CHAPTER 9
Market Efficiency
1. A stock represents
a. credit risk by the issuer.
b. ownership of part of the issuing firm.
c. debt of the issuer.
d. the yield to maturity.
ANSWER: b
2. A bond represents
a. credit risk by the issuer.
b. ownership of part of the issuing firm.
c. debt of the issuer.
d. the yield to maturity.
ANSWER: c
3. The size of a shareholder’s ownership position depends on
a. the price of the stock only.
b. the liquidity of the stock.
c. the number of shares owned relative to the total number of shares outstanding.
d. the value the company declares the stock is worth.
ANSWER: c
4. In general, as current and expected future earnings rise
a. the stock’s price declines.
b. the stock’s price also rises.
c. the stock’s price remains constant.
d. there is no relationship between future earnings and stock prices.
ANSWER: b
5. There is often a __________ correlation between the growth of real national income and stock
prices.
a. positive.
b. negative.
c. inverse.
d. none of the above.
ANSWER: a
6. If you pay $100 for a share of stock, and the expected dividend is $5 per share, and you expect
the price to rise $10 over the year, the expected return is:
a. 1 percent
b. 5 percent
c. 10 percent
d. 15 percent
ANSWER: d
121
122
Chapter 9
7. If the face value of a bond is $500 and the coupon rate is 4 percent, then the coupon payment is
a. $20
b. $40
c. $60
d. $80
ANSWER: a
8. Price expectations are related to all of the following except
a. expected changes in production costs.
b. possible unknown future government intervention in the economy.
c. expected changes in national income.
d. current and past prices.
ANSWER: b
9. Adaptive expectations are formed by looking at
a. the average changes of a variable.
b. changes in all substitute variables.
c. both past and expected future values of a variable.
d. past values of a variable.
ANSWER: d
10. Rational expectations are formed by looking at
a. the average changes of a variable.
b. changes in all substitute variables.
c. both past values and at all currently available information about the economy.
d. past values of a variable.
ANSWER: c
11. The optimal forecast is
a. the best guess possible arrived at by using the smallest amount of information possible.
b. the best guess possible arrived at by using adaptive expectations.
c. the best guess possible arrived at by using all the information available.
d. the worst guess possible arrived at by using all the information available.
ANSWER: c
12. The efficient market hypothesis states that when financial markets are in equilibrium
a. the prices of financial instruments reflect all readily available information.
b. the economy will eventually reach its steady state, long run, equilibrium.
c. the future markets will become more efficient than in previous years.
d. all financial instruments have the same amount of risk.
ANSWER: a
13. What is the percentage return over time when the current price of the stock is $200, the price of
the stock at the end of the time period is $250, and the dividend payment made during the time
period is $15.
a. 15.5 percent
b. 32.5 percent
c. 45.5 percent
d. 53.5 percent
ANSWER: b
Market Efficiency
123
14. If inflation had been 4 percent for four years, but then inflation increased to 8 percent in the past
two years, given the adaptive expectations theory, expected inflation in the next year will be
closer to
a. 4 percent
b. 6 percent
c. 8 percent
d. 10 percent
ANSWER: c
15. Typically, the economy is composed of surplus sectors and of deficit sectors. When combined,
the surpluses of the surplus sectors ______________ to the deficits of the deficits sectors.
a. are inversely related
b. are positively related
c. are never equal
d. are always equal
ANSWER: d
16. A sector in which the combined deficits of the deficit spending units are greater than the
combined surpluses of the surplus spending units is a
a. financial sector.
b. business sector.
c. surplus sector.
d. deficit sector.
ANSWER: d
17. Which sector is not included in the flow of funds social accounting system
a. household sector
b. business sector
c. marketing sector
d. rest-of-the-world sector
ANSWER: c
18. A sector in which the combined surpluses of the surplus spending units are greater than the
combined deficits of the deficit spending units is a
a. financial sector.
b. business sector.
c. surplus sector.
d. deficit sector.
ANSWER: c
19. The stronger version of the Efficient Markets Hypothesis states that
a. the prices of all financial instruments reflect only the optimal forecast of the financial
instrument.
b. the prices of all financial instruments reflect not only the optimal forecast of the financial
instrument but also the true fundamental value of the instrument.
c. many factors have a direct effect on future income streams of the financial instruments.
d. many factors have a direct effect on value of the assets and the expected income systems of
those assets on which the financial instruments represent claims.
