SW Answers

CHAPTER 6
EFFICIENT CAPITAL MARKETS
CONCEPTS
1. Discuss the rational for expecting an efficient capital market. What factors would you look for
to differentiate the market efficiency for two alternative stocks?
A: There are several reasons why one would expect capital markets to be efficient:
a. The foremost being that there are a large number of independent, profit-maximizing investors
engaged in the analysis and valuation of securities.
b. A second assumption is that new information comes to the market in a random fashion.
c. The third assumption is that the numerous profit-maximizing investors will adjust security
prices rapidly to reflect this new information. Thus, price changes would be independent and
random.
d. Finally, because stock prices reflect all information, one would expect prevailing prices to
reflect true current value.
Capital markets as a whole are generally expected to be efficient, but the markets for some
securities might not be as efficient as others. Recall that markets are expected to be efficient
because there are a large number of investors who receive new information and analyze its effect
on security values. If there is a difference in the number of analysts following a stock and the
volume of trading, one could conceive of differences in the efficiency of the markets.
For example, new information regarding actively traded stocks such as IBM and Exxon is
well publicized and numerous analysts evaluate the effect. Therefore, one should expect the
prices for these stocks to adjust rapidly and fully reflect the new information. On the other hand,
new information regarding a stock with a small number of stockholders and low trading volume
will not be as well publicized and few analysts follow such firms. Therefore, prices may not
adjust as rapidly to new information and the possibility of finding a temporarily undervalued
stock are also greater.
Some also argue that the size of the firms is another factor to differentiate the efficiency
of stocks. Specifically, it is believed that the markets for stocks of small firms are less efficient
than that of large firms.
2. Define and discuss the weak-form EMH. Describe the two sets of tests used to examine the
weak-form EMH.
A: The weak-form efficient market hypothesis contends that current stock prices reflect all available
security-market information including the historical sequence of prices, price changes, and any
volume information. The implication is that there should be no relationship between past price
changes and future price changes. Therefore, any trading rule that uses past market data alone
should be of little value.
The two groups of tests of the weak-form EMH are:
(1) statistical tests of independence and
(2) tests of trading rules.
Statistical tests of independence can be divided further into two groups:
a. the autocorrelation tests and
b. the runs tests.
The autocorrelation tests are used to test the existence of significant correlation, whether
positive or negative, of price changes on a particular day with a series of consecutive
previous days.
The runs tests examine the sequence of positive and negative changes in a series and
attempt to determine the existence of a pattern. For a random series one would expect 1/3(2n
- 1) runs, where n is the number of observations. If there are too few runs (i.e., long
sequences of positive changes or long sequences of negative changes), the series is not
random, i.e., you would not expect a positive change to consistently follow a positive change
and a negative change consistently after a negative change. Alternatively, if there are too
many runs (+-+-+-+- etc.), again the series is not random since you would not expect a
negative change to consistently follow a positive change.
6-1

SW Answers

In the trading rule studies, the second major set of tests, investigators attempted to examine
alternative technical trading rules through simulation. The trading rule studies compared the riskreturn results derived from the simulations, including transaction costs, to results obtained from a
simple buy-and-hold policy.
3. Define and discuss the semistrong-form EMH. Describe the two sets of tests used to examine
the semistrong-form EMH.
A: The semistrong-form efficient market hypothesis contends that security prices adjust rapidly to
the release of all new public information and that stock prices reflect all public information. The
semistrong-form goes beyond the weak-form because it includes all market and also all
nonmarket public information such as stock splits, economic news, political news, etc.
Using the organization developed by Fama, studies of the semistrong-form EMH can be
divided into two groups:
(1) Studies that attempt to predict futures rates of return using publicly available information
(goes beyond weak-form EMH). These studies involve either time-series analysis of returns or
the cross-section distribution of returns.
(2) Event studies that examine abnormal rates of return surrounding specific event or item of
public information. These studies determine whether it is possible to make average risk-adjusted
profits by acting after the information is made public.
4. What is meant by the term abnormal rate of return?
A: Abnormal rate of return is the amount by which a securitys return differs from the expected rate
of return based upon the markets rate of return and the securitys relationship with the market.
5. Describe how you would compute the abnormal rate of return for a stock for a period
surrounding an economic event. Give a brief example for a stock with a beta of 1.40.
A: The CAPM is grounded in the theory that investors demand higher returns for higher risks. As a
result of risks specific to each individual security, the announcement of a significant economic
event will tend to affect individual stock prices to a greater or lesser extent than the market as a
whole. Fama, Fisher, Jensen, and Roll portrayed this unique relationship of stock returns and
market return for a period prior to and subsequent to a significant economic event as follows:
Rit = ai + Bi Rmt + e
where
Rit =
ai =
Bi =
Rmt =
e =

the rate of return on security i during period t

the intercept or constant for security in the regression
the regression slope coefficient for security i equal to covim/m2
the rate of return on a market index during period t
a random error that sums to zero

