Tutorial Solutions

As part of efforts to provide feedback on your learning progress, I provide an indicative difficulty
level of questions, measured as the passing rate (e.g., easy questions have higher passing rates).
This is based on the students’ performance in the previous years. For example, a level “B” multiple
choice question means about 70% students passed this question; a level “B” problem solving
question means on average students got about 70% of total marks. You can use it to assess your
performance.
Keep in mind that questions in the Problem Set are highly selective, so the Problem Set on average
is more difficult than the final exam paper.

Difficulty level Passing rate Indicator

Easy >80% A
Moderate 60 – 80% B
Difficult 40 – 60% C
Very difficult 25 – 40% D
Extremely difficult <25% E

1. Which one of the following investment approaches is always useful even when market is
efficient?
A. Technical analysis
B. Fundamental analysis
C. Portfolio analysis
D. All of the above
Difficulty level: A

Answer: (C)

2. Which statement could be evidence of market inefficiency?

A. Monthly market returns are serially correlated.
B. Microsoft consistently earns large profits.
C. Most investors agree that firm ABC is poorly run.
D. Stock A and B have the same market betas, but stock A has higher prices.
Difficulty level: B

Answer: (A)
A: Time-series correlation means returns in two different dates are correlated. For example, if
𝐶𝑜𝑟𝑟 𝑟 , 𝑟 0.5, then we can use today’s return to forecast tomorrow’s return as they are
negatively correlated.
Note B and C are related to firm operation efficiency, not informational efficiency of financial
markets.
D doesn’t say anything about the market efficiency. Same beta assets have the same expected
returns, but not prices.
3. According to the efficient market hypothesis:
A. High beta stocks are mispriced.
B. Portfolio analysis is useless.
C. Negative alpha stocks give lower returns to the arbitrageurs
D. Positive alpha stocks will disappear quickly.
Difficulty level: B

Answer: (D)
C: arbitrageurs can take a short position to turn negative alpha assets into positive ones.

4. Which of the followings is/are evidence(s) against EMH?

I. A market decline of 20% on a day when there is no significant macroeconomic event.

II. Some investors earn a positive return in the stock market
III. There exist professional money management companies.
IV. Investors need to diversify away idiosyncratic risk.
V. Nicholas Manufacturing just announced yesterday that its fourth quarter earnings will be 10%
higher than last year's fourth quarter. You observe that Nicholas had an abnormal return of -
1.2% yesterday.

A. I only
B. I and V only
C. I and II and III
D. II and III and IV
E. All of the above
Difficulty level: C

Answer: (A)
II: Not surprising, lots of stocks provide positive returns.
III: Professional asset management companies can exist due to economy of scale.
V could be consistent with EMH. The negative abnormal return during the announcement could
mean that investors expected higher earnings growth, e.g., 15%. So an announcement of 10%
increase in earnings is NEGATIVE surprise to the market.

5. Which of the following are correct arguments supporting passive investment strategies?
I. Active trading strategies may not guarantee higher returns but guarantee higher costs
II. Passive investors can free ride on the activity of knowledge investors whose trades force
prices to reflect currently available information
III. Passive investors are guaranteed to earn higher rates of return than active investors over
sufficiently long time horizons
A. I only
B. I and II only
C. II and III only
D. I, II and III
Difficulty level: B

Answer: (B)

6. Evaluate the following statement:

“Highly variable stock prices suggest that the market does not know how to price stocks”.

Difficulty level: B

Incorrect. Information is constantly flowing in the economy and investors each have different
expectations that vary constantly. A fluctuating market accurately reflects this logic. Furthermore,
increased variability may merely increase risk and the price is adjusted accordingly. In other words,
highly variable stock prices do not imply that you can consistently earn positive abnormal returns.

7. Which of the following would provide evidence against the semi-strong form of the efficient
market theory? Why?
A. Mutual fund managers do not on average make superior returns.
B. You can’t make superior profits by buying (or selling) stocks after the announcement of an
abnormal rise in dividends.
C. Low P/E stocks tend to have positive abnormal returns.
D. In any year approximately 50% of pension funds outperform the market.
Difficulty level: B

Answer: (C)

The P/E ratio is public information so this observation would provide evidence against the semi-
strong form of the efficient market theory.

