Acturial Science

Chapter 11: The Efficient Market Hypothesis

1. If markets are efficient, what should be the correlation coefficient between stock returns for two non-overlapping time periods?

If markets are efficient, then the correlation coefficient between stock returns for two non-overlapping periods (the autocorrelation) should be zero. If not, one could use returns from one period to predict returns in later periods and make abnormal profits.

Note that we do observer some non-zero return autocorrelations. See page 358 to 359 in the text.

2. A successful firm like Microsoft has consistently generated large profits for years. Is this a violation of the EMH?

No. The EMH implies that Microsoft’s investors, over any period, have earned the correct risk-adjusted return on their investment.

3. “If all securities are fairly priced, all must offer equal expected rates of return.” Comment.

No. Expected rates of return vary according to premium earned from incurring risk. The CAPM implies that the risk-premium of a security is solely a function of its share of market risk (as measured by its market-beta), while other theories/models allow for other “priced” risk-factors.

For example, according the results of tests of the Fama-French Three Factor Model (FF3F Model), a security’s risk-premium (it’s return in excess of the risk-free return) is a function of its market risk (measured by market beta), its relative size (measured by SMB beta) and its relative price (its book value of equity to its market value of equity measured by HML beta).

Other risk factors such as exchange rates or commodity prices may also be important to determining the correct risk premia.

4. Steady Growth Industries has never missed a dividend payment in its 94-year history. Does this make it more attractive to you as a possible purchase for your stock portfolio?

Not more (or less) attractive. The EMH implies the predictability of its dividend...