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

Evidence shows that a stock's price rises steadily for several weeks after a favourable earnings announcement, allowing traders to earn abnormal returns using only the public announcement. Which conclusion is most appropriate?

The pattern contradicts the semi-strong form, because traders earn abnormal returns using only public announcement information, meaning prices did not adjust fully and quickly to it. Since the strong form encompasses public information, it fails too.

  1. AThe semi-strong form of the efficient markets hypothesis is contradictedCorrect
  2. BThe weak form of the hypothesis is contradicted but the semi-strong form is not
  3. CThe strong form holds but the weak form does not
  4. DAll three forms of the hypothesis are confirmed
  5. Only the strong form is contradicted

Explanation

If trading on public information after its release yields abnormal returns, prices did not adjust fully and quickly to public information, which violates semi-strong efficiency. Since the strong form includes public information, it is also violated. The option saying the weak form fails alone is wrong because the data used are announcements, not past prices.

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