Question

3. (a) A stock’s returns for the past 3 years are 10%, -15%, and 35%. What is the historical Average return? What is the historical sample standard deviation?

(b). What is the Efficient Markets Hypothesis (EMH)?

(c). i. Suppose you observed that High-Level managers make superior returns on investments in the company’s stock, would this be a violation of weak-form Market Efficiency? Would it be a violation of strong-form Market Efficiency?

2. If the weak-form of the efficient market Hypothesis is valid, must the strong-form also hold? Conversely, does strong-form efficiency imply weak-form efficiency?

(d). Which of the following statements are True if the Efficient Market Hypothesis holds?

1. It implies that future events can be forecast with prefect accuracy
2. It implies that prices reflect all available information.
3. It implies that security prices change for no discernible reason.

4. It implies that prices do not fluctuate.

Answer 1

a. Historical average return:

Historical sample standard deviation:

Here, there are 3 data points: 10%, -15%, 35%

Variance

= 20.3%

b) Efficient Markets Hypothesis theory states that asset prices fully reflect all available information. Thus, it is impossible to beat the market consistently on a risk-adjusted basis since market prices should only react to new information. This theory was developed by Eugene Fama.

c) i) Under the weak- form market efficiency, share prices reflect the publicly available information. However, high-level managers may have access to hidden /insider information which may enable the managers to have a better idea about company's future earnings/ prospects. Thus, high-level managers getting a higher return on investment is not a violation of weak-form market efficiency but of strong-form market efficiency.

ii) If the weak-form of the efficient market hypothesis is valid, strong-form doesn't need to hold. Market prices may not be factoring in the hidden information.

However, the converse is true i.e. strong-form implies weak-form efficiency. If market prices reflect even the hidden information, they do factor in publicly available information.

d) Under the efficient market hypothesis, prices reflect all available information. Thus ii) is true.