TUTORIAL 5

STOCK MARKET: THE EFFICIENT MARKET HYPOTHESIS

Part 1: Review questions

1. Gordon Growth model
2. Efficient market hypothesis

Part 2: Multiple-choice questions

1. Rational expectations are:

A. identical to optimal forecasts using all available information.
B. always correct.
C. based only on past information.
D. identical to optimal forecasts using all information.

2. An implication of rational expectation is that

A. Forecast errors of expectations will, on the average, be zero.
B. Changes in how a variable move over time will not affect the way expectations
are formed.
C. Some error can be forecast.
D. Forecast error will always be zero

3. People and firms make optimal forecasts based upon all available information
because:
A. Forecasting error is costly.
B. Optimal forecasting errors are zero.
C. Optimal forecasting errors are small.
D. All forecasting errors are small

4. The efficient market hypothesis states that

A. prices of securities in financial markets reflect only past price information on that
and similar securities.
B. prices of securities in financial markets reflect all available information.
C. prices of securities in financial markets reflect only monetary policy changes.
D. prices of securities in financial markets reflect only past price information on that
security

5. The expected rate of return (RETe) on a security is:

A. (Pet+1 – Pt + C)/Pt
B. (Pet+1 – Pt+1 + C)/Pt+1
C. (Pet+1 – Pt + C)/Pt+1
D. (Pet+1 – Pt+1 + C)/Pt

6. Based upon unexploited profit opportunities, if RETOF > RET*, then:

A. people will buy the security, increasing its price, and reducing RET*.
B. people will not buy the security, lowering its price, and reducing RET*.
 C. people will buy the security, increasing its price, and reducing RETOF.
D. people will not buy the security, lowering its price, and reducing RETOF.

7. A random walk describes movements of a variable:

A. whose future changes can be perfectly predicted.
B. whose future changes can only be predicted with past information.
C. whose future changes can be predicted based upon money supply changes.
D. whose future changes cannot be predicted.

8. Technical analysis:
A. is the study of past stock price data in search of patterns.
B. generates buy/sell rules that usually outperform the markets as a whole.
C. exploits the idea that stocks follow a random walk.
D. examines the role of unexpected events in determining stock prices

9. Which of the following is not part of the evidence against market efficiency?
A. Markets overreact to news and announcements.
B. Stocks with high returns now tend to have high returns in the future.
C. The January effect.
D. The small firm effect.

10. Stock prices respond to announcements and news only when:

A. the announcements are well-known anyway before the official release of the
announcement.
B. the announcements are new and unexpected.
C. the announcements are about predictable events.
D. the announcements are made early in the day.

11. Which of the following is true regarding adaptive expectations?

A. They are identical to optimal forecasts.
B. They are based only on past values of the variable being forecasted.
C. They quickly adjust to changes in the value of the variable being forecasted.
D. They are based on all available information.

12. Which is not an implication of the stronger version of efficient markets theory?
A. There are unexploited profit opportunities.
B. Any investment is as good as any other.
C. Securities' prices are based on market fundamentals.
D. Securities' prices are correct.

13. The generalized dividend model of determining stock prices hypothesizes that
A. The price you are willing to pay for a stock depends only on the amount of the
dividends you expect to receive from the stock.
B. The price you are willing to pay for a stock today depends on the price you expect
it to be next year.
 C. The price you are willing to pay for a stock depends upon both the dividends you
expect to receive and the capital gain you expect to get from owning the stock.
D. The price you are willing to pay for a stock depends on the present value of the
dividends you expect to receive from the stock.

14. In an auction environment, a stock's price

A. Is determined by the buyer willing to pay the lowest price.
B. Is determined by the buyer for whom the stock poses the greatest risk.
C. Will rise with the perceived risk of the stock.
D. Is determined by the buyer willing to pay the highest price.

15. “An efficient market is one in which no one ever profits from having better
information than the rest”. Why this statement is false?
A. Acting by better information is not allowed by market regulators and organized
exchange
B. People with better information make the market more efficient by exploiting
profit-making opportunities
C. An efficient market is one where the share prices never change
D. If markets follow a “random walk”, there is never opportunity for making profit

Part 3: End-of-chapter questions and problems

Chapter 7: Questions and Problems 3, 5, 7, 22, 23
3. Some economists think that central banks should try to prick bubbles in the stock
market before they get out of hand and cause later damage when they burst. How
can monetary policy be used to prick a market bubble? Explain using the Gordon growth
model.

5. Suppose that you are asked to forecast future stock prices of ABC Corporation, so you
proceed to collect all available information. The day you announce your forecast,
competitors of ABC Corporation announce a brand new plan to merge and reshape the
structure of the industry. Would your forecast still be considered optimal?

7. Suppose that you decide to play a game. You buy stock by throwing a dice a few
times, using that method to select which stock to buy. After ten months you calculate the
return on your investment and the return earned by someone who followed “expert”
advice during the same period. If both returns are similar, would this constitute evidence
in favor of or against the efficient market hypothesis?

22. Compute the price of a share of stock that pays a $5 per year dividend and that you
expect to be able to sell in one year for $40, assuming you require a 5% return.

23. After careful analysis, you have determined that a firm’s dividends should grow at
15%, on average, in the foreseeable future. The firm’s last dividend was $1.5.
Compute the current price of this stock, assuming the required return is 20%