ANSWER: b
124
Chapter 9
20. Which statement best describes the uses of funds for any sector:
a. the combined surpluses of all spending units in the sector
b. the combined deficits of all deficit spending units in the sector
c. the income and borrowing of any sector
d. the current spending and changes in financial instruments held by any sector
ANSWER: d
21. Which statement best describes the sources of funds for any sector:
a. the combined surpluses of all spending units in the sector
b. the combined deficits of all deficit spending units in the sector
c. the income and borrowing of any sector
d. the current spending and changes in financial instruments held by any sector
ANSWER: c
22. _____________________ are factors that have a direct effect on future income streams of the
instruments including the value of the assets and the expected income streams of those assets on
which the financial instruments represent claims.
a. The efficient markets hypothesis
b. Market fundamentals
c. The flow of funds
d. The sources and uses of funds
ANSWER: b
23. _______________assert(s) that when financial markets are in equilibrium, the prices of financial
instruments reflect all readily available information.
a. The efficient markets hypothesis
b. Market fundamentals
c. The flow of funds
d. The sources and uses of funds
ANSWER: a
24. In equilibrium, differences in rates of return on financial instruments are based on differences in
a. future expectations of interest rates.
b. liquidity and risk.
c. the stronger version of the efficient markets hypothesis.
d. future expectations about the economy.
ANSWER: b
25. The _______________ may explain why someone would buy a stock that they believe is
overvalued.
a. “greater fool” theory
b. efficient markets hypothesis
c. stronger version of the efficient markets hypothesis
d. bubble theory
ANSWER: a
Market Efficiency
125
26. The __________________ states that in equilibrium, prices of financial instruments reflect the
true fundamental value of the firm.
a. efficient markets hypothesis
b. stronger version of the efficient markets hypothesis
c. fundamental value theory
d. rational expectation theory.
ANSWER: b
27. Bond prices and interest rates are
a. independent of one another.
b. inversely related.
c. directly related.
d. positively related.
ANSWER: b
28. The ________________ states that in equilibrium, prices of financial instruments reflect all
available information.
a. efficient markets hypothesis
b. stronger version of the efficient markets hypothesis
c. fundamental value theory
d. rational expectation theory.
ANSWER: a
29. The efficient markets hypothesis is based on the ________________ theory.
a. rational expectations
b. adaptive expectations
c. fundamental value
d. optimal value theory
ANSWER: a
30. The ______________ states that expectations of financial prices will be equal to optimal
forecasts arrived at by using all available information.
a. adaptive expectations theory
b. rational expectations theory
c. fundamental value theory
d. optimal value theory
ANSWER: b
31. If the price of a financial asset is $100 at the beginning of the period, $120 at the end of the
period and a $5 dividend was paid, what was the percentage return?
a. 20 percent
b. 5 percent
c. 25 percent
d. 15 percent
ANSWER: c
126
Chapter 9
32. If the price of a financial asset is $100 at the beginning of the period, pays a $5 dividend, and
earns a 10 percent return over the period, what is the price at the end of the period?
a. $110
b. $105
c. $115
d. $120
ANSWER: b
33. If the price of a financial asset is $120 at the end of a period where no dividend was paid, what
was the price at the beginning of the period if a 20 percent return was earned?
a. $140
b. $120
c. $100
d. It is impossible to know, given the information provided.
ANSWER: c
34. Which of the following is false?
a. When interest rates change, some spending units that were DSUs become SSUs and vice
versa.
b. When interest rates changes, the surpluses and deficits within any sector can change so that a
sector that was a surplus sector before the change can become a deficit sector and vice versa.
c. Changes in interest rates cause changes in the flow of funds among sectors.
d. Within any sector, the combined surpluses always equal the combined deficits.
ANSWER: d
35. The _____________ is the best guess possible arrived at by using all of the available
information.
a. fundamental value
b. rational value
c. optimal forecast
d. efficient value
ANSWER: c
36. The ________________________hypothesizes that expectations will on average be equal to the
optimal value.
a. theory of adaptive expectations
b. theory of rational expectations
c. optimal forecast theory
d. fundamental value theory
ANSWER: b
37. Expectations formed by looking both forward and backward are
a. rational expectations.
b. optimal expectations.
c. adaptive expectations.
d. based on fundamental values.
