Skip to content

IAI Actuarial Core Principles · Economic Modelling · Rational expectations theory and the efficient markets hypothesis

A fund manager has beaten the Nifty 50 in each of the last four years. A client concludes the market is not efficient. Which response is the most defensible under the efficient markets hypothesis?

A short winning record among many managers is weak evidence, since some will outperform by chance. Any claim of skill must be tested after adjusting for risk and costs over a large sample, so one four-year record does not refute market efficiency.

  1. AAmong many managers, some will outperform by chance, so four years of outperformance is weak evidence and must be judged after costs and risk adjustmentCorrect
  2. BOutperformance for four years proves the strong form of efficiency
  3. CAny outperformance can only come from insider trading, so the manager should be reported
  4. DOutperformance shows the manager has a lower beta, so it must be skill
  5. Four years is enough to prove that all active managers beat the index

Explanation

With many managers, chance alone produces some with a good record, so a short record does not refute efficiency. Performance must be adjusted for risk (for example beta) and fees and tested over a large sample. The other options draw unjustified conclusions from a single record.

Did you get it right without looking?

One question tells you little. A timed set on Rational expectations theory and the efficient markets hypothesis shows your real accuracy, how long you take and where you lose marks.

Practise Rational expectations theory and the efficient markets hypothesisFree diagnostic mock

More Rational expectations theory and the efficient markets hypothesis questions