FIN4504 CH.8 HW Exam 2

Assume that a company announces an unexpectedly large cash dividend to its shareholders. In an efficient market without information leakage, one might expect: a. An abnormal price change at the announcement. b. An abnormal price increase before the announcement. c. An abnormal price decrease after the announcement. d. No abnormal price change before or after the announcement.

A, An abnormal price change at the announcement. The information should be absorbed instantly.

Some scholars contend that professional managers are incapable of outperforming the market. Others come to an opposite conclusion. Compare and contrast the assumptions about the stock market that support (a) passive portfolio management and (b) active portfolio management.

Assumptions supporting passive management are: a. informational efficiency b. primacy of diversification motives Active management is supported by the opposite assumptions, in particular, that pockets of market inefficiency exist.

Which of the following most appears to contradict the proposition that the stock market is weakly efficient? Explain. a. Over 25% of mutual funds outperform the market on average. b. Insiders earn abnormal trading profits. c. Every January, the stock market earns abnormal returns.

C, Every January, the stock market earns abnormal returns. Weak market efficiency is concerned with information in past returns. If you can predict that January returns yield high abnormal returns from past returns that contradicts weak form efficiency.

Which of the following observations would provide evidence against the semistrong form of the efficient market theory? Explain. a. Mutual fund managers do not on average make superior returns. b. You cannot make superior profits by buying (or selling) stocks after the announcement of an abnormal rise in dividends. c. Low P/E stocks tend to have positive abnormal returns. d. In any year approximately 50% of pension funds outperform the market.

C, Low P/E stocks tend to have positive abnormal returns. The P/E ratio is public information so this observation would provide evidence against the semi-strong form of the efficient market theory.

Suppose that, after conducting an analysis of past stock prices, you come up with the following observations. Which would appear to contradict the weak form of the efficient market hypothesis? Explain. a. The average rate of return is significantly greater than zero. b. The correlation between the return during a given week and the return during the following week is zero. c. One could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall. d. One could have made higher-than-average capital gains by holding stocks with low dividend yields.

C, One could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall. This is a classic filter rule, which would appear to contradict the weak form of the efficient market hypothesis.

Which one of the following would provide evidence against the semistrong form of the efficient market theory? a. About 50% of pension funds outperform the market in any year. b. You cannot make abnormal profits by buying stocks after an announcement of strong earnings. c. Trend analysis is worthless in forecasting stock prices. d. Low P/E stocks tend to have positive abnormal returns over the long run.

D, Low P/E stocks tend to have positive abnormal returns over the long run. P/E ratios are public knowledge. So if you can pick stocks based on P/E ratios and earn abnormal returns, there is a violation of the semi-strong form market efficiency.

A market anomaly refers to: a. An exogenous shock to the market that is sharp but not persistent. b. A price or volume event that is inconsistent with historical price or volume trends. c. A trading or pricing structure that interferes with efficient buying and selling of securities. d. Price behavior that differs from the behavior predicted by the efficient market hypothesis.

D, Price behavior that differs from the behavior predicted by the efficient market hypothesis. Unexpected results are by definition an anomaly.

Good News, Inc., just announced an increase in its annual earnings, yet its stock price fell. Is there a rational explanation for this phenomenon?

Even though the annual earnings have increased, the market was expecting an even better increase. The report for the market was thus a disappointment. (A good example: Yahoo reported record high earnings in January 2006, but the earnings per share was one cent under the consensus analyst expectation. The stock price dropped by 12.29%!)

We know that the market should respond positively to good news and that good-news events such as the coming end of a recession can be predicted with at least some accuracy. Why, then, can we not predict that the market will go up as the economy recovers?

If you can predict the end of a recession, so can other market players. The information that the recession will end is already incorporated into market prices.

Steady Growth Industries has never missed a dividend payment in its 94-year history. Does this make it more attractive to you as a possible purchase for your stock portfolio?

No, it is not more attractive as a possible purchase. Any value associated with dividend predictability is already reflected in the stock price.

