CFA Level 1 - Equity Investments Session 13 - Reading 49 (Notes, Practice Questions, Sample Questions) 1. An e cient capital market: A)fully reﬂects all of the information currently available abouta given security, excluding risk. B)fully reﬂects all of the information currently available abouta given security, including risk. C)does not fully reﬂect all of the information currentlyavailable about a given security, including risk. Explanation: (B) An e cient capital market fully reﬂects all ofthe information currently available about a given security,including risk 2. The implication of e cient capital markets and a lack of superior analysts have led to the introduction of: A)balanced funds. B)index funds. C)futures options. Explanation: (B) An index fund is designed to duplicate thecomposition of a speciﬁc index series or market segment.There is a strong argument suggesting that portfoliomanagers cannot beat the market after fees, therefore anindex fund should be used to try to match the market
3 . In an informationally e cient market: A)buying and holding a broad market portfolio is thepreferred investment strategy. B)the conditions exist for active investment strategies toachieve superior risk-adjusted returns.C)share prices adjust rapidly when companies announceresults in line with expectations Explanation: (A) If ﬁnancial markets are informationallye cient, active investment strategies cannot consistentlyachieve risk-adjusted returns superior to holding a passivelymanaged index portfolio. In addition, a passive investmentstrategy has lower transactions costs than an activemanagement strategy. Share prices should not adjust when acompany announces results in line with expectations in aninformationally e cient market, because the market pricealready reﬂects the expected results 4. Hume Inc. announces fourth quarter earnings per share of $1.20, which is 15% higher than last year. Hume’s earnings areequal to the consensus analyst forecast for the quarter.Assuming markets are e cient, the announcement will mostlikely cause the price of Hume’s stock to: A)decrease. B)remain the same. C)increase Explanation: (B) An e cient capital market would priceHume’s stock based on the expectation for earnings pershare. Since actual earnings equal expected earnings, thestock price should not change as a result of theannouncement
5. Which of the following would be inconsistent with an e cient market? A)Stock prices adjust rapidly to new information. B)Price adjustments are biased. C)Price changes are independent Explanation: (B) Market e ciency assumes that investorsadjust their estimates of security prices rapidly to reﬂecttheir unbiased interpretation of the new information. Newinformation arrives randomly and independently. Therefore,price changes are independent 6. A market’s e ciency is most likely to negatively a ected by: A)substantial analyst coverage of the exchange listedcompaniesB)a high amount of trading activity. C)a ban on short selling Explanation: (C) Research supports the conclusion that shortselling helps to prevent market prices from becomingovervalued, while limiting short selling has the oppositee ect. More analyst coverage and more liquidity contributeto market e ciency 7. Which of the following forms of the EMH assumes that no group of investors has monopolistic access to relevantinformation? A)Weak-form.B)Both weak and semistrong form. C)Strong-form Explanation: (C) According to the strong-form EMH, securityprices reﬂect all information, which includes the privatelyavailable (monopolistic) information
8. If the e cient markets hypothesis is true, portfolio managers should do all of the following EXCEPT: A)Minimize transaction costs. B)Spend more time working on security selection. C)Work more with clients to better quantify their riskpreferences Explanation: (B) In an e cient market all stocks are properlypriced and reﬂect all publicly available information.Therefore, individual selection of stocks is not important theonly thing that is relevant is the portfolio’s beta. 9. Which of the following statements concerning market e ciency is least accurate? A)Market e ciency assumes that individual marketparticipants correctly estimate asset prices. B)If weak-form market e ciency holds, technical analysiscannot be used to earn abnormal returns over the long-run.C)Tests of the semi-strong form of the EMH require thatsecurity returns be risk-adjusted using a market model Explanation: (A) Market e ciency does not assume thatindividual market participants correctly estimate assetprices, but does assume that their estimates are unbiased.That is, some agents will over-estimate and some willunder-estimate, but they will be correct, on average 10. Under the e cient market hypothesis (EMH), the major e ort 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
Explanation: (A) In an e cient market, portfolio managersmust create and maintain the appropriate mix of assets tomeet their client’s needs. The portfolio should be diversiﬁedto eliminate unsystematic risk. The appropriate systematicrisk will depend on the clients risk tolerance and returnrequirement. Over time the needs of the client andenvironment will justify changes to the portfolio. Themanager should also try to minimize transaction costs and atleast try to match the performance of a benchmark 11. In a perfectly e cient 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 ofthe client's liquidity, income, time horizon, legal, andregulatory constraints Explanation: (A) Portfolio managers cannot eliminatesystematic risk (i.e., market risk) thru the use ofdiversiﬁcation. Portfolio managers should try to eliminateunsystematic portfolio risk 12. Which of the following statements least likely describes the role of a portfolio manager in perfectly e cient markets?Portfolio managers should: A)construct a portfolio that includes ﬁnancial and real assets. B)quantify client's risk tolerance, communicate portfoliopolicies and strategies, and maintain a strict buy and holdpolicy avoiding any changes in the portfolio to minimizetransaction costs. C)construct diversiﬁed portfolios that include internationalsecurities to eliminate unsystematic risk.
