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THE UNIVERSITY OF HONG KONG
Faculty of Business and Economics
FINA2320_ABC_Investments and Portfolio Analysis
1st SEMESTER, 2019-2020
Chapter 11 The Efficient Market Hypothesis
➢ 11.1 Random Walks and the Efficient Market Hypothesis
✓ Stock prices today should have reflected all available information.
✓ Future prices change must respond to new information immediately that is previously
unpredictable.
✓ Stock prices should follow a random walk, that is, price changes should be random and
unpredictable in a well-functioning and efficient market.
✓ Efficient Market Hypothesis (EMH) is the notion that stocks already reflect all
available information.
✓ Competition among different market participants ensures that stock prices should
reflect all available information.
✓ Versions of the Efficient Market Hypothesis
▪ Weak-form version:
- Stock prices already reflect all information that can be derived by
examining market trading data such as history of past prices, trading
volume, trading patterns, short interest, etc.
- Implications: Trend Analysis and Technical Analysis are wastes of time. Any
buy or sell signal should be already exploited by investors.
▪ Semistrong-form version:
- Stock prices already reflect all publicly available information regarding
the prospects of a firm.
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- Such Information includes: history of past prices, trading volume, or
short interest (weak form) and fundamental data such as quality of
management, quality of product line, accounting practices and forecasts
(from annual reports and analysts reports).
- Implications: Not only Trend Analysis and Technical Analysis are wastes of
time but also Fundamental Analysis is fruitless.
▪ Strong-form version:
- Stock prices already reflect all available information regarding the firm,
even including information available only to company insiders (weak
form + semis-strong + insider information).
- Implications: All analysis including exploiting insider information is fruitless.
➢ 11.2 Implications of the EMH
✓ Active portfolio management strategy like Technical Analysis, Fundamental analysis,
and even using insider information are all time-wasting!
✓ Most investors should only earn a fair rate of return.
✓ Only serious analysis and uncommon techniques are likely to generate the differential
insights necessary to yield abnormal return.
✓ Advocates passive investment strategy that makes no attempt to outsmart the market.
✓ Follows a buy-and-hold strategy by establishing a well-diversified portfolio.
✓ Frequent trading incurs large amount of trading costs without increasing expected
performance.
✓ Investing in index funds and ETFs are some of the recommended strategies.
➢ 11.3 Event Studies
✓ An event study describes a technique of empirical financial research that enables an
observer to assess the impact of a particular event on a firm’s stock price.
✓ The abnormal return due to the event is the difference between the stock’s actual
return and a benchmark return. The benchmark return can be estimated using different
models (SIM, CAPM, APT, etc.)
✓ R i = Benchmark return + ei
✓ 𝐀𝐛𝐧𝐨𝐫𝐦𝐚𝐥 𝐑𝐞𝐭𝐮𝐫𝐧 = 𝐞𝐢 = 𝐑 𝐢 − 𝐁𝐞𝐧𝐜𝐡𝐦𝐚𝐫𝐤 𝐫𝐞𝐭𝐮𝐫𝐧
✓ A better indicator would be the Cumulative Abnormal Return (CAR), which is simply
the sum of all abnormal returns over the time period of interest.
✓ The main reason is because leakage of information may arise before announcement
date.CAR thus captures the total firm-specific stock movement for the entire period
when the market might be responding to new information.
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➢ 11.4 Are Markets Efficient?
✓ The Issues
▪ The Magnitude Issue
▪ The Selection Bias Issue
▪ The Lucky Event Issue
✓ Anomalies in Weak-Form Tests:
▪ Serial Correlation: the tendency for stock returns to be related to past
returns
▪ Momentum Effect: recent good or poor performance continues over time.
▪ Reversal Effect: the tendency of poorly performing and well-performing
stocks in one period to experience reversals in following periods.
▪ Implications: They should not exist if weak-form efficient market holds.
✓ Anomalies in Semistrong-Form Tests:
▪ P/E Effect: low P/E stocks outperform high P/E stocks on average.
▪ The Small-Firm-in-January Effect: small firms stocks have higher average
risk-adjusted returns in January.
▪ Book-to-Market Ratios Effect: high book value of equity-to-market value of
equity ratios stocks have higher average annual returns.
▪ Post-Earnings-Announcement Price Drift Effect: positive (negative) earnings
announcement stocks continue to rise (fall) after announcement date.
▪ Implications: They should not exist if semistrong-form efficient market holds.
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Take Home Exercise 1
The semistrong form of the efficient market hypothesis asserts that stock prices:
a. Fully reflect all historical price information.
b. Fully reflect all publicly available information.
c. Fully reflect all relevant information, including insider information.
d. May be predictable.
