Horace Lance, CFA, states that the efficient market hypothesis and its rigorous testing have yielded many benefits to investors. Lance makes the following statements concerning an efficient market.
Statement I:The Efficient Market Hypothesis (EMH) assumes that changes in security prices occur in a random fashion.
Statement 2:Portfolio managers should reduce trading turnover of client accounts.
Statement 3:The EMH establishes that the expected rate of return is the risk-free rate plus a risk premium that is the security beta times the market price of risk.
Which of Lance's statements is least likely to be correct?
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A. B. C.C
Statement 3 is the least likely to be correct.
Statement 1: The Efficient Market Hypothesis (EMH) assumes that changes in security prices occur in a random fashion. This statement is consistent with the EMH. According to the EMH, stock prices reflect all available information, and any new information is quickly and accurately incorporated into the stock price, making it difficult to consistently predict future price movements. This implies that changes in security prices are random and not predictable based on past information.
Statement 2: Portfolio managers should reduce trading turnover of client accounts. This statement is also consistent with the principles of efficient markets. The EMH suggests that it is difficult for investors to consistently outperform the market by actively buying and selling securities. Therefore, reducing trading turnover and adopting a more passive investment strategy, such as holding a diversified portfolio for the long term, is often recommended.
Statement 3: The EMH establishes that the expected rate of return is the risk-free rate plus a risk premium that is the security beta times the market price of risk. This statement is not accurate. The EMH does not establish this formula for expected rate of return. Instead, the EMH suggests that in an efficient market, the expected rate of return for a security should be equal to its required rate of return, which incorporates the risk-free rate and a risk premium. However, the specific formula mentioned in Statement 3, involving the security beta and the market price of risk, is not a direct implication of the EMH.
Therefore, the least likely correct statement among the three is Statement 3 (C).