managed, large cap equity funds outperform the S&P 500 Index.

Question 43

The SEC has laws to punish insider trading, which implies that the SEC believes in the strong form of the Efficient Market Hypothesis.

Question 44

Event studies analyze return patterns around specific events such as stock splits or dividend announcements.

Question 45

One explanation for the January effect is that tax-induced sales in December temporarily depress prices, and these prices tend to recover in January.

Question 46

Financial economists have tested various technical trading rules and found they fail to earn consistent abnormal returns.

Question 47

Behavioral finance integrates sociology with finance. It argues that investors often make systematic mistakes when processing social information about market participants.

Question 48

If a public company reports earnings substantially lower than expected, the stock should subsequently earn a positive abnormal return.

Question 49

The snake-bit effect causes investors to avoid stocks where they had previous losses.

Question 50

To have strong form market efficiency, semi-strong form efficiency is necessary.

Question 51

Efficient markets imply investors can not earn abnormal returns.

Question 52

On average, small, less well-known companies have lower long-run returns than larger, more well-known companies.