CHAPTER 2

SECURITY ANALYSIS AND EFFICIENT MARKETS

LEARNING OBJECTIVES
1. The goal of security analysis.
2. The concept of an efficient securities market and the differences between weak-form, semistrong-form, and
strong-form efficient markets.
3. The implications of an efficient market on the behavior of security prices.
4. The key role investors play in an efficient market.
5. What creates comparative advantage in security analysis.
6. How investors beliefs about efficient markets determine their style of investment analysis.
7. The recent empirical evidence on efficient markets.

TRUE/FALSE QUESTIONS
1.

Successful securities analysis only identifies securities that are likely to have future stock returns below the
returns of other equity securities of similar risk.
(easy, L.O. 1, Section 1, false)

2.

The market could be efficient with respect to some, but not all, of the information in a particular
information set.
(moderate, L.O. 2, Section 2, true)

3.

We can evaluate the efficiency of the market relative to several different information sets.
(moderate, L.O. 2, Section 2, false)

4.

Price changes are not really random, but are caused by the arrival of unpredictable information.
(moderate, L.O. 3, Section 3, true)

5.

A strong-form efficient market is one in which prices reflect not only all public information per se but also
everything that can be inferred from that information.
(moderate, L.O. 3, Section 3, false)

6.

Prices constantly reflect expectations for the future.

(easy, L.O. 3, Section 3, true)

7.

A positive earnings surprise is a situation in which positive earnings are reported when the market does not
expect them.
(easy, L.O. 3, Section 3, true)

8.

Truly random prices would move without regard to relevant information or changed expectations.
(moderate, L.O. 3, Section 3, true)

9.

In theory a market whose prices are unrelated to relevant information about the underlying values of
securities is not sustainable.
(moderate, L.O. 3, Section 3, true)

10.

A graph that charts a securitys prices at certain points in time or after certain events is called a price path.
(easy, L.O. 3, Section 3, true)

11.

In an efficient market, investors will continue a buy/sell process until they believe the prices of securities
are correct.

(easy, L.O. 4, Section 4, true)

12.

If a market reflects a certain piece of information, then only certain individuals can profit from knowledge
of that information.
(moderate, L.O. 5, Section 5, false)

13.

An investor who expects investments to earn returns greater than the market average will be inclined to do
fundamental analysis.
(moderate, L.O. 6, Section 5, false)

14.

It is quite possible to test whether a single stock is priced correctly.

(moderate, L.O. 7, Section 6, false)

15.

Cross-sectional tests focus on weak-form and semistrong-form efficiency.

(moderate, L.O. 7, Section 6, true)

MULTIPLE CHOICE QUESTIONS

16.

The benchmark used in successful securities analysis is:

a. to avoid stocks that are selling at too high a price
b. to buy stocks whose earnings are close to the average return for the market
c. to earn a return greater than can be earned without doing any analysis
d. to earn the average market return over a five-year period
(easy, L.O. 1, Section 1, c)

17.

The efficient market hypothesis argues that securities are always priced correctly. However, many
researchers believe that on occasion there are mispricings in the marketplace. For an analyst to identify and
trade on these mispricings, the analyst:
a. must be smarter than most everyone
b. must be faster to react to information than most everyone
c. must be able to act in a more cost effective manner than most everyone
d. All of the answers above are correct.
(easy, L.O. 1, Section 1, d)

18.

Market prices that only reflect the trading volume and prior price patterns of stocks are considered:
a. abnormal returns
b. weak-form efficient
c. semistrong-form efficient
d. strong-form efficient
(moderate, L.O. 2, Section 2, b)

19.

To evaluate market efficiency, an information set must be specified. By definition, a securities market is
considered efficient with respect to a set of information if:
a. market prices reflect all past stock information
b. market prices reflect a situation in which abnormal returns occur
c. prices in the market reflect that information
d. market prices reflect all publicly available information
(difficult, L.O. 2, Section 2, c)

20.

