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.
A. regret avoidance
B. selection bias
C. framing
D. insider trading
E. None of these is correct.
This is an example of selection bias.
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.
A. regret avoidance
B. selection bias
C. overconfidence
D. the lucky event issue
E. None of these is correct.
This is an example of the lucky event issue.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Efficient Markets
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
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
Answer E; not sufficiently profitable to cover trading costs.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Efficient Markets
64. If you believe in the reversal effect, you should
A. sell bonds in this period if you held stocks in the last period.
B. sell stocks in this period if you held bonds in the last period.
C. sell stocks this period that performed well last period.
D. go long.
E. sell stocks this period that performed well last period and go long
A. sell bonds in this period if you held stocks in the last period.
B. sell stocks in this period if you held bonds in the last period.
C. sell stocks this period that performed well last period.
D. go long.
E. sell stocks this period that performed well last period and go long
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
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
A. 10 minutes
B. 45 minutes
C. 2 hours
D. 4 hours
E. 2 trading days
The correct answer is 10 minutes.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Efficient Markets
Short Answer Questions
66. Discuss the various forms of market efficiency. Include in your discussion the information sets involved in each form and the relationships across information sets and across forms of market efficiency. Also discuss the implications for the various forms of market efficiency for the various types of securities' analysts.
The weak form of the efficient markets hypothesis (EMH) states that stock prices immediately reflect market data. Market data refers to stock prices and trading volume. Technicians attempt to predict future stock prices based on historic stock price movements. Thus, if the weak form of the EMH holds, the work of the technician is of no value.
The semistrong form of the EMH states that stock prices include all public information. This public information includes market data and all other publicly available information, such as financial statements, and all information reported in the press relevant to the firm. Thus, market information is a subset of all public information. As a result, if the semistrong form of the EMH holds, the weak form must hold also. If the semistrong form holds, then the fundamentalist, who attempts to identify undervalued securities by analyzing public information, is unlikely to do so consistently over time. In fact, the work of the fundamentalist may make the markets even more efficient!
The strong form of the EMH states that all information (public and private) is immediately reflected in stock prices. Public information is a subset of all information, thus if the strong form of the EMH holds, the semistrong form must hold also. The strong form of EMH states that even with inside (legal or illegal) information, one cannot expect to outperform the market consistently over time.
Studies have shown the weak form to hold when transactions costs are considered. Studies have shown the semistrong form to hold in general, although some anomalies have been observed. Studies have shown that some insiders (specialists, major shareholders, major corporate officers) do outperform the market.
Feedback: The purpose of this question is to assure that the student understands the interrelationships across different forms of the EMH, across the information sets, and the implications of each form for different types of analysts.
The semistrong form of the EMH states that stock prices include all public information. This public information includes market data and all other publicly available information, such as financial statements, and all information reported in the press relevant to the firm. Thus, market information is a subset of all public information. As a result, if the semistrong form of the EMH holds, the weak form must hold also. If the semistrong form holds, then the fundamentalist, who attempts to identify undervalued securities by analyzing public information, is unlikely to do so consistently over time. In fact, the work of the fundamentalist may make the markets even more efficient!
The strong form of the EMH states that all information (public and private) is immediately reflected in stock prices. Public information is a subset of all information, thus if the strong form of the EMH holds, the semistrong form must hold also. The strong form of EMH states that even with inside (legal or illegal) information, one cannot expect to outperform the market consistently over time.
Studies have shown the weak form to hold when transactions costs are considered. Studies have shown the semistrong form to hold in general, although some anomalies have been observed. Studies have shown that some insiders (specialists, major shareholders, major corporate officers) do outperform the market.
Feedback: The purpose of this question is to assure that the student understands the interrelationships across different forms of the EMH, across the information sets, and the implications of each form for different types of analysts.
AACSB: Reflective Thinking
Bloom's: Analyze
Difficulty: Intermediate
Topic: Efficient Market Hypothesis
67. What is an event study? It is a test of what form of market efficiency? Discuss the process of conducting an event study, including the best variable(s) to observe as tests of market efficiency.
A event study is an empirical test which allows the researcher to assess the impact of a particular event on a firm's stock price. To do so, one often uses the index model and estimates et, the residual term which measures the firm-specific component of the stock's return. This variable is the difference between the return the stock would ordinarily earn for a given level of market performance and the actual rate of return on the stock. This measure is often referred to as the abnormal return of the stock. However, it is very difficult to identify the exact point in time that an event becomes public information; thus, the better measure is the cumulative abnormal return, which is the sum of abnormal returns over a period of time (a window around the event date).
This technique may be used to study the effect of any public event on a firm's stock price; thus, this technique is a test of the semistrong form of the EMH.
Feedback: The rationale for this question is to ascertain if the student understands the methodology most commonly used as a test of the semistrong form of market efficiency.
This technique may be used to study the effect of any public event on a firm's stock price; thus, this technique is a test of the semistrong form of the EMH.
Feedback: The rationale for this question is to ascertain if the student understands the methodology most commonly used as a test of the semistrong form of market efficiency.
AACSB: Reflective Thinking
Bloom's: Analyze
Difficulty: Challenge
Topic: Event Studies
68. Discuss the small firm effect, the neglected firm effect, and the January effect, the tax effect and how the four effects may be related.
