Question

Given the following situations, evaluate in each scenario whether the hypothesis of an efficient capital market of semi-strong form is violated.

(i) Through the introduction of an advanced webinar into the analysis of the past share price movements, a brokerage firm is able to predict price movements are able to earn consistent 1% profit more than normal market returns after adjusted for risk.

(ii) On average, investors in the stock market this year are expected to earn a positive return on their investment. Some investors will earn considerably more than others.

(iii) 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 20%.

Answer 1

(i) 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 webinar costs exceed the excess 1 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 1 percent, then semi-strong form market efficiency hypothesis may be rejected.

(ii) 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.

(iii) This violates the semi-strong form market efficiency hypothesis.