As an example of how one would derive abnormal risk-adjusted returns for a stock during a
specific period, assume the following values for a firm:
ai = .01 and Bi = 1.40
If the market return (Rmt) during the specified period were 8 percent, the expected return for stock i
would be:
E(Rit)

.01 + 1.4(.08) =

.01 + .112 = .122

The fact that this is the expected value implies that the actual value will tend to deviate around
the expected value. We will define the abnormal return (ARit) as the actual return minus the expected
return. In our example, if the actual return for the stock during this period were 10 percent, the
abnormal return for the stock during the period would be
ARit = .10 - .122 = -.022
Thus, the stock price reacted to the economic event in a manner that was 2.2 percent less than
expected where expectations were based upon what the aggregate market did and the stocks
relationship with the market. This abnormal return surrounding an economic event can be used to
6-2

SW Answers

determine the effect of the event on the individual security.

9. For many of the EMH tests, it is really a test of a joint hypothesis. Discuss what meant by
this concept.
A: Studies on market efficiency are considered to be dual tests of the EMH and the CAPM. These
tests involve a joint hypothesis because they consider not only the efficiency of the market, but
also are dependent on the asset pricing model that provides the measure of risk used in the test.
For example, if a test determines that it is possible to predict future differential risk-adjusted
returns, the results could either have been caused by the market being inefficient or because the
risk measure is bad thereby providing an incorrect risk-adjusted return.
10. Define and discuss the strong-form EMH. Why do some observers contend that the strongform hypothesis really requires a perfect market in addition to an efficient market. Be specific.
A: The strong-form efficient market hypothesis asserts that stock prices fully reflect all information,
whether public or private. It goes beyond the semistrong-form because it requires that no group
of investors have a monopolistic access to any information. Thus, the strong-form efficient
market hypothesis calls for perfect markets in which all information is available to everyone at
the same time.
14. Describe the general goal of behavioral finance.
A: Behavioral finance deals with individual investor psychology and how it affects individuals
actions as investors, analysts, and portfolio managers. The goal of behavioral finance is to
understand how psychological decisions affect markets and to be able to predict those effects.
Behavioral finance looks to explain anomalies that can arise in markets due to psychological
factors.
16. What does the EMH imply for the use of technical analysis?
A: The basic premise of technical analysis is that the information dissemination process is slow-thus
the adjustment of prices is not immediate but forms a pattern. This view is diametrically opposed
to the concept of efficient capital markets, which contends that there is a rapid dissemination
process and, therefore, prices reflect all information. Thus, there would be no value to technical
analysis because technicians act after the news is made public which would negate its value in an
efficient market.
17. What does the EMH imply for fundamental analysis? Discuss specifically what it does not
imply.
A: The proponents of fundamental analysis advocate that at one point in time there is a basic
intrinsic value for the aggregate stock market, alternative industries, and individual securities and
if this intrinsic value is substantially different from the prevailing market value, the investor
should make the appropriate investment decision. In the context of the efficient market
hypothesis, however, if the determination of the basic intrinsic value is based solely on
historical data, it will be of little value in providing above average returns.
Alternatively, if the fundamental analyst makes superior projections of the relevant variables
influencing stock prices then, in accordance with the efficient market hypothesis, he could expect
to outperform the market. The implication is that even with an excellent valuation model, if
you rely solely on past data, you cannot expect to do better than a buy-and-hold policy.
21. Describe the goals of an index fund. Discuss the contention that index funds are the ultimate
answer in a world with efficient capital markets.
A: Index funds are security portfolios specially designed to duplicate the performance of the overall
security market as represented by some selected market index series. The first group of index
funds was created in the early 1970s because people started realizing that capital markets are
efficient and it is extremely difficult to be a superior analyst. Thus, instead of trying to
outperform the market, a large amount of money should be managed passively so that the
investment performance simply matches that achieved by the aggregate market and costs are
minimized so as not to drop returns below the market.
An abundance of research has revealed that the performance of professional money managers is
not superior to the market, and often has been inferior. This is precisely what one would expect in an
6-3

