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If a corporation announces that it expects quarterly earnings to increase by 25 percent and it
actually sees an increase of 22 percent, what should happen to the price of the corporation's stock
if the efficient markets hypothesis holds, everything else held constant?
Answer: The stock's price should fall. The price had adjusted based on the statement of expected
earnings. When the actual number turned out to be lower than expected, the stock price changes
to reflect the additional information.
Diff: 3 Type: SA Page Ref: 151 - 152
Skill: Applied
Objective List: 7.2 Determine how information in the market affects asset prices
Your best friend calls and gives you the latest stock market "hot tip" that he heard at the
health club. Should you act on this information? Why or why not?
Answer: No, if this information is readily available, it will already be reflected in the stock
price.
Diff: 1 Type: SA Page Ref: 151
Skill: Applied
Objective List: 7.2 Determine how information in the market affects asset prices
If you your stock broker tells you that you should buy stock in Ford as it has devised a new
hybrid engine system that will reduce consumption of fuel by 90 percent, would you follow this
advice and buy Ford's stock?
Answer: The efficient market hypothesis indicates that you should be skeptical of any such
information. If the market is efficient then it has already priced Ford's stock so that its expected
return will equal the equilibrium return. The tip is not valuable. But if the tip is based on new
information and gives you an edge on the rest of the market, only them it can be valuable to you
and you should buy the stock. In any other case Ford stock price will have already reflected the
news.
Diff: 2 Type: SA Page Ref: 151
Skill: Applied
Objective List: 7.2 Determine how information in the market affects asset prices
What is a recommended strategy for a small investor and how it is associated with the
efficient market hypothesis?
Answer: Students should be able to explain that a recommended strategy is to purchase no-load
mutual funds. EMH suggests that only "extremely clever investors" may be able top outperform
a buy-and-hold strategy.
Diff: 3 Type: SA Page Ref: 152
Skill: Recall
Objective List: 7.2 Determine how information in the market affects asset prices