ANSWER: a
Market Efficiency
127
38. Which of the following is true?
a. Shareholders are entitled to be paid dividends before bondholders are paid interest.
b. The coupon payment is the current interest rate multiplied by the face value of the bond. It is
irrelevant what the interest rate was at the time the bond was issued.
c. The coupon payment is the face value of the bond multiplied by the coupon rate.
d. When interest rates go up, bond prices also go up.
ANSWER: c
39. Which of the following will causes prices of financial instruments to change?
a. current earnings
b. expected future earnings
c. both a and b
d. none of the above
ANSWER: c
40. A decrease in the expected future earnings of a stock
a. will have a positive impact on the stock’s price.
b. will have a negative impact on the stock’s current price.
c. will affect the stock’s future price but not the current price.
d. will not affect the stock’s price.
ANSWER: b
41. Bonds represent
a. debt of the issuer.
b. debt of individual.
c. ownership of part of a firm.
d. ownership of part of a firm project.
ANSWER: a
42. Dividends are
a. a firm’s total profit.
b. a distribution of profits to stockholders.
c. both a and b.
d. total shares owned by a stockholder.
ANSWER: b
43. There is a __________________ correlation between national income and stock prices.
a. negative
b. lack of
c. positive
d. inverse
ANSWER: c
44. The expected return on a stock is the expected _________________ plus the expected
_______________ in the price of a stock, all divided by the ____________________price at the
time of purchase.
a. dividend, share, change
b. share, change, dividend
c. share, change, share
d. dividend, change, share
ANSWER: d
128
Chapter 9
45. If you pay $100 a share, the expected dividend is $9, and you expect the price to rise $4, the
expected return is
a. 130 percent.
b. 8 percent.
c. 4 percent.
d. 13 percent.
ANSWER: d
46. The expected percentage return on a bond is the _______________ plus the expected percentage
change in the bond’s price.
a. current interest rate
b. coupon rate
c. dividend
d. change in the interest rate
ANSWER: b
47. Research suggests that all of the following are important in shaping the public’s expectations of
future prices, except
a. current and past prices.
b. expected changes in exchange rates.
c. expected changes in national income.
d. expected changes in production cost.
ANSWER: b
48. Expectations formed by looking back at past values of a variable are
a. historic adaptations.
b. past-oriented adaptations.
c. rational expectations.
d. adaptive expectations.
ANSWER: d
49. Expectations formed by looking both backward and forward are
a. rational expectations.
b. optimal expectations.
c. past-future expectations.
d. adaptive expectations.
ANSWER: a
50. The theory of rational expectations is the theory that expectations will on average be equal to
a. optimal forecasts.
b. adaptive expectations.
c. market changes.
d. actual values.
Answer:
a
51. The optimal forecast is the best guess possible arrived at by using
a. past information.
b. all available information.
c. future expectations.
d. none of the above.
Answer: b
Market Efficiency
129
52. An implication of rational expectations is that as new information becomes available market
participants (the public) should adjust accordingly. But there is a _____________; the lag is
believed to be _________________.
a. lag, lengthening
b. lag, shortening
c. understatement, lengthening
d. overstatement, shortening
ANSWER: b
53. The efficient market hypothesis states that when markets are in _______________ the prices of
financial instruments reflect all readily available information.
a. equilibrium
b. an inflationary cycle
c. disequilibrium
d. motion
Answer: a
54. Financial markets are in equilibrium when the quantity demanded of any security is
_________________ the quantity supplied of that security.
a. more than
b. less than
c. equal to
d. none of the above
ANSWER: c
55. A person buying an overvalued stock using the rationale someone else will be willing to buy it
for even more, is participating in a phenomenon known as the
a. hope theory.
b. greater fool theory.
c. goofy theory.
d. lamebrain theory.
ANSWER: b
56. The rationale behind the efficient markets hypothesis is that the drive for profits ensures that
a. most unexploited opportunities will be exhausted.
b. all unexploited opportunities will be exhausted.
c. people use most available recent information.
d. people buy only valuable stocks and bonds.
ANSWER: b
57. Market fundamentals are factors that have a
a. direct affect on future income streams of the financial instruments.
b. indirect affect on future income streams of the financial instruments.
c. negative influence on stock and bond prices.
d. major impact on bond prices but not on stock prices.