SW Answers

efficient capital market. Thus, rather than expending a lot of effort in selecting a portfolio, the
performance of which may turn out to be inferior to the market, it is contended by some that
portfolios should be designed to simply match the market. If you match the market and minimize
transactions costs you will beat two-thirds of the institutional portfolio managers on average. The
index funds are intended to match the market and minimize costs as suggested above. Thus, they are
consistent with the EMH.
24(c). Briefly explain two major roles or responsibilities of portfolio managers in an efficient
market environment.
A: Portfolio managers have several roles or responsibilities even in perfectly efficient markets. The
most important responsibility is to:
1. Identify the risk/return objectives for the portfolio given the investors constraints. In an efficient
market, portfolio managers are responsible for tailoring the portfolio to meet the investors needs
rather than requirements and risk tolerance.
Rational portfolio management also requires examining the investors constraints, such as
liquidity, time horizon, laws and regulations, taxes, and such unique preferences and
circumstances as age and employment.
Other roles and responsibilities include:
2. Developing a well-diversified portfolio with the selected risk level. Although an efficient market
prices securities fairly, each security still has firm-specific risk that portfolio managers can
eliminate through diversification. Therefore, rational security selection requires selecting a welldiversified portfolio that provides the level of systematic risk that matches the investors risk
tolerance.
3. Reducing transaction costs with a buy-and-hold strategy. Proponents of the EMH advocate a
passive investment strategy that does not try to find under-or-overvalued stocks. A buy-and-hold
strategy is consistent with passive management. Because the efficient market theory suggests
that securities are fairly priced, frequently buying and selling securities, which generate large
brokerage fees without increasing expected performance, makes little sense. One common
strategy for passive management is to create an index fund that is designed to replicate the
performance of a broad-based index of stocks.
4. Developing capital market expectations. As part of the asset-allocation decision, portfolio
managers need to consider their expectations for the relative returns of the various capital markets to
choose an appropriate asset allocation.
5. Implement the chosen investment strategy and review it regularly for any needed adjustments.
Under the EMH, portfolio managers have the responsibility of implementing and updating the
previously determined investment strategy of each client.
PROBLEM SOLVING
Given:
Stock Rit
Rmt
i
B
F
T
C
E

11.5%
10.0
14
12
15.9

4.0%
8.5
9.6
15.3
12.4

0.95
1.25
1.45
0.70
-0.30

Rit - Rmt

Rit (Rmt)

7.5
1.5
4.4
-3.3
3.5

(beta)
7.7
-.625
.08
1.29
19.62

Rit = return for stock i during period t

Rmt = return for the aggregate market during period t

= systematic risk measure

1. Compute the abnormal rates of return for the ff. stocks during period t (ignore differential
systematic risk).
Abnormal Returnit = Rit Rmt
6-4

SW Answers

ARit
ARBt
ARFt
ARTt
ARCt
AREt

=
=
=
=
=
=

Rit - Rmt
11.5 - 4.0 =
10.0 - 8.5 =
14.0 - 9.6 =
12.0 - 15.3 =
15.9 - 12.4 =

7.5
1.5
4.4
- 3.3
3.5

2. Compute the abnormal rates of return for the five stocks assuming the given betas.
Abnormal Returnit = Rit (Beta Rmt)
ARit
ARBt
ARFt
ARTt
ARCt
AREt

=
=
=
=
=
=

Rit - (beta) (Rmt)

11.5 - .95(4.0) = 7.7
10.0 - 1.25(8.5) = -.625
14.0 - 1.45(9.6) = .08
12.0 - .70(15.3) = 1.29
15.9 - (-.3)(12.4) = 19.62

3. Compare the abnormal returns in items 1 & 2 and discuss the reason for the difference in each
case.
A: The reason for the difference in each case is due to the implications of beta. Beta determines how
the stock will move in relation to movements in the market.
Considering stock C, a one percent change in the market return will result in a .70 percent
change in stock Cs return. Therefore, comparing the abnormal return for stock C, the value
becomes positive in Problem 2. Conversely, the 1.25 percent change expected by stock F, for
every 1 percent change in the market, resulted in the abnormal return moving from positive to
negative.
Stock E should move opposite the market because of the negative beta value. Thus, stock E
has a very large abnormal return.
For stocks B and T, the positive abnormal returns remain positive but do change in value.

6-5