Studies have shown that small firms earn a risk-adjusted rate of return greater than that of larger firms. Additional studies have shown that firms that are not followed by analysts (neglected firms) also have a risk-adjusted return greater than that of larger firms. However, the neglected firms tend to be small firms; thus, the neglected firm effect may be a manifestation of the small firm effect. Finally, studies have shown that returns in January tend to be higher than in other months of the year. This effect has been shown to persist consistently over the years. However, the January effect may be the tax effect, as investors may have sold stocks with losses in December for tax purposes and reinvested in January. Small firms (and neglected firms) would tend to be more affected by this increased buying than larger firms, as small firms tend to sell for lower prices.
Feedback: The purpose of this question is to reinforce the interrelationships, that "effects" may not always be independent and thus readily identifiable. In addition, these effects are widely discussed in the financial press, and the January effect appears to be quite persistent.
Feedback: The purpose of this question is to reinforce the interrelationships, that "effects" may not always be independent and thus readily identifiable. In addition, these effects are widely discussed in the financial press, and the January effect appears to be quite persistent.
AACSB: Reflective Thinking
Bloom's: Analyze
Difficulty: Intermediate
Topic: Efficient Markets
69. Why might the degree of market efficiency differ across various markets? State three reasons why this might occur and explain each reason briefly.
1. Market efficiency depends on information being essentially free and costless to market participants. In the U.S. this is the case to a large extent. The U.S. markets are well developed and professional analysts often follow securities. Information is available on television, in the press, and on the Internet. The opposite may be true in other markets, such as those of developing countries, where there are fewer or no analysts and few market participants with these resources. 2. Accounting disclosure requirements are different across markets. In the U.S. firms must meet SEC requirements to be publicly traded. In other countries the requirements may be different or nonexistent. This has implications about the ease with which analysts can evaluate the company to determine its proper value. 3. Markets for "neglected" stocks may be less efficient than markets for stocks that are heavily followed by analysts. If analysts feel that it is not worthwhile to give their attention to particular stocks then ample information about these stocks will not be readily available to investors.
Feedback: This question leads the student to look at some of the fundamental reasons for market efficiency and why there may be differences among markets with regard to the reasons. Alternative answers are possible.
Feedback: This question leads the student to look at some of the fundamental reasons for market efficiency and why there may be differences among markets with regard to the reasons. Alternative answers are possible.
AACSB: Reflective Thinking
Bloom's: Analyze
Difficulty: Intermediate
Topic: Efficient Markets
70. With regard to market efficiency, what is meant by the term "anomaly"? Give three examples of market anomalies and explain why each is considered to be an anomaly.
Anomalies are patterns that should not exist if the market is truly efficient. Investors might be able to make abnormal profits by exploiting the anomalies, which doesn't make sense in an efficient market.
Possible examples include, but are not limited to, the following.
The small-firm effect—average annual returns are consistently higher for small-firm portfolios, even when adjusted for risk by using the CAPM.
The January effect—the small-firm effect occurs virtually entirely in January.
The neglected-firm effect—small firms tend to be ignored by large institutional traders and stock analysts. This lack of monitoring makes them riskier and they earn higher risk-adjusted returns. The January effect is largest for neglected firms.
The liquidity effect—investors demand a return premium to invest in less-liquid stocks. This is related to the small-firm effect and the neglected-firm effect. These stocks tend to earn high risk-adjusted rates of return.
Book-to-market ratios—firms with the higher book-to-market-value ratios have higher risk-adjusted returns, suggesting that they are underpriced. When combined with the firm-size factor, this ratio explained returns better than systematic risk as measured by beta.
The reversal effect—stocks that have performed best in the recent past seem to underperform the rest of the market in the following periods, and vice versa. Other studies indicated that this effect might be an illusion. These studies used portfolios formed mid-year rather than in December and considered the liquidity effect.
Investors should not be able to earn excess returns by taking advantage of any of these. The market should adjust prices to their proper levels. But these things have been documented to occur repeatedly.
Feedback: This question tests whether the student grasps the basic concept of anomalies and allows some choice in explaining some of them.
Possible examples include, but are not limited to, the following.
The small-firm effect—average annual returns are consistently higher for small-firm portfolios, even when adjusted for risk by using the CAPM.
The January effect—the small-firm effect occurs virtually entirely in January.
The neglected-firm effect—small firms tend to be ignored by large institutional traders and stock analysts. This lack of monitoring makes them riskier and they earn higher risk-adjusted returns. The January effect is largest for neglected firms.
The liquidity effect—investors demand a return premium to invest in less-liquid stocks. This is related to the small-firm effect and the neglected-firm effect. These stocks tend to earn high risk-adjusted rates of return.
Book-to-market ratios—firms with the higher book-to-market-value ratios have higher risk-adjusted returns, suggesting that they are underpriced. When combined with the firm-size factor, this ratio explained returns better than systematic risk as measured by beta.
The reversal effect—stocks that have performed best in the recent past seem to underperform the rest of the market in the following periods, and vice versa. Other studies indicated that this effect might be an illusion. These studies used portfolios formed mid-year rather than in December and considered the liquidity effect.
Investors should not be able to earn excess returns by taking advantage of any of these. The market should adjust prices to their proper levels. But these things have been documented to occur repeatedly.
Feedback: This question tests whether the student grasps the basic concept of anomalies and allows some choice in explaining some of them.
AACSB: Reflective Thinking
Bloom's: Analyze
Difficulty: Intermediate
Topic: Efficient Markets
