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

An actuary tests weak-form efficiency in the Indian equity market by examining whether past daily returns on the Nifty 50 can be used to earn abnormal profits. Which finding would be most clearly inconsistent with weak-form efficiency?

Significant serial correlation that supports a trading rule earning abnormal returns after costs contradicts weak-form efficiency, because it shows past prices can predict future returns. The other findings support efficiency or concern different forms, such as strong-form insider information.

  1. ADaily index returns show statistically significant positive serial correlation, and a trading rule based on it yields abnormal returns after transaction costsCorrect
  2. BDaily index returns show zero serial correlation at all lags
  3. CFund managers with access to inside information earn abnormal returns
  4. DShare prices react quickly to the announcement of quarterly results
  5. Returns on small-cap shares exceed those on large-cap shares by an amount explained by beta

Explanation

Weak-form efficiency says past price data cannot be used to earn abnormal returns. A profitable rule based on serial correlation, net of costs, contradicts this. Zero correlation supports it, inside information relates to the strong form, and quick reaction to results supports semi-strong efficiency.

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