8. In October 2000, Regulation Fair Disclosure (REGFD) was passed in the U.S. to restrict
selective disclosure by CEOs to security analysts. What does the passage of REGFD imply
about market efficiency? Briefly comment.
Difficulty level: B

Not strong form efficient. CEOs have private information that can generate abnormal returns
consistently. Hence, CEOs must be restricted from passing their private information to analysts.
9. Doug is considering investing in a hedge fund. The fund manager shows him that this fund
has an expected return of 18% per year with a standard deviation of 30% per year. Doug knows
that the market portfolio has an expected return of 10% per year with a standard deviation of
20% per year and the risk-free rate is 2% per year. After some careful calculations with the
CAPM, Doug concludes:

The market cannot be efficient. This hedge fund is performing too well relative to the market.

How does Doug reach this conclusion? Is this the only conclusion that could be reached? Back
up your argument with some calculations or a graph.
Difficulty level: D

Answers:

Think this in a CAPM world first. The market risk premium is 8% while this hedge fund has
a risk premium of 16%. This implies a beta of 2 if CAPM holds, which in turn implies the
systematic risk of this fund is at least 2*20%=40%. However, this hedge fund only has a total
standard deviation of 30%. So, we see this hedge fund is located above CML. This could imply
a positive alpha. However, remember that market efficiency is jointly tested with the asset
pricing model. So, it could be the case that CAPM is NOT the right model to use, instead of
markets are inefficient.

10. Consider each statement independently. Which of the statements would likely indicate a
violation of the strong form of EMH?

[I] A target company (that is acquired by another company) experienced positive

abnormal returns in the following weeks after the public merger announcement.

[II] An acquiring firm experienced negative abnormal returns in the following weeks after
the public merger announcement.

A. I only
B. II only
C. I and II
D. Neither
Difficulty level: C

Answer: (C)
Both likely violate strong form efficiency because in a strong form market, private news is
immediately incorporated in the stock price around the public announcement. Both statements
suggest that the market reacts to public news some time after the announcement.
11. Someone who invests in the Vanguard Index 500 mutual fund could most accurately be
described as using which approach?

A. Active management
B. Arbitrage
C. Fundamental analysis
D. Passive investment

Difficulty level: B
Answer: (D)
Index investing is a passive strategy.

12. Among the important characteristics of market efficiency is (are) that:

I. There are no arbitrage opportunities.

II. Security prices react quickly to new information.
III. Active trading strategies will not consistently outperform passive strategies.

A. I only
B. II only
C. I and III only
D. I, II, and III

Difficulty level: B
Answer: (D)
13.

Difficulty level: D

The negative abnormal returns (downward drift in CAR) just prior to stock purchases suggest
that insiders deferred their purchases until after bad news was released to the public. This is
evidence of valuable inside information. The positive abnormal returns after purchase suggest
insider purchases in anticipation of good news. The analysis is symmetric for insider sales.
Trading on insider information, though illegal, can generate abnormal returns. This would
violate the strong-form of EMH.
14.

Difficulty level: C

a. Such shifts would be expected to occur as a result of a recession, but the recession is
not predictable; thus it is not actually a violation of EMH. That being said, such a
shift is consistent with EMH since the shift occurs after a recession or recovery
occurs. The time-varying risk aversion can generate seemingly predictable changes in
risk premium. As the news hits the market, the risk premiums are adjusted.

b. The reason this is perceived as an overreaction is because there are two events
occurring. First, recessions lead to reduced profits, impacting the numerator in a
fundamental analysis. This reduced cash flow represses stock prices. Simultaneously,
the recession causes risk premiums to rise, thus increasing the denominator in the
fundamental analysis calculation. An increase in the denominator further reduces the
price. The result is the appearance of an overreaction.

15.

Difficulty level: C

The market responds positively to new news. If the eventual recovery is anticipated, then the
recovery is already reflected in stock prices. Only a better-than-expected recovery (or a worse-
than-expected recovery) should affect stock prices.