ANSWER: a
130
Chapter 9
58. The flow of funds is a social accounting system that divides the economy into a number of
sectors. The sectors include all of the following, except the
a. household sector.
b. tax sector.
c. government sector.
d. financial sector.
ANSWER: b
59. Sources of funds for any sector are
a. spending and accounting.
b. spending and taxing.
c. income and taxing.
d. income and borrowing.
ANSWER: d
60. Uses of funds for any sector are
a. past spending on financial instruments.
b. current spending and changes in financial instruments held.
c. future spending plans.
d. future consumption plans.
ANSWER: b
61. A sector where the combined surpluses of the SSUs are greater than the combined deficits of the
DSUs is a
a. surplus sector.
b. disciplined sector.
c. deficit sector.
d. spending sector.
ANSWER: a
62. A sector where the combined deficits of the DSUs are greater than the combined surpluses of the
SSUs is called a
a. consuming sector.
b. irrational sector.
c. surplus sector.
d. deficit sector.
ANSWER: d
63. Which of the following is false?
a. Short term interest rates are determined by income, the money supply, and expected
inflation.
b. Expected short term interest rates are determined by expected income, the expected money
supply, and expected inflation.
c. Prices of financial instruments adjust so that the expected value of the forecast is equal to the
optimal forecast given all the available information.
d. The expected return to owning stock is the dividend less any change in the price of the stock.
ANSWER: d
Market Efficiency
131
64. Which of the following is true?
a. In equilibrium, the risk-adjusted return to owning stock will be equal to the risk-adjusted
return to owning bonds.
b. The risk-adjusted return to owning stock is the nominal return less compensation for the
higher risk of owning stock.
c. In equilibrium, differences in returns on various financial instruments represent only
differences in risk and liquidity.
d. All of the above.
ANSWER: d
65. Which of the following is false with regards to adaptive expectations?
a. Adaptive expectations is backward looking.
b. Adaptive expectations makes use of all available information.
c. Adaptive expectations are formed as a weighted average of past values.
d. Adaptive expectations may give more recent values a greater weight in forming expectations.
ANSWER: b
66. Which of the following is false?
a. If information about a financial instrument is expected, then an announcement of the
information will have little or no effect on the instrument’s price.
b. An implication of the efficient markets hypothesis is that it is impossible to beat the market
(earn an above average return).
c. When interest rates change, there is no effect on default risk and therefore risk premiums are
unaffected.
d. Powerful mood swings of optimism or pessimism can sweep markets and become part of the
changing information that affects prices.
ANSWER: c
67. The _________________________ holds that the prices of all financial instruments reflect the
true fundamental value of the instruments.
a. efficient markets hypothesis
b. stronger version of the efficient markets hypothesis
c. weak version of the efficient markets hypothesis
d. rational expectations theory
ANSWER: b
68. The _________________________ holds that the prices of all financial instruments are based on
the optimal forecast arrived at by using all available information.
a. efficient markets hypothesis
b. stronger version of the efficient markets hypothesis
c. weak version of the efficient markets hypothesis
d. rational expectations theory
ANSWER: a
132
Chapter 9
69. The difference between the efficient markets hypothesis and the stronger version of the efficient
markets hypothesis is that
a. although both theories hold that financial prices are equal to optimal forecasts, the stronger
version holds that the optimal forecast is also the fundamental value of the financial
instrument.
b. the efficient markets hypothesis uses adaptive expectations while the stronger version uses
rational expectations.
c. according to the efficient markets hypothesis, prices are equal to optimal values only in
equilibrium, while according to the stronger version, prices are always equal to optimal
values.
d. according to the efficient markets hypothesis, prices are always equal to optimal values,
while according to the stronger version, prices are equal to optimal values only when markets
are in equilibrium.
ANSWER: a
70. Which of the following is false?
a. If the household, business, and government sectors are all deficit sectors, then the rest-of-theworld sector must be a surplus sector.
b. For any sectors, the uses of funds are current spending and changes in financial instruments
held.
c. For any sector, the sources of funds are current and past income.
d. The combined surpluses of the surplus sectors must equal the combined deficits of the deficit
sectors for the economy as a whole.
ANSWER: c