An example of information that will make a market strong-form efficient is:

a. trading volume
b. management changes
c. market share
d. undisclosed new product information
(moderate, L.O. 2, Section 2, d)

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21.

Which type of information given below would not originate from a public source?
a. a press release announcing a merger
b. two members of a board of directors discuss a possible dividend increase
c. trading volume
d. market share
(easy, L.O. 2, Section 2, b)

22.

If future prices are unpredictable using available information, then:

a. prices will appear to fluctuate randomly when analyzed against the information
b. the analyst must conclude that future prices cannot be estimated
c. future prices really do fluctuate randomly
d. both the information and prior expectations are the same
(moderate, L.O. 3, Section 3, a)

23.

We define efficiency in terms of the kind of information incorporated in price. This statement implies:
a. prices do not reflect expectations for the future
b. future price movements will be predictable
c. future price movements will appear to fluctuate randomly
d. the expectations used are biased
(moderate, L.O. 3, Section 3, c)

24.

Given a market in which prices fluctuate randomly:

a. relevant information will influence prices
b. the market would be judged to be highly efficient
c. truly random prices would move without regard to changed expectations
d. the market would be sustainable in industrial economies
(difficult, L.O. 3, Section 3, c)

25.

An investor who is risk neutral:

a. requires no additional expected return to incur risk
b. requires an additional expected return to incur risk
c. uses a series of coin tosses as a factor in making unbiased investment decisions
d. believes in the random fluctuation of markets
(easy, L.O. 3, Section 3, a)

26.

A semi-strong efficient market is one in which:

a. prices reflect concrete public information
b. prices reflect not only public information per se but also everything else that can be inferred from that
information
c. information released on one date will not change the future expectations of the market
d. prices reflect public and private information
(moderate, L.O. 3, Section 3, b)

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27.

One mechanism that forces prices to efficient levels in an efficient market is:
a. investors placing buy orders
b. investors placing sell orders
c. investors continually reevaluate the relationship between price and their desire for the security
d. All of the above answers are correct.
(easy, L.O. 4, Section 4, d)

28.

The concept of an efficient market is a useful benchmark because:

a. it can identify a specific abnormal return for a security
b. we cannot use a theoretical model as a benchmark since markets have some mispricings
c. we can determine the extent to which a particular market is efficient
d. we cannot use a theoretical model as a benchmark since a perfectly efficient market does not exist
(difficult, L.O. 4, Section 4, c)

29.

The concept of comparative advantage has two implications for security analysis. One is that primarily
those who have some comparative advantage will do security analysis. Another implication is that:
a. passive investors will do whatever kind of analysis gives them a comparative advantage
b. analysts will do whatever kind of analysis gives them a comparative advantage
c. passive investors holding mutual funds have a comparative advantage
d. passive investors holding index funds have a comparative advantage
(moderate, L.O. 5, Section 5, b)

30.

Which would not be considered a source of comparative advantage in security analysis?

a. faster access to data
b. superior ability to analyze data, due either to understanding of markets and firms or to the ability to use
statistical techniques
c. higher transaction costs
d. ability to keep trading rules proprietary
(moderate, L.O. 5, Section 5, c)

31.

The kinds of activities an analyst perceives to be most profitable will depend on the relationship between
the analysts beliefs and approach to investing. An analyst who believes the market may be inefficient and
attempts to earn higher than normal returns has adopted:
a. a technical analysis approach to the market
b. a fundamental analysis approach to the market
c. a passive investment strategy
d. an active investment strategy
(moderate, L.O. 6, Section 5, d)

32.

The analysis of an individual firm or a cross-sectional analysis of a portfolio of companies is referred to as:
a. technical analysis
b. fundamental analysis
c. passive investment analysis
d. active investment analysis
(easy, L.O. 6, Section 5, b)

33.

A situation in which a contradictory factor appears to predict a stocks future returns is known as a:
a. cross-sectional anomaly
b. pre-earnings announcement drift
c. stock price anomaly
d. behavioral finance analysis
(easy, L.O. 7, Section 6, c)

34.