Explanation: (B) A portfolio manager should quantify eachclient's risk tolerance and communicate portfolio policiesand strategies. However, portfolio managers should monitorclient's needs and changing circumstances and makeappropriate changes to the portfolio. Adhering to a strictbuy and hold policy would not be in the client's best interest.Portfolios need to be rebalanced and changed to meetclient’s changing needs 13. Which of the following is a limitation to fully e cient markets? A)The gains to be earned by information trading can be lessthan the transaction costs the trading would entail. B)There are no limitations to fully e cient markets becausethe trading actions of fundamental and technical analystsare continuously keeping prices at their intrinsic value.C)Information is always quickly disseminated and fullyembedded in a security’s prices Explanation: (A) Market prices that are not precisely e cientcan persist if the gains to be made by information tradingare less than the transaction costs such trading would entail 14. David Farrington is an analyst at Farrington Capital Management. He is aware that many people believe that thecapital markets are fully e cient. However, he is notconvinced and would like to disprove this claim. Which of thefollowing statements would support Farrington in his e ort todemonstrate the limitations to fully e cient markets? A)Stock prices adjust to their new e cient levels within hoursof the release of new information.B)Technical analysis has been rendered useless by manyacademics who have shown that analyzing market trends,past volume and trading data will not lead to abnormalreturns.
C)Processing new information entails costs and takes at leastsome time, so security prices are not always immediatelya ected Explanation: (C) If market prices are e cient there are noreturns to the time and e ort spent on fundamental analysis.But if no time and e ort is spent on fundamental analysisthere is no process for making market prices e cient. Toresolve this apparent conundrum one can look to the timelag between the release of new value-relevant informationand the adjustment of market prices to their new e cientlevels. Processing new information entails costs and takes atleast some time, which is a limitation of fully e cient markets 15. The opportunity to take advantage of the downward pressure on stock prices that result from end-of-the-year taxselling is known as the: A)end-of-the-year e ect. B)January anomaly. C)end-of-the-year anomaly Explanation: (B) The January Anomaly is most likely the resultof tax induced trading at year end. An investor can proﬁt bybuying stocks in December and selling them during the ﬁrstweek in January 16. Which of the following would provide evidence against the semistrong form of the e cient market theory? A)Low P/E stocks tend to have positive abnormal returns overthe long run. B)Trend analysis is worthless in determining stock prices.C)All investors have learned to exploit signals related to futureperformance
Explanation: (A) P/E information is publicly availableinformation and therefore this test relates to thesemistrong-form EMH. Trend analysis is based on historicalinformation and therefore relates to the weak-form EMH. Inan e cient market one would expect 50% of pension fundmanagers to do better than average and 50% of pensionfund managers to do worse than average. If all investorsexploit the same information no excess returns are possible 17. Which of the following statements best describes the overreaction e ect? A)High returns over a one-year period are followed by highreturns over the following year. B)Low returns over a three-year period are followed by highreturns over the following three years. C)High returns over a one-year period are followed by lowreturns over the following three years Explanation: (B) The overreaction e ect refers to stocks withpoor returns over three to ﬁve-year periods that had highersubsequent performance than stocks with high returns in theprior period. The result is attributed to overreaction in stockprices that reverses over longer periods of time. Stocks withhigh previous short-term returns that have high subsequentreturns show a momentum e ect 18. An investor who is more risk averse with respect to potential negative outcomes than potential positiveoutcomes most likely exhibits: A)gambler’s fallacy.B)mental accounting. C)loss aversion Explanation: (C) Loss aversion is exhibited by an investor whodislikes a loss more than he likes an equal gain. That is, the
investor’s risk preferences are asymmetric. Gambler’s fallacyis the belief that recent past outcomes a ect the probabilityof future outcomes. Mental accounting refers to mentallyclassifying investments in separate accounts rather thanconsidering them from a portfolio perspective 19. Investor overreaction that has been documented in securities markets is most likely attributable to investorsexhibiting: A)risk aversion. B)loss aversion. C)conservatism Explanation: (B) Loss aversion refers to the tendency forinvestors to dislike downside risks more than upside riskscreating asymmetrical risk preferences. This dislike of lossesmay be a cause of investor overreaction. The standardeconomic notion of risk aversion assumes symmetric riskpreferences. Conservatism is the behavioral bias wherebyinvestors react slowly to new information and is unlikely tocause overreaction 20. In behavioral ﬁnance theory, how is loss aversion most accurately deﬁned? For gains and losses of equal amounts,investors: A)dislike losses more than they like gains. B)like gains more than they dislike losses.C)dislike for losses and like for gains are proportionate Explanation: (A) Behavioral ﬁnance proposes that investorsare loss averse. Loss aversion means investors dislike lossesmore than they like gains of the same amount
21. The idea that uninformed traders, when faced with unclear information, observe the actions of informed traders to makedecisions, is referred to as: A)information cascades. B)herding behavior.C)narrow framing Explanation: (A) “Information cascades” refers to uninformedtraders watching the actions of informed traders whenmaking investment decisions. Herding behavior is whentrading occurs in clusters, not necessarily driven byinformation. Narrow framing refers to investors viewingevents in isolation