Finance 406
What are the many questions would you ask before determining this is indeed a violation of the EMH? (bullet points are fine)
(How) was risk adjusted for? What was the length of the sample (1 year?, 10 years?)? How many firms were in the 'clever ticker' portfolio? What portfolio/index represented the 'market'? Do the results hold for various subperiods / economic cycles? Are the results unique to a sector (e.g., consumer)? (How) are transactions costs accounted for? Does this strategy seem to work in other markets / countries? How were 'clever' tickers determined?
Instead of selling the T-bill, you decide to hold it to maturity. What will your annualized HPR be?
HPR = (P1 - P0) / P0 = ($10,000 - $9,911.22) / $9,911.22 annualized HPR = HPR 365 / 170 = 1.92% multiply the HPR by 365/170 since the bill was held to maturity You could have also saved yourself some effort (or double-checked your answer) by realizing that I was just asking you for the BEY which is given in the quote as 1.92%.
What is meant by 'reversal' in returns and how does this relate to the Efficient Market Hypothesis (EMH)? Explain in detail.
Reversal or a negative serial correlation in returns indicates that above-average (or positive) returns tend to be followed by below-average (or negative) returns in the next period and below-average (or negative) returns tend to be followed by above-average (or positive) returns. The ability to use past returns to predict future returns would be a violation of the weak-form EMH since past returns are considered weak-form information.
What is the risk for Dealer D in placing such a high bid?
The higher the bid, the higher the likelihood of NOT receiving an allocation of T-bills. If these have already been promised to customers, they must be purchased from Dealers who were allocated T-bills at the auction or in the secondary market.
Explain how and why the price-to-book ratio could be used to classify a stock as a 'growth' stock or a 'value' stock.
The price-to-book ratio is the market price of equity (stock) divided by the book (accounting) value of equity for the same firm. The price is forward looking and considers the market's expectations of future growth opportunities. Book value is generally backward looking and summarizes the firm's accounting performance up to the present. The higher the price relative to the book value, the higher the price-to-book ratio and therefore this might be an indication that the firm is expected to grow more in the future than it did in the past.
Explain why a low price-to-book ratio might be an indication of a stock of a firm in financial distress rather than a 'value' stock.
If a firm experiences a severe adverse event (e.g., declares bankruptcy, product recall, etc.), the market price of the stock would likely decrease to immediately reflect the impact of this event of the firm's future. In contrast, the first time any of the information related to the event will be reflected in the book value of equity will be the next time the firm releases its financial statements. This would tend to cause the price-to-book ratio to decrease immediately, reflecting the firm's financial distress rather than indicating a 'value' firm.
After weighing the evidence, you conclude the semistrong-form of the Efficient Market Hypothesis (EMH) is true. What does this imply about your belief as to whether or not the weak-form EMH is true? Explain.
If the semistrong-form EMH is true, this implies that you cannot consistently 'beat the market' using any type of public information. This implies that you also could not 'beat the market' using weak-form information such as past prices, returns, or volume. This would mean that the weak-form EMH is also true.
After weighing the evidence, you conclude the semistrong-form of the Efficient Market Hypothesis (EMH) is true. What does this imply about your belief as to whether or not the weak-form EMH is true? Briefly explain and also provide a definition of the weak-form EMH.
If the semistrong-form of the EMH is true, the weak-form EMH must also be true. If the semistrong form is true, it means that the market incorporates all public information; this means that the market must also incorporate low-cost public information since this is a subset of public information. This is the definition of the weak-form EMH: the market incorporates all low-cost public information such as past prices, returns, and trading volume. Similarly, if the semistrong-form EMH is true, it implies that you cannot 'beat the market' consistently by using any kind of public information. This implies that you could not beat the market using a subset of that information such as past prices, returns, or trading volume. This implies that the weak-form EMH is true.
After weighing the evidence, you conclude the strong-form of the Efficient Market Hypothesis (EMH) is false. What does this imply about your belief as to whether or not the semistrong-form EMH is true? Explain.
If the strong-form EMH is false, this means that there is some information that is NOT reflected in prices. However, we do not know if this information is public or private. Therefore, we cannot say anything about the semistrong-form EMH being true or false simply based on the fact that the strong-form EMH is false.
You observe the following quote for a T-bill with a face value of $10,000: Mar 5 20 170 1.89 1.88 +0.01 1.92 Based on this quote, how much would you pay to buy this T-bill from a dealer? Express your answer to 2 decimal places.
P = $10,000 × [1 - rBD × (n / 360)] P = $10,000 × [1 - 0.0188 × (170 / 360)] P = $9,911.22 As an investor you would buy at the 'ask' rate of 1.88%
If interest rates do not change, at what price will you be able to sell the T-bill in 20 days?
P = $10,000 × [1 - rBD × (n / 360)] P = $10,000 × [1 - 0.0189×(150 / 360)] P = $9,921.25 As an investor you would sell at the 'bid' rate of 1.89% Since 20 days have elapsed, n = 170 - 20 = 150.
Why might a positive serial correlation of returns (rho>0) be evidence against the weak-form of the Efficient Market Hypothesis (EMH)? Explain.
Similar to part a., a serial correlation that is not 0 would imply that you could predict future returns only using past returns, which are weak-form information. This is inconsistent with the weak-form EMH that says that past prices, returns, and volume are already incorporated in current prices and thus could not be used to predict future returns or price movements.
Even though interest rates did not change, what are the two reasons why your answers to a. and b. are different?
Since the T-bill is a discount security, if interest rates do not change, it will increase in value as it approaches maturity. The difference in the 'bid' and 'ask' rates will also result in different prices.
A recently published article in The Quarterly Review of Economics and Finance showed that a portfolio of stocks with 'clever' tickers (e.g., Cheesecake Factory (CAKE), Anheuser Busch (BUD), Papa John's Pizza (PZZA)) outperformed the market by 8% per year. 5) Explain what form of the Efficient Market Hypothesis (EMH) this relates to.
This could be a violation of the semistrong-form EMH since ticker symbols are public information but are not past prices, returns, or trading volume. If you stated that tickers are low-cost public information (like past prices), this could also be a violation of the weak-form EMH. In either case, the study seems to imply that you could 'beat the market' by simply selecting a portfolio based on ticker symbols and would therefore violate the EMH.
Explain why a low price-to-book ratio might be an indication of a stock of a firm in financial distress rather than a 'value' stock.
Typically, a low P/B ratio indicates that a firm's future will resemble its past and be categorized as a 'value' stock. However, consider a firm where there is bad news about the firm's future prospects (e.g., a bankruptcy filing). This will be immediately reflected in the market price (P) as the price is forward looking, causing the numerator in the P/B ratio to decrease. The bad news will only be reflected in the denominator when the firm's accounting statements incorporate this bad news. Most accounting numbers are not forward looking and therefore the P/B ratio will decrease and the firm might look like a 'value' stock but in reality be a firm in severe financial distress and therefore be expected to have higher returns in the future to compensate investors for this increased risk.
