BBFN3014
INTERNATIONAL FINANCE
TUTORIAL 4 (MARKING GUIDE)
1. Define the 3 forms of market efficiency.
The three forms of the efficient markets hypothesis are:
i. Weak form. Market prices reflect information contained in historical prices.
Investors are unable to earn abnormal returns using historical prices to
predict future price movements.
ii. Semi-strong form. In addition to historical data, market prices reflect all
publicly-available information. Investors with insider, or private information,
are able to earn abnormal returns.
iii. Strong form. Market prices reflect all information, public or private. Investors
are unable to earn abnormal returns using insider information or historical
prices to predict future price movements.
2. A stock market analyst is able to identify misprices stocks by comparing the average
price for the last 10 days to the average price for the last 60 days. If this is true what do
you know about the market?
The market is not weak form efficient
3. Which of the following statements are true about EMH?
a. It implies perfect forecasting ability.
False. Market efficiency implies that prices reflect all available information,
but it does not imply certain knowledge. Many pieces of information that are
available and reflected in prices are fairly uncertain. Efficiency of markets
does not eliminate that uncertainty and therefore does not imply perfect
forecasting ability.
b. It implies that prices reflect all available information.
True. Market efficiency exists when prices reflect all available information.
To be efficient in the weak form, the market must incorporate all historical
data into prices. Under the semi-strong form of the hypothesis, the market
incorporates all publicly-available information in addition to the historical
data. In strong form efficient markets, prices reflect all publicly and privately
available information.
c. It implies an irrational market.
False. Market efficiency implies that market participants are rational.
Rational people will immediately act upon new information and will bid
prices up or down to reflect that information.
International Finance (Topic 4)
d. It implies that prices do not fluctuate.
False. In efficient markets, prices reflect all available information. Thus,
prices will fluctuate whenever new information becomes available.
e. It results from keen competition among investors.
True. Competition among investors results in the rapid transmission of new
market information. In efficient markets, prices immediately reflect new
information as investors bid the stock price up or down.
4. A hundred years ago or so, companies did not compile annual reports. Even if you
owned stock in a particular company, you were unlikely to be allowed to see the balance
sheet and income statement for the company. Assuming the market is semi strong from
efficient, what does this say about market efficiency then compared to now?
It is likely the market has a better estimate of the stock price, assuming it is semi-
strong form efficient. However, semi-strong form efficiency only states that you
cannot easily profit from publicly available information. If financial statements are
not available, the market can still price stocks based upon the available public
information, limited though it may be. Therefore, it may have been as difficult to
examine the limited public information and make an extra return.
5. A famous economist just announced in The Wall Street Journal his findings that the
recession is over and the economy is again entering an expansion. Assume market
efficiency. Can you profit from investing in the stock market after you read this
announcement?
Stock prices should immediately and fully rise to reflect the announcement. Thus,
one cannot expect abnormal returns following the announcement.
6. Suppose the market is a semi strong form efficient. Can you expect to earn excess
returns if you make trades based on:
i. Your broker’s information about record earnings for a stock?
No. Earnings information is in the public domain and reflected in the current
stock price.
ii. Rumors about a merger of a firm?
Possibly. If the rumors were publicly disseminated, the prices would have
already adjusted for the possibility of a merger. If the rumor is information
that you received from an insider, you could earn excess returns, although
trading on that information is illegal.
iii. Yesterday’s announcement of a successful new product test?
No. The information is already public, and thus, already reflected in the stock
price.
International Finance (Topic 4)