Cross-sectional tests have found evidence to suggest that there are systematic mispricings of equities in the
United States. It has been documented that:
a. there is no relationship between different returns associated with different calendar months

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b. there is no relationship between the PE ratio and subsequent returns

c. investors appear to react very quickly to the information contained in earnings announcements
d. over the last 30 years abnormal returns of as much as 5% to 6% can be earned over the 9 months
following an earnings announcement
(difficult, L.O. 7, Section 6, d)
35.

Behavioral finance is a field of literature that attempts to explain inefficient prices with psychology. This
literature argues that:
a. people often make decisions incorrectly
b. researchers who believe in inefficiencies also say relationships between information and subsequent
stock returns can be explained by econometric errors or by luck
c. fundamental analysis is invalid
d. cross-sectional testing is invalid
(moderate, L.O. 7, Section 6, a)

36.

One result of the research of Bernard and Thomas concerning post-earnings announcement drift is that their
analysis predicts:
a. positive abnormal returns in the three quarters following good news and negative abnormal returns in
the fourth quarter after good news
b. positive abnormal returns in the four quarters following good news
c. negative abnormal returns in the three quarters following good news and positive abnormal returns in
the fourth quarter after good news
d. negative abnormal returns in the four quarters following bad news
(moderate, L.O. 7, Section 6, a)

ESSAYS
37.

Identify and discuss the three levels of market efficiency proposed by Eugene Fama.
Suggested solution:
Fama created a model of three levels of market efficiency based on information specified in a certain set
that is available to those markets. The three levels are:
Weak-form efficient
Semistrong-form efficient
Strong-form efficient
A weak-form efficient market is a market in which prices reflect only past stock price information. This
means that the current price of a stock incorporates only relevant information from the past. Current
information or future estimates are not considered. The types of relevant information from the past include
trading volumes and prior price patterns.
A market that reflects not only past stock price information but also all publicly available information is
known as semistrong-form efficient. Publicly available information includes such items as corporate
earnings and security analysis reports, newspaper and magazine articles, SEC filings, Internet postings and
opinions, and rumors. If a market is semistrong-form efficient, it is automatically weak-form efficient as
well, since all relevant information from the past is available currently to the public.

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A strong-form efficient market is one in which prices reflect all information, both from public as well as
private sources. This means that all publicly available information, relevant past information, and private
information that may be known only to a few individuals is included in the information set. Examples of
such private information include undisclosed dividend increases and new product information. Again, a
strong-form efficient market is also by definition semistrong- and weak-form efficient as well.
Such levels of market evaluation are based with respect to a certain set of information. A market may only
react to certain public information, while ignoring other public information, which means that the market is
not perfectly semistrong-form efficient. Since markets as such may not react to all available information, an
analysis must be made relative to only a particular set of information.
(moderate, L.O. 2, Section 2)
38.

What would happen if prices really did fluctuate randomly? Explain.

Suggested solution:
If prices truly fluctuate at random, prices will move independently of any relevant information of changed
expectations. This type of market would be entirely arbitrary, and in no form efficient. It would be difficult
for such a market to exist since investors would not be able to make use of falling market prices to invest in
stock with hopes of a potential increase in the future, or to sell stock short at any point in time. No theory
could be applied that would provide any estimate of a stocks true value or future worth, since prices would
follow no set of rules or conventions. Such a market would never make use of any public or private
information to determine pricing.
(moderate, L.O. 3, Section 3)

39.

Discuss the role of investors in an efficient market.

Suggested solution:
A market that operates at efficient levels would be the result of investors gathering information and reacting
to the information in their investment decisions. Investors would analyze the information and place either
buy or sell orders accordingly. The prices of securities would change in response to the market demand of
investors. Investors may again react in the marketplace to the new pricing information by either buying or
selling the stock. This cycle would continue and perpetuate itself until the securities are priced at a level
investors believe would be correct.
(moderate, L.O. 4, Section 4)

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