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CMA Final · Strategic Financial Management · Efficient Market Hypothesis

A fund manager, Ms. Iyer, tests 40 independent trading rules on past data at a 5% significance level, assuming in truth none has any predictive power (markets efficient). How many rules would be expected to appear significantly profitable purely by chance, and which concept does this illustrate?

About 2 rules would look profitable by chance, since 40 multiplied by 5% equals 2. This illustrates data mining or data snooping bias, where testing many rules produces spurious patterns. Such apparent profits do not prove that the market is inefficient.

  1. A2 rules; data mining (spurious pattern) biasCorrect
  2. B5 rules; semi-strong inefficiency
  3. C2 rules; strong form inefficiency
  4. D0.5 rules; weak form inefficiency

Explanation

Expected false positives = 40 × 0.05 = 2 rules. Finding apparently profitable rules among many tested is the data mining or data snooping problem, not evidence of inefficiency. The option of 5 mistakes the percentage for a count of rules, and 0.5 divides instead of multiplying.

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