Chapter 13 - Efficient Markets and Behavioral Finance

CHAPTER 13

Efficient Markets and Behavioral Finance

The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

Answers to Problem Sets

1. c; Price changes are independent of one another and follow a “random walk”.
Efficient markets dictate that stock price changes must be random and
unpredictable.

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2. Weak, semistrong, strong, strong, weak

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3. a. False. The efficient market hypothesis recognizes investors read financial

statements and understand the impact of taxes.

b. False. The principles of arbitrage dictate that there is no such thing as

perfect foresight.

c. True.

d. False. Many investors are affected by their attitudes toward risk and their
beliefs about probabilities as found in behavioral finance studies, but
arbitrage eliminates any profit opportunities.

e. False. Transaction costs are often quite high. For example, some trading
costs are very high and some trades are difficult to execute.

f. True
 
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4. a. False. Financing decisions do not have the same degree of finality as

investment decisions and are therefore more easily reversed.

b. False. Tests have shown that there is essentially no correlation between

stock price changes.

c. True

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Chapter 13 - Efficient Markets and Behavioral Finance

d. False. An individual stock’s return is dependent on the stock’s market risk

as measured by beta.  
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5. Abnormal stock return = Actual stock return – Expected stock return

Abnormal stock return = Actual stock return – (α + β × Return on market index)
Abnormal stock return = .06 – (–.002 + 1.45 × .05)
Abnormal stock return = –.0105, or –1.05%
 
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6. a. True. Overconfidence is a systematic bias.

b. False. Once investors have incurred a loss, they are often even more
concerned about future losses.

c. True.

d. False. There are limits on the ability of the rational investors to exploit
market inefficiencies. These limits include things such as trading costs and
the availability of shares to borrow.
 
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7. Decrease. The stock price already reflects an expected 25% increase. The 20%
increase conveys bad news relative to expectations.

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8. a. An investor should not buy or sell shares based on apparent trends or

cycles in returns.

b. A CFO should not speculate on changes in interest rates or foreign

exchange rates. There is no reason to think that the CFO has superior
information.

c. A financial manager evaluating the creditworthiness of a large customer

could check the customer’s stock price and the yield on its debt. A falling
stock price or a high yield could indicate trouble ahead.

d. The company should not seek diversification just to reduce risk. Investors
can diversify on their own.

e. Stock issues do not depress price if investors believe the issuer has no
private information.

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Chapter 13 - Efficient Markets and Behavioral Finance

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9. a. There is evidence that two securities with identical cash flows (e.g., Royal
Dutch Shell and Shell Transport & Trading) sold at different prices.

b. Small-cap stocks appear to have provided above-average returns for their

level of risk in some historical time periods.

c. Evidence seems to indicate that some IPOs provide relatively low returns
after their first few days of trading.

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10. a. An individual can do crazy things, but still not affect the efficiency of
markets. The price of the asset in an efficient market is a consensus price
as well as a marginal price. A nutty person can give assets away for free
or offer to pay twice the market value. However, when the person’s
supply of assets or money runs out, the price will adjust back to its prior
level (assuming there is no new, relevant information released by his
action). If you are lucky enough to know such a person, you will receive a
positive gain at the nutty investor’s expense. You had better not count on
this happening very often, though. Fortunately, an efficient market
protects crazy investors in cases less extreme than the above. Even if
they trade in the market in an “irrational” manner, they can be assured of
getting a fair price since the price reflects all information.

b. Yes, and how many people have dropped a bundle? Or, more to the
point, how many people have made a bundle only to lose it later? People
can be lucky and some people can be very lucky; efficient markets do not
preclude this possibility.

c. Investor psychology is a slippery concept, more often than not used to

explain price movements that the individual invoking it cannot personally
explain. Even if it exists, is there any way to make money from it? If
investor psychology drives up the price one day, will it do so the next day
also? Or will the price drop to a “true” level? Almost no one can tell you
beforehand what “investor psychology” will do. Theories based on it have
no content.

d. What good is a stable value when you can’t buy or sell at that value
because new conditions or information have developed which make the
stable price obsolete? It is the market price, the price at which you can
buy or sell today, which determines value.