A successful firm like Microsoft has consistently generated large profits for years. Is this a violation of the EMH?

No, this is not a violation of the EMH. Microsoft's continuing large profits do not imply that stock market investors who purchased Microsoft shares after its success already was evident would have earned a high return on their investments.

If prices are as likely to increase as decrease, why do investors earn positive returns from the market on average?

Over the long haul, there is an expected upward drift in stock prices based on their fair expected rates of return. The fair expected return over any single day is very small (e.g., 12% per year is only about 0.03% per day), so that on any day the price is virtually equally likely to rise or fall. However, over longer periods, the small expected daily returns cumulate, and upward moves are indeed more likely than downward ones.

Examine the accompanying figure, which presents cumulative abnormal returns both before and after dates on which insiders buy or sell shares in their firms. How do you interpret this figure? What are we to make of the pattern of CARs before and after the event date?

The negative abnormal returns (downward drift in CAR) just prior to stock purchases suggest that insiders deferred their purchases until after bad news was released to the public. This is evidence of valuable inside information. The positive abnormal returns after purchase suggest insider purchases in anticipation of good news. The analysis is symmetric for insider sales.

"If all securities are fairly priced, all must offer equal expected rates of return." Comment.

The phrase would be correct if it were modified to say "expected risk adjusted returns." Securities all have the same risk adjusted expected return, however, actual results can and do vary. Unknown events cause certain securities to outperform others. This is not known in advance so expectations are set by known information.

"If the business cycle is predictable, and a stock has a positive beta, the stock's returns also must be predictable." Respond.

While positive beta stocks respond well to favorable new information about the economy's progress through the business cycle, these should not show abnormal returns around already anticipated events. If a recovery, for example, is already anticipated, the actual recovery is not news. The stock price should already reflect the coming recovery.

You know that firm XYZ is very poorly run. On a scale of 1 (worst) to 10 (best), you would give it a score of 3. The market consensus evaluation is that the management score is only 2. Should you buy or sell the stock?

You should buy the stock, since you think the management is better than what the market thinks as a whole.

You are a portfolio manager meeting a client. During the conversation that follows your formal review of her account, your client asks the following question: My grandson, who is studying investments, tells me that one of the best ways to make money in the stock market is to buy the stocks of small-capitalization firms late in December and to sell the stocks one month later. What is he talking about? a. Identify the apparent market anomalies that would justify the proposed strategy. b. Explain why you believe such a strategy might or might not work in the future.

a) The grandson is recommending taking advantage of (i) the small firm anomaly and (ii) the January anomaly. In fact, this seems to be one anomaly: the small-firm-in-January anomaly. b) (i) Concentration of one's portfolio in stocks having very similar attributes may expose the portfolio to more risk than is desirable. The strategy limits the potential for diversification. (ii) Even if the study results are correct as described, each such study covers a specific time period. There is no assurance that future time periods would yield similar results. (iii) After the results of the studies became publicly known, investment decisions might nullify these relationships. If these firms in fact offered investment bargains, their prices may be bid up to reflect the now-known opportunity.

Which of the following phenomena would be either consistent with or a violation of the efficient market hypothesis? Explain briefly. a. Nearly half of all professionally managed mutual funds are able to outperform the S&P 500 in a typical year. b. Money managers who outperform the market (on a risk-adjusted basis) in one year are likely to outperform in the following year. c. Stock prices tend to be predictably more volatile in January than in other months. d. Stock prices of companies that announce increased earnings in January tend to outperform the market in February. e. Stocks that perform well in one week perform poorly in the following week.

a. Consistent. Half of all managers should outperform the market based on pure luck in any year. b. Violation. This would be the basis for an "easy money" rule: simply invest with last year's best managers. c. Consistent. Predictable volatility does not convey a means to earn abnormal returns. d. Violation. The abnormal performance ought to occur in January, when the increased earnings are announced. e. Violation. Reversals offer a means to earn easy money: simply buy last week's losers.