Gypsy

Which of the following would be inconsistent with an efficient market?

A) Stock prices adjust rapidly to new information.

B) Price adjustments are biased.

C) Price changes are independent.

---

Market efficiency assumes that investors adjust their estimates of security prices rapidly to reflect their unbiased interpretation of the new information. New information arrives randomly and independently. Therefore, price changes are independent.

Gypsy

Hume Inc. announces fourth quarter earnings per share of $1.20, which is 15% higher than last year. Hume’s earnings are equal to the consensus analyst forecast for the quarter. Assuming markets are efficient, the announcement will most likely cause the price of Hume’s stock to:

A) decrease.

B) remain the same.

C) increase.

---

An efficient capital market would price Hume’s stock based on the expectation for earnings per share. Since actual earnings equal expected earnings, the stock price should not change as a result of the announcement.

Gypsy

In an informationally efficient market:

A) buying and holding a broad market portfolio is the preferred investment strategy.

B) the conditions exist for active investment strategies to achieve superior risk-adjusted returns.

C) share prices adjust rapidly when companies announce results in line with expectations.

---

If financial markets are informationally efficient, active investment strategies cannot consistently achieve risk-adjusted returns superior to holding a passively managed index portfolio. In addition, a passive investment strategy has lower transactions costs than an active management strategy. Share prices should not adjust when a company announces results in line with expectations in an informationally efficient market, because the market price already reflects the expected results.

Gypsy

The implication of efficient capital markets and a lack of superior analysts have led to the introduction of:

A) balanced funds.

B) index funds.

C) futures options.

---

An index fund is designed to duplicate the composition of a specific index series or market segment. There is a strong argument suggesting that portfolio managers cannot beat the market after fees, therefore an index fund should be used to try to match the market.