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Chapter 13 - Efficient Markets and Behavioral Finance

11. a. There is risk in almost everything you do in daily life. You could lose your
job or your spouse, or suffer damage to your house from a storm. That
doesn’t necessarily mean you should quit your job, get a divorce, or sell
your house. If we accept that our world is risky, then we must accept that
asset values fluctuate as new information emerges. Moreover, if capital
markets are functioning properly, then stock price changes will follow a
random walk. The random walk of values is the result of rational investors
coping with an uncertain world.

b. To make the example clearer, assume that everyone believes in the same
chart. What happens when the chart shows a downward movement? Are
investors going to be willing to hold the stock when it has an expected
loss? Of course not. They start selling, and the price will decline until the
stock is expected to give a positive return. The trend will “self-destruct.”

c. Random-walk theory as applied to efficient markets means that

fluctuations from the expected outcome are random. Suppose there is an
80% chance of rain tomorrow (because it rained today). Then the local
umbrella store’s stock price will respond today to the prospect of high
sales tomorrow. The store’s sales will not follow a random walk, but its
stock price will because each day the stock price reflects all that investors
know about future weather and future sales.

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12. One of the ways to think about market inefficiency is that it implies there is
easy money to be made. The following appear to suggest market
inefficiency:
(b) Strong form. The strong form says that prices reflect all information
available about a company; even what is known by management.
(d) Weak form. The weak form dictates that it is impossible to make
consistently superior profits by studying past returns.
(f) Semistrong form. In the semistrong form, stock prices will adjust
immediately to new information, such as earnings announcements.

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13. The estimates are first substituted in the market model. Then the result from this
expected return equation is subtracted from the actual return for the month to
obtain the abnormal return.
Abnormal return (Intel) = actual return – [(.97) + (1.08  market return)]
Abnormal return (Conagra) = actual return – [(.51) + (.67  market return)]

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Chapter 13 - Efficient Markets and Behavioral Finance

14. The efficient market hypothesis does not imply that portfolio selection should be
done with a pin. The manager still has three important jobs to do. First, she
must make sure that the portfolio is well diversified. It should be noted that a
large number of stocks is not enough to ensure diversification. Second, she
must make sure that the risk of the diversified portfolio is appropriate for the
manager’s clients. Third, she might want to tailor the portfolio to take advantage
of special tax laws for pension funds. These laws may make it possible to
increase the expected return of the portfolio without increasing risk.

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15. They are both under the illusion that markets are predictable, and they are
wasting their time trying to guess the market’s direction. Remember the first
lesson of market efficiency: Markets have no memory. The decision as to when
to issue stock should be made without reference to “market cycles.”

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16. The efficient-market hypothesis says that there is no easy way to make money.
Thus, when such an opportunity seems to present itself, we should be very
skeptical. For example:
 In the case of short- versus long-term rates, and borrowing short term versus
long term, there are different risks involved. For example, suppose that we
need the money long term but we borrow short term. When the short-term
note is due, we must somehow refinance. However; this may not be possible
or may be possible only at a very high interest rate.
 In the case of Japanese versus United States interest rates, there is the risk
that the Japanese yen–U.S. dollar exchange rate will change during the
period of time for which we have borrowed.

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17. This does present some evidence against the efficient capital market hypothesis.
One key to market efficiency is the high level of competition among participants
in the market. For small stocks, the level of competition is relatively low because
major market participants (e.g., mutual funds and pension funds) are biased
toward holding the securities of larger, well-known companies. Thus, it is
plausible that the market for small stocks is fundamentally different from the
market for larger stocks and, hence, that the small-firm effect is simply a
reflection of market inefficiency.

