Brad Rich uses an investment strategy that assumes stock prices will not reflect quarterly earnings surprises as quickly as suggested by the efficient market hypothesis. Rich believes stocks will earn positive abnormal rates of return over the six months following an earnings surprise. Which form of the efficient market hypothesis would this violate?
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A. B. C.C
Brad Rich's investment strategy assumes that stock prices will not reflect quarterly earnings surprises as quickly as suggested by the efficient market hypothesis. The efficient market hypothesis (EMH) is a theory that states that financial markets are efficient and that prices of financial assets reflect all available information. There are three forms of the EMH: weak form, semistrong form, and strong form.
Weak Form Efficient Market Hypothesis: The weak form of the EMH states that stock prices already reflect all historical price and volume information, including past trading patterns and returns. In other words, this form assumes that it is impossible to consistently earn abnormal returns by analyzing historical market data. If Brad's investment strategy violates the weak form, it means he believes it is possible to predict future stock returns based on historical price and volume information. This would imply that historical patterns can be used to earn abnormal rates of return.
Semistrong Form Efficient Market Hypothesis: The semistrong form of the EMH goes beyond the weak form by stating that stock prices reflect all publicly available information, including historical data, financial statements, news, and other relevant information. If Brad's investment strategy violates the semistrong form, it means he believes it is possible to earn abnormal returns by analyzing publicly available information, such as quarterly earnings surprises. He assumes that stock prices do not adjust immediately and completely to reflect this new information, and therefore, there is an opportunity to earn positive abnormal rates of return over the six months following an earnings surprise.
Strong Form Efficient Market Hypothesis: The strong form of the EMH is the most stringent form and states that stock prices reflect all information, whether it is public or private. If Brad's investment strategy violated the strong form, it would mean that he believes it is possible to earn abnormal returns even when considering all available information, including insider information. This would imply that he can consistently outperform the market by having access to superior information.
Based on the given information, Brad Rich's investment strategy violates the semistrong form of the efficient market hypothesis (Option C). He assumes that stock prices will not reflect quarterly earnings surprises as quickly as suggested by the EMH, and therefore, he believes stocks will earn positive abnormal rates of return over the six months following an earnings surprise. This implies that he believes there is an opportunity to exploit publicly available information and earn abnormal returns, contradicting the idea that stock prices already reflect all available information.