Practice Question
Consider the following scenarios:
I. You use a simple trading rule: buy every stock that has gone up three days in a row, hold the stock for two (2) days and then sell. On average, you make an unusual profit using this strategy.
II. On average, analysts who analyze the financial reports of AMC do not make unusual profits using this strategy.
Choose the following statement that is the most correct:
A) I is consistent with weak-form market efficiency while II is consistent with semi-strong form efficiency
B) I is consistent with weak-form market efficiency while II is not consistent with semi-strong form efficiency
C) I is not consistent with weak-form market efficiency while II is consistent with semi-strong form efficiency
D) Both I and II are consistent with Weak form market efficiency
E) I is not consistent with weak-form market efficiency while II is consistent with strong form efficiency
You’re using a trading rule based purely on historical price movements (buy stocks that have gone up three days in a row). This strategy exploits patterns in past stock prices. According to the weak-form market efficiency, all information from past prices is already reflected in current prices. Thus, no trading strategy based solely on past prices should consistently yield abnormal returns.
Since you are earning an unusual profit using this price-based rule, that contradicts weak-form efficiency.
Analysts are relying on publicly available information (financial statements). Under semi-strong form market efficiency, all public information is already incorporated into stock prices. Therefore, investors or analysts should not be able to consistently earn excess returns by analyzing such information.
Since analysts are not earning unusual profits, this supports semi-strong form efficiency.
Scenario I contradicts weak-form efficiency. Scenario II is consistent with semi-strong form efficiency.
Final Answer: C) I is not consistent with weak-form market efficiency while II is consistent with semi-strong form efficiency.