But there are at least two alternative possibilities. First, this difference might just
be coincidental. In statistical inference, we never prove an affirmative fact. The
best we can do is to accept or reject a specified hypothesis with a given degree
of confidence. Thus, no matter what the outcome of a statistical test, there is

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Chapter 13 - Efficient Markets and Behavioral Finance

always a possibility, however slight, that the small-firm effect is simply the result
of statistical chance.

Second, firms with small market capitalization may contain some type of
additional risk that is not measured in the studies. Given the information available
and the number of participants, it is hard to believe that any securities market in
the United States is not very efficient. Thus, the most likely explanation for the
small-firm effect is that the model used to estimate expected returns is incorrect
and that there is some as-yet-unidentified risk factor.

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18. There are several ways to approach this problem, but all should give
approximately the same answer. We have chosen to use the regression analysis
function of an electronic spreadsheet program to calculate the alpha and beta for
each security. The regressions are in the following form:
Security return = alpha + (beta  market return) + error term
The results are:
Alpha Beta
Executive Cheese 0.1176 0.78
Paddington Beer -0.8095 1.45

The abnormal return for Executive Cheese in January 2015 was:

5.7 – [0.1176 + 0.78  4.0] = 2.46%
For Paddington Beer, the abnormal return was:
4.1 – [-0.8095 + 1.45  4.0] = –0.89%
Thus, the average abnormal return of the two stocks during the month of the
earnings announcement was 0.79%.

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19. The market is most likely efficient. The government of Kuwait is not likely to have
nonpublic information about the BP shares. Goldman Sachs is providing an
intermediary service for which they should be remunerated. Stocks are bought
by investors at (higher) ask prices and sold at (lower) bid prices. The spread
between the two ($0.11) is revenue for the broker. In the United States at that
time, a bid-ask spread of 1/8 ($0.125) was not uncommon. The “profit” of $15
million reflects the size of the order more than any mispricing.

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20. Anytime there is a separation of ownership and control, it is possible that the
resulting agency costs will lead to market distortions. Many people hire others

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Chapter 13 - Efficient Markets and Behavioral Finance

(explicitly or implicitly) to manage their money, and these managers may not
have the same incentives to push for the best price. Over large markets, we
might expect many of these distortions to have less impact, but some
imperfections may remain.

As described in the text, one example of this is the mortgage securitization

market. Because banks were paid a fee for packaging the securities and did not
retain the risks of ownership, they may not have pushed for adequate
underwriting. This may have led to easy credit terms and a housing market
bubble.

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21. Opinion question; answers will vary. Some of the blame may indeed rest with
borrowers who held overly optimistic views of housing market appreciation and of
their ability to repay mortgages. Similarly, purchasers of mortgage-backed
securities may have unwisely believed that these instruments offered an
adequate return. Alternative explanations include inaccurate ratings, agency cost
problems (where loan originators lacked incentives to underwrite the loans
effectively), the purchase activity and implicit government backing of Fannie Mae
and Freddie Mac, and other information asymmetry problems.

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22. a. The probability that mutual fund X achieved superior performance in any
one year is .50. The probability that mutual fund X achieved superior
performance in each of the past 10 years is:
.510 = .00097656

b. The probability that, out of 10,000 mutual funds, none of them obtained 10
successive years of superior performance is:
(1 – .00097656)10,000 = .00005712
Therefore, the probability that at least one of the 10,000 mutual funds
obtained 10 successive years of superior performance is:
1 – .00005712 = .99994288

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23. It is difficult to define ex ante rules for identifying bubbles where prices differ from
some measure of intrinsic value. Research in this area focuses on excessive
liquidity, inflationary pressures, a rigorous analysis of “underlying fundamentals,”
and other factors that may cause prices to exceed intrinsic value (whatever that
means). But since we expect prices to move in a random walk—and since this
random walk might sometimes move rapidly upwards—the process of identifying
bubbles is vexing.

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McGraw-Hill Education.
Chapter 13 - Efficient Markets and Behavioral Finance

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Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.