CFA Practice Question

CFA Practice Question

In an efficient capital market, ______

I. price movements are completely unpredictable.
II. prices adjust rapidly to the arrival of new information.
III. current stock prices reflect all available information.
A. II and III.
B. I and II.
C. I, II and III.
Explanation: Contrary to a commonly held misconception, the efficient market theory does not claim that price movements are completely unpredictable. Indeed, most stocks are expected to have positive expected returns to compensate for the risks involved. This component of stock price movements is predictable. What the efficient markets theory does say is that these movements are not systematically over-or under-estimated. In effect, the price changes follow a "random walk" with drift.

User Contributed Comments 11

User Comment
andrewsutton What does "...these movements are not systematically over- or under-estimated" mean?
ahug I think it means that whether a price will be overestimated or underestimated is unpredictable.
frcfa Concluding that prices are predicted to follow a random walk is roughly equal to say they´re unpredictable!
JZino frcfa, I got the question wrong too but the answer is right. The EMH holds that prices will reflect the RoR (i.e., price movements will be predictable in the long run) However, because new information can come in at any time prices are not COMPLETELY predictable.
wollogo Very good explantation for this answer. Random walk does not mean that you can not have a long term direction or 'drift' it just means that you can not predict at any one point of time whether the price will be above or below the long term drift. Think of it as a drunk guy walking home, you can be fairly certain that they will keep walking in one direction, but they could be anywhere on the footpath/street.
antony Wollogo, nice analogy...I will remember that one for the exam
Miketo Always remember that the efficient market hypothesis does allow portfolio managers to outperform the market strictly and only if they use superior analysts to determine future variables using fundamental analysis, thus allowing a slight predictibility in the price movements of, proving I to be incorrect.
iambroke miketo: I thought fundamental analysis is of no use in semi-strong form....
Analysts earning higher returns discredits the semi-strong form
cjpatel Response to Miketo Efficient Market Hypothesis doesnt allow protfolio managers to outperform because Arbitrage in almost non-existant!!!

In reality there are mispricing in the asset values that allow porfolio managers to outperform and hence Efficient Market hpothesis doesnt hold!!!
Insipidity Commonly held misconception indeed.
cbracho54 somebody pointed out that extremes, such as "always" "virtually impossible", in this case "completely" are a clue that the answer might not be true.

good point
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