Question

The Stock Market and Efficient Markets

Multiple Choice

1. Suppose you read a story in the financial section of the local newspaper that announces the proposed merger of Dell Computer and Gateway. The merger is expected to greatly increase the profitability of Gateway. If you should now decide to invest in Gateway stock, you can expect to earn

a. above average returns since you will get to share in the higher profits.

b. above average returns since your stock will definitely appreciate as the profits are earned.

c. a normal return since stock prices adjust to reflect change profit expectations almost immediately.

d. none of the above.

2. After the announcement of higher quarterly profits, the price of a stock falls. Such an occurrence is

a. clearly inconsistent with efficient markets theory.

b. possible if market participants expected lower profits.

c. consistent with efficient markets theory.

d. not possible.

3. Since a change in regulations permitting their existence in the mid-1970s and the explosive growth in the number of people who surf the internet, discount brokers have grown rapidly. Efficient markets theory would seem to suggest that people who use discount brokers

a. will likely earn lower returns than those who use full-service brokers.

b. will likely earn about the same as those who use full-service brokers, but will net more after brokerage commissions.

c. are going against evidence that suggests that the financial analysis provided by full-service brokers can help one outperform the overall market.

d. are likely to be poor.

4. Efficient markets theory suggests that stock prices tend to follow a “random walk.” Thus the best strategy for investing in stock is

a. a “churning strategy” of buying and selling often to catch the market swings.

b. turning over your stock portfolio each month, selecting stocks by throwing darts at the stock page.

c. a “buy and hold strategy” of holding onto stocks to avoid brokerage commissions.

d. to do none of the above.

5. If expectations are formed rationally, forecast errors of expectations will on average be          and therefore          be predicted ahead of time.

a. positive; can

b. positive; cannot

c. zero; cannot

d. zero; can

6. Mutual funds that outperform the market in one period are

a. highly likely to consistently outperform the market in subsequent periods due to their superior investment strategies.

b. likely to under-perform the market in subsequent periods to average the funds’ returns.

c. not likely to consistently outperform the market in subsequent periods.

d. not likely to outperform the market in any subsequent periods.

7. According to the theory of efficient capital markets

a. incorrectly valued assets are quickly discovered and bought or sold until their prices are brought into line with their correct underlying value.

b. most investors will not earn excess returns from spending resources on technical market analysis.

c. the best strategy for most investors is to buy and hold a well-diversified portfolio of securities.

d. all of the above are true

8. New information may lead to an immediate change in the price of a stock because

a. the required return on this equity investment may change.

b. the expected constant growth rate in dividends may change.

c. the forecast of the future sales price of the stock may change.

d. all of the above.

e. only (a) and (c) of the above.

9. The value of a company's stock may fall when the economy enters a recession because

a. the value of expected future dividends falls.

b. the required return on equity investments falls.

c. the expected growth rate of dividends fall.

d. only (a) and (b) of the above.

e. only (a) and (c) of the above.

Answer 1

1. If you should now decide to invest in Gateway stock , you can expect to earn a normal return since stock prices adjust to reflect expected changes in profitability almost immediately. Hence, option(C) is correct.

2. After the announcement of higher quarterly profits , the price of a stock falls . Such an occurrence is consistent with efficient market theory if the earnings were not as high as anticipated. Hence,option(C) is correct.

3. Efficient market theory would seem to suggest that people who use discount brokers will likely earn the same as those who use full service brokers, but will net more after brokerage commissions. Hence,option(B) is correct.

4. Efficient market theory suggests that stock prices tend to follow a "random walk".Thus the best strategy for investing in stock is a "buy and hold "strategy of holding onto stocks to avoid brokerage commissions. Hence,option(C) is correct.

5. If expectations are formed rationally , forecast errors of expectations will on average be zero and therefore cannot be predicted ahead of time. Hence,option(C) is correct.