Take Home Exercise 2
Assume that a company announces an unexpectedly large cash dividend to its shareholders.
In an efficient market without information leakage, one might expect:
a. An abnormal price change at the announcement.
b. An abnormal price increase before the announcement.
c. An abnormal price decrease after the announcement.
d. Abnormal price change before or after the announcement.
Take Home Exercise 3
Which one of the following would provide evidence against the semistrong form of the
efficient market theory?
a. About 50% of pension funds outperform the market in any year.
b. All investors have learned to exploit signals about future performance.
c. Trend analysis is worthless in determining stock prices.
d. Low P/E stocks tend to have positive abnormal returns over the long run.
Take Home Exercise 4
According to the efficient market hypothesis:
a. High-beta stocks are consistently overpriced.
b. Low-beta stocks are consistently overpriced.
c. Positive alphas on stocks will quickly disappear.
d. Negative alpha stocks consistently yield low returns for arbitrageurs.
Take Home Exercise 5
A “random walk” occurs when:
a. Stock price changes are random but predictable.
b. Stock prices respond slowly to both new and old information.
c. Future price changes are uncorrelated with past price changes.
d. Past information is useful in predicting future prices.
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Take Home Exercise 6
Suppose that, after conducting an analysis of past stock prices, you come up with the
following observations. Which would appear to contradict the weak form of the efficient
market hypothesis?
a. The average rate of return is significantly greater than zero.
b. The correlation between the return during a given week and the return during the
following week is zero.
c. One could have made superior returns by buying stock after a 10% rise in price and
selling after a 10% fall.
d. One could have made higher-than-average capital gains by holding stocks with low
dividend yields.
Take Home Exercise 7
Which of the following statements are true if the efficient market hypothesis holds?
a. It implies that future events can be forecast with perfect accuracy.
b. It implies that prices reflect all available information.
c. It implies that security prices change for no discernible reason.
d. It implies that prices do not fluctuate.
Take Home Exercise 8
Which of the following would be a viable way to earn abnormally high trading profits if
markets are semistrong-form efficient?
a. Buy shares in companies with low P/E ratios.
b. Buy shares in companies with recent above-average price changes.
c. Buy shares in companies with recent below-average price changes.
d. Buy shares in companies for which you have advance knowledge of an improvement in
the management team.
Take Home Exercise 9
Which of the following phenomena would be either consistent with or a violation of the
efficient market hypothesis? Explain briefly.
a. Nearly half of all professionally managed mutual funds are able to outperform the S&P
500 in a typical year.
b. Money managers that outperform the market (on a risk-adjusted basis) in one year are
likely to outperform in the following year.
c. Stock prices of companies that announce increased earnings in January tend to
outperform the market in February.
d. Stocks that perform well in one week perform poorly in the following week.
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Take Home Exercise 10
The monthly rate of return on T-bills is 1%. The market went up this month by 1.5%. In
addition, AmbChaser, Inc., which has an equity beta of 2, surprisingly just won a lawsuit
that awards it $1 million immediately.
a. If the original value of AmbChaser equity were $100 million, what would you guess was
the actual return if the benchmark return is based on CAPM for the stock this month?
b. What is your answer to (a) if the market had expected AmbChaser to win $2 million?
Take Home Exercise 11
In a recent closely contested lawsuit, Apex sued Bpex for patent infringement. The jury
came back today with its decision. The rate of return on Apex was rA = 3.1%. The rate of
return on Bpex was only rB = 2.5%. The market today responded to very encouraging news
about the unemployment rate, and rM = 3%. The historical relationship between returns
(benchmark returns) on these stocks and the return of the market portfolio has been
estimated from index model regressions as:
R A = 0.2% + 1.4R M
R B = −0.1% + 0.6R M
Based on these data, which company do you think won the lawsuit?
Take Home Exercise 12
We know that the market should respond positively to good news and that good-news
events such as the coming end of a recession can be predicted with at least some accuracy.
Why, then, can we not predict that the market will go up as the economy recovers?
Take Home Exercise 13
Good News, Inc., just announced an increase in its annual earnings, yet its stock price fell.
Is there a rational explanation for this phenomenon?
Take Home Exercise 14
a. Briefly explain the concept of the efficient market hypothesis (EMH) and each of its
three forms—weak, semistrong, and strong—and briefly discuss the degree to which
existing empirical evidence supports each of the three forms of the EMH.
b. Briefly discuss the implications of the efficient market hypothesis for investment policy
as it applies to:
i. Technical analysis in the form of charting.
ii. Fundamental analysis.
c. Briefly explain the roles or responsibilities of portfolio managers in an efficient market
environment.
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