Practice Problem Set #7: Stocks – Market Efficiency

1. What are the characteristics of an efficient market?

2. Net Present Value (NPV) is equal to the PV of the benefits minus the PV of the costs of an
investment. If securities markets are efficient, what is the NPV of any security, regardless of
its risk?

3. Given the following situations, determine in each case whether there is evidence against the
semi-strong form EMH:

a) 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 95%.

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 will.

c) An Ontario Securities Commission lawsuit was filed against ATI Technologies. ATI
Technologies’ founder and chairman Mr. Kwok Yuen Ho and his wife Betty Ho were
accused of avoiding almost $7 million in losses by selling ATI shares prior to a May 2000
negative earnings announcement.

4. Insider trading is illegal. Individuals who have traded on inside information about their own
firms have frequently been been prosecuted. What conclusion can you draw from this, and
how does this information affect which form of the EMH you might adopt?

5. Suppose that the market, as confirmed by numerous unbiased studies, is determined to be

semi-strong form efficient. Investment firms therefore decide to retire all the financial analysts
and portfolio managers and let random choice govern the security selection process. What
mistake are investment firms likely making?

6. Suppose you observe that companies’ CEOs make abnormally high returns on investments
in their own company’s stock. Is this evidence against the weak-form EMH? Is this evidence
against the strong-form EMH?

7. Does weak-form efficiency imply strong-form efficiency? What about the reverse?

8. Suppose that Canadian Tire announced this morning that its profit from last quarter has
dropped 15% compared to the previous quarter. The closing price today of Canadian Tire
was up 2% from yesterday. Is this evidence against the EMH?

9. Illustrate market over-or-under reaction with an example.

10. Is market over-or-under reaction evidence against market efficiency?