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Which of the following statements concerning market efficiency is least accurate?
A)
Market efficiency assumes that individual market participants correctly estimate asset prices.
B)
If weak-form market efficiency holds, technical analysis cannot be used to earn abnormal returns over the long-run.
C)
Tests of the semi-strong form of the EMH require that security returns be risk-adjusted using a market model.



Market efficiency does not assume that individual market participants correctly estimate asset prices, but does assume that their estimates are unbiased. That is, some agents will over-estimate and some will under-estimate, but they will be correct, on average.

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Under the efficient market hypothesis (EMH), the major effort of the portfolio manager should be to:
A)
achieve complete diversification of the portfolio.
B)
minimize systematic risk in the portfolio.
C)
follow a strict buy and hold strategy.



In an efficient market, portfolio managers must create and maintain the appropriate mix of assets to meet their client’s needs. The portfolio should be diversified to eliminate unsystematic risk. The appropriate systematic risk will depend on the clients risk tolerance and return requirement. Over time the needs of the client and environment will justify changes to the portfolio. The manager should also try to minimize transaction costs and at least try to match the performance of a benchmark.

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In a perfectly efficient market, portfolio managers should do all of the following EXCEPT:
A)
diversify to eliminate systematic risk.
B)
monitor their client's needs and circumstances.
C)
quantify their risk and return needs within the bounds of the client's liquidity, income, time horizon, legal, and regulatory constraints.



Portfolio managers cannot eliminate systematic risk (i.e., market risk) thru the use of diversification. Portfolio managers should try to eliminate unsystematic portfolio risk.

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Which of the following statements least likely describes the role of a portfolio manager in perfectly efficient markets? Portfolio managers should:
A)
construct a portfolio that includes financial and real assets.
B)
quantify client's risk tolerance, communicate portfolio policies and strategies, and maintain a strict buy and hold policy avoiding any changes in the portfolio to minimize transaction costs.
C)
construct diversified portfolios that include international securities to eliminate unsystematic risk.



A portfolio manager should quantify each client's risk tolerance and communicate portfolio policies and strategies. However, portfolio managers should monitor client's needs and changing circumstances and make appropriate changes to the portfolio. Adhering to a strict buy and hold policy would not be in the client's best interest. Portfolios need to be rebalanced and changed to meet client’s changing needs.

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Which of the following is a limitation to fully efficient markets?
A)
The gains to be earned by information trading can be less than the transaction costs the trading would entail.
B)
There are no limitations to fully efficient markets because the trading actions of fundamental and technical analysts are continuously keeping prices at their intrinsic value.
C)
Information is always quickly disseminated and fully embedded in a security’s prices.



Market prices that are not precisely efficient can persist if the gains to be made by information trading are less than the transaction costs such trading would entail.

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David Farrington is an analyst at Farrington Capital Management. He is aware that many people believe that the capital markets are fully efficient. However, he is not convinced and would like to disprove this claim. Which of the following statements would support Farrington in his effort to demonstrate the limitations to fully efficient markets?
A)
Stock prices adjust to their new efficient levels within hours of the release of new information.
B)
Technical analysis has been rendered useless by many academics who have shown that analyzing market trends, past volume and trading data will not lead to abnormal returns.
C)
Processing new information entails costs and takes at least some time, so security prices are not always immediately affected.



If market prices are efficient there are no returns to the time and effort spent on fundamental analysis. But if no time and effort is spent on fundamental analysis there is no process for making market prices efficient. To resolve this apparent conundrum one can look to the time lag between the release of new value-relevant information and the adjustment of market prices to their new efficient levels. Processing new information entails costs and takes at least some time, which is a limitation of fully efficient markets.

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The opportunity to take advantage of the downward pressure on stock prices that result from end-of-the-year tax selling is known as the:
A)
end-of-the-year effect.
B)
January anomaly.
C)
end-of-the-year anomaly.



The January Anomaly is most likely the result of tax induced trading at year end. An investor can profit by buying stocks in December and selling them during the first week in January.

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Which of the following would provide evidence against the semistrong form of the efficient market theory?
A)
Low P/E stocks tend to have positive abnormal returns over the long run.
B)
Trend analysis is worthless in determining stock prices.
C)
All investors have learned to exploit signals related to future performance.



P/E information is publicly available information and therefore this test relates to the semistrong-form EMH. Trend analysis is based on historical information and therefore relates to the weak-form EMH. In an efficient market one would expect 50% of pension fund managers to do better than average and 50% of pension fund managers to do worse than average. If all investors exploit the same information no excess returns are possible.

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Which of the following statements best describes the overreaction effect?
A)
High returns over a one-year period are followed by high returns over the following year.
B)
Low returns over a three-year period are followed by high returns over the following three years.
C)
High returns over a one-year period are followed by low returns over the following three years.



The overreaction effect refers to stocks with poor returns over three to five-year periods that had higher subsequent performance than stocks with high returns in the prior period. The result is attributed to overreaction in stock prices that reverses over longer periods of time. Stocks with high previous short-term returns that have high subsequent returns show a momentum effect.

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If the momentum effect persists over time, it would provide evidence against which of the following forms of market efficiency?
A)
Weak form only.
B)
Semistrong form only.
C)
Both weak form and semistrong form.



The momentum effect suggests it is possible to earn abnormal returns using market data. All three forms of market efficiency (weak form, semistrong form, and strong form) assume that market prices fully reflect market data.

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