 Strong EMH: 

Expresses confidence that any information, private or

public, is priced into stocks investors won’t gain any advantage over
the market in general. 
The efficient market hypothesis does not imply that investors can’t
outperform the market, it believes that there are always outliers beating the
market averages, together with those who dramatically lose to the market.
Still, the majority is closer to the median.

Past question

ECMC49Y Market Efficiency Hypothesis Practice Questions

Date: Aug 2, 2006
 
[1] How to define an efficient market?
 
 ANSWER: It is a market where current prices reflect/incorporate all available
information.
 
[2] Describe the 3 forms of efficient market hypothesis.
 
[a] Weak-form: Prices already reflect all PAST information.
[b] Semi-strong form: Prices not only reflect the history of prices but all publicly
available information.
[c] Strong from: Prices reflect all available information, regardless of them being
public or private/insider.
 
[3] Does market efficiency mean you can randomly pick stocks from a stock exchange to
form your portfolio?
 
Absolutely not. As I said in class, all that the market efficiency hypothesis implies is that
prices should be correct signals because it has already incorporated all available
information. But that does not mean your preference is totally irrelevant in making your
investment decision. You may have specific situation to deal with. It may be your family
issue, your age, your inherent risk preference, your career, your tax bracket, your film-
making dream, your Hawaiian wife’s dream etc. Thus, there is a need to optimize your
portfolio so that you maximize your happiness, as measured by your entire investment
portfolio’s return-risk tradeoff. A simplified version of such a complicated optimization
decision is provided by Markowitz’s Portfolio’s theory. It suggests you pick a risk-level
that you would be willing to bear. What accounts for a risk-level then? It is the systematic
risk that you are willing to be exposed to. That means diversifying away non-systematic
risk is a must. Randomly picking stocks neither guarantee you an appropriate portfolio
risk-level you want to bear, nor guarantee you a well-diversified portfolio. The list of
reasons to support portfolio management is long. Try to think of more. And I am
definitely looking for non-academic answers without any economic jargons in the exam.
 
[4] What does it mean by the price you pay for a stock is fair?
 
That means the prices has already incorporated all available information. As of this
moment, the price you pay is justified. However, if you have paid that price, it does not
guarantee you the price is still fair two second from the moment of purchase. And it has
nothing wrong with that. And this is an implication of market being efficient.
 
[5] List some of the implications of efficient market hypothesis.
 
Again, the list of implications here is not confined to what you have learnt in this course.
In class, we have gone through the four traits of EMH, which in logical terms, are
necessary conditions for EMH of various forms. You should definitely try to think of more
implications. Among many of the implications, the ones we’ve gone through are more
obvious. For example, prices movement should be unpredictable because prices should
only reflect relevant new information. Professional investors may not systematically
outperform individual investors. Technical analysis, like those done by chartists, cannot
benefit you by figuring out any “sure-win” trading strategy. Etc.
 
[6] If securities markets are efficient, what is the NPV of any security, regardless of its
risk?
 
NPV = 0, because “what you pay should be what you are expected to get” in an efficient
market as of that moment.
 
[7] The efficient market hypothesis implies that abnormal returns are expected to be
zero. Yet in order for markets to be efficient, arbitrageurs must be able to force prices
back into equilibrium. If they earn profits in doing so, is this fact inconsistent with market
efficiency?
 
There is nothing in the efficient market hypothesis that implies arbitrageurs cannot make
profits. But it is important to look at their net economic profits rather than their accounting
profits. By economic profits I mean we have to subtract the opportunity costs from the
gross profits. Costs include the cost of gathering information and a fair rate of return on
physical and human capital. Also, it is important to distinguish between net expected
economic profits. Efficient market hypothesis expect, at the margin, the net expected
economic profits is zero. If an arbitrageurs were able to make net positive economic
profits in a consistent basis for a long period of time, more individuals would have
entered the arbitrage business until such situation become close to impossible to happen
again, a so-called “Long run perfectly competitive market equilibrium” in 2 nd year Micro. It
is precisely the competition force that drives down the economic profit. We always
wondered why any firm would exist in a perfectly competitive market if everyone would
be making zero profit. In some sense, this question confuses the causes from the
consequences. It is the competition that drives economic profit to zero and firms have no
incentive to leave or enter the market. If economic profit is positive, it would drives more
potential firms into the market. This analogy is perfect for understanding the existence of
multi-billions financial analysis industry.
 
[8] Given the following situations, determine in each case whether or not the hypothesis
of an efficient capital market (semi-strong form) is violated.
 
a) Through the introduction of an advanced computer software into the analysis of past
stock price movements, a brokerage firm is able to predict price movements well enough
to earn a consistent 2% profit, adjusted for risk, above normal market returns.
 
This question requires you to distinguish net versus gross profits. As a rational investor,
you should ask the cost of acquiring needed information. If the computer costs exceed
the excess 2
2 percent profits from the stocks, the firm is actually earning worse than normal returns.
If the total cost including computer costs plus brokerage fee and all other transaction
costs is less than 2 percent, then semi-strong form market efficiency hypothesis may be
rejected.
 
b) On average, investors in the stock market this year are expected to earn a positive
return (profit) on their investment. Some investors will earn considerably more than
others.
 
