Asset Portfolio

Question # 1: Discuss the rationale for expecting an efficient capital market.
What factor would

you look for to differentiate the market efficiency for two alternative stocks?
Answer:
There are three reasons why investor would expect capital markets to be efficient that
will be discussed in three points
1. The foremost being that there are a large number of independent, profit-maximizing investors
engaged in the analysis and valuation of securities.
2. A second assumption is that new information comes to the market in a random fashion. The
3. 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. 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.
Example:
New information regarding actively traded stocks such as IBM and Exxon are 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.
Question # 2: Describe the results of a study that did not support the strong-form EMH. Discuss
the test involved and specifically why the results reported did not support the hypothesis.
Answer:
The tests of the strong-form EMH have generated mixed results. The result for corporate
insiders did not support the hypothesis because these individuals apparently have monopolistic access
to important information and use it to derive above-average returns. Tests to determine whether there
are any analysts with private information concentrated on the Value Line rankings and publications of
analysts’ recommendations. The results for Value Line rankings have changed over time and currently
tend toward support for the EMH. Specifically, the adjustment to rankings and ranking changes is
fairly rapid, and it appears that trading is not profitable after transaction costs. Alternatively,
individual analysts’ recommendations and changes in overall consensus estimates seem to contain
significant information. Finally, recent performance by professional money managers provided mixed
support for the strong-form EMH. Most money manager performance studies before 2002 have
indicated that these highly trained, full-time investors could not consistently outperform a simple buy
and-hold policy on a risk-adjusted basis.
Question # 3:
a. Briefly explain the concept of the efficient market hypothesis (EMH) and each of its three
forms—weak, semi strong, and strong—and briefly discuss the degree to which existing
empirical evidence supports each of the three forms of the EMH.
Answer:
Efficient market hypothesis (EMH) states that a market is efficient if security prices
immediately and fully reflect all available relevant information. Efficient means informationally
efficient, not operationally efficient. Operational efficiency deals with the cost of transferring funds. If
the market fully reflects information, the knowledge that information would not allow anyone to profit
from it because stock prices already incorporate the information.
Weak Form EMH:
Weak form EMH asserts that stock prices already reflect all information that can be derived by
examining market trading data such as the history of past prices and trading volume. Empirical
evidence supports the weak-form. A strong body of evidence supports weak-form efficiency in the
major U.S. securities markets. For example, test results suggest that technical trading rules do not
produce superior returns after adjusting for transaction costs and taxes.
Semi-Strong EMH:
Semi-strong form EMH says that a firm’s stock price already reflects all publicly available
information about a firm’s prospects. Examples of publicly available information are annual reports of
companies and investment data. Empirical evidence mostly supports the semi-strong form. Evidence
strongly supports the notion of semi-strong efficiency, but occasional studies (e.g., those identifying
market anomalies including the small-firm effect and the January effect) and events (e.g., stock
market crash of October 1987) are inconsistent with this form of market efficiency. Black suggests
that most so-called “anomalies” result from data mining.
Strong Form EMH:
Strong form of EMH holds that current market prices reflect all information, whether publicly
available or privately held, that is relevant to the firm. Empirical evidence does not support the strong
form. Empirical evidence suggests that strong-form efficiency does not hold. If this form were correct,
prices would fully reflect all information, although a corporate insider might exclusively hold such
information. Therefore, insiders could not earn excess returns. Research evidence shows that
corporate officers have access to pertinent information long enough before public release to enable
them to profit from trading on this information.
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, and
(ii) fundamental analysis.
Answer:
Technical analysis in the form of charting:

Technical analysis in the form of charting involves the search for recurrent and predictable patterns in
stock prices to enhance returns. The EMH implies that this type of technical analysis is without value.
If past prices contain no useful information for predicting future prices, there is no point in following
any technical trading rule for timing the purchases and sales of securities. According to weak-form
efficiency, no investor can earn excess returns by developing trading rules based on historical price
and return information. A simple policy of buying and holding will be at least as good as any
technical procedure. Tests generally show that technical trading rules do not produce superior returns
after making adjustments for transactions costs and taxes.
Fundamental analysis:
Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest
rates, and risk evaluation of the firm to determine proper stock prices. The EMH predicts that most
fundamental analysis is doomed to failure. According to semi-strong form efficiency, no investor can
earn excess returns from trading rules based on any publicly available information. Only analysts with
unique insight receive superior returns. Fundamental analysis is no better than technical analysis in
enabling investors to capture above-average returns. However, the presence of many analysts
contributes to market efficiency.
c. Briefly explain two major roles or responsibilities of portfolio managers in an efficient market
environment.
Answer:
Two major roles of portfolio managers are as follows:
1. 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.
2. Identify the risk/return objectives for the portfolio given the investor’s constraints. In an
efficient market, portfolio managers are responsible for tailoring the portfolio to meet the
investor’s needs rather than requirements and risk tolerance. Rational portfolio management
also requires examining the investor’s constraints, such as liquidity, time horizon, laws and
regulations, taxes, and such unique preferences and circumstances as age and employment.

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Question # 1: Discuss the rationale for expecting an efficient capital market.

What factor would

Technical analysis in the form of charting:

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