On average the stock market provides a positive return. This does not contradict with the
market being efficient or not. This is considered a normal return. The fact that ended up
some investors did better than others just merely reflect the result of uncertainty in stock
returns. Given any probability distribution, some observations will lie above the mean
and some will lie below. The expected returns do not have to coincident with the actual
realized returns all the time. If it were coincident all the time, we would not have
uncertainty to deal with at all.
 
c) You have discovered that the square root of any given stock price multiplied by the
day of the month provides an indication of the direction in price movement of that
particular stock with a probability of 75%
 
This violates the semi-strong form market efficiency hypothesis.
 
d) An Ontario Securities Commission (OSC) suit was filed against ATI in 2003. ATI’s
founder and chairman Mr. Kwok Yuen Ho and his wife Betty Ho were accused of
avoiding almost $CAD 7 million in losses and maximizing charitable tax benefits by
selling or donating ATI shares ahead of a May 2000 profit warning.
 
The semi-strong form of market efficiency hypothesis assumes publicly available
information is instantaneously incorporated into prices. Thus benefits from insider
information are possible. In the above example, strong-form is rejected but not semi-
strong form.
 
[9] You just got hired by an investment advisory firm. After a successful trading day, you
go for a drink with your boss. At the pub, you argue strongly for the strong form of the
efficient market hypothesis. Your boss’s eyes narrow, and you begin to get nervous.
What is the issue here?
 
Because expressing your opinion right in front of him is of no difference from bluntly
telling him that he has no value. And the fact that he hired you was also damn stupid.
You also implicitly say that all that he has achieved so far was purely based on luck and
nothing related to his talent. If strong-form market efficiency hypothesis holds, those who
acquire insider information quickly act on it and force the prices to reflect the information.
Hence efforts to seek out insider information are futile. The process of seeking ways to
beat the market is also futile. Professional investors have little value.
 
[10] The law strictly forbids insider trading. There has been regular prosecution against
individuals who have traded with insider information about their own firms. What
conclusion can you draw from this, and how does this information affect which form of
the market efficiency hypothesis you might adopt?
 
That may imply the strong-form market efficiency hypothesis probably does not hold.
 
[11] If the weak-form market efficiency hypothesis is valid, what do the security prices
reflect?
 
All information you can acquire from the history.
 
[12] Assume the computer technology is so advanced that the market, as confirmed by
numerous unbiased studies, have been shown to be efficient. Investment firms therefore
have decided to retire all the portfolio managers and financial analysts and let random
choice govern the security selection process. What mistake is implicit in this action?
 
The mistake is the omission that the efficiency of market is actually based upon the
continuing services of the analysts to actively scout the market. If there is no analyst left,
the prices will definitely not reflect all the available information. Think of the analogy of a
perfectly competitive product market again. If everyone’s making zero profit that’s why
some will exit. Then profit quickly become positive and some new firms enter to try to
earn the positive profit again until another equilibrium with no profit is achieved. If you
can link this analogy with the efficient market hypothesis, you are doing very well.
 
[13] What would happen to market efficiency if all investors follow a passive buy-and-
hold investment strategy?
 
Sooner or later prices will fail to reflect new information. At this point there are
profit/arbitrage opportunities for active investors who uncover mispriced securities.
 
[14] Suppose you observed that companys’ CEOs make abnormally high returns on
investments in their own company’s stock. Would this invalidate the weak-form efficiency
market hypothesis? Would this invalidate the strong-form efficiency market hypothesis?
 
High-level managers might well have insider information about their own firms. Their
ability to realize profits based on their insider information is not surprising. It does not
violate the weak-form market efficiency hypothesis, but it does violate the strong-form.
 
[15] Does weak-form efficiency market hypothesis implies strong-form efficiency market
hypothesis? What about the reverse?
 
Strong-form EMH implies semi-strong form and weak form holds. Semi-strong form
holds also implies weak-form holds, but not the reverse. To understand these
relationships, we should be able to tell the entire sets of information used in the strong-
form also includes the set of information used in semi-strong form and weak-form. But
the set of information used in weak-form does not include the entire sets of information
for either the semi-strong form or the strong-form.
 
[16] Suppose Wal-Mart announced today morning that its profit from last quarter has
dropped 15% compared to the previous quarter, Wal-Mart’s closing price today was up
2% from yesterday. Is this evidence against the efficiency market hypothesis?
 
It is not. There are two reasons. First, the 15% drop may be a positive news if the
general public expected a worse drop before the announcement. Second, except for the
piece of news, there may be some other news simultaneously affecting Wal-Mart’s future
performance, e.g., consumer confidence becoming stronger, etc. So it is hard to isolate
one single event’s effect on the stock price. Since it is so hard to isolate one event from
other, that’s why in any event study, we rely on a big sample of firms. If there is only one
firm or a few firms in the sample, it is likely that we cannot isolate the event that we want
to study from all other events that simultaneously affect share prices of those firms in the
sample.
 
If securities markets are efficient, what is the
NPV of any security, regardless of its risk?
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Question:
If securities markets are efficient, what is the NPV of any
security, regardless of its risk?

Securities Markets
The securities market is a market where buying and selling of securities take place. It is
the market for equity, debts, derivatives, bonds, preference shares, etc. The securities
market is divided into two parts: government securities markets and industrial
securities markets.

Answer and Explanation:

The net present value of any security will be zero if securities markets are efficient. An
efficient market describes the prices of financial instruments that reflect the available
information. When investors pay, they expect to receive the normal rate of return.
When the company sells the securities, they expect to receive fair value.