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Introduction to Corporate Finance, Second Edition

Booth, Cleary

Chapter 10: Market Efficiency Multiple Choice Questions 1. Section: 10.1 The Importance of Market Efficiency Learning Objective: 10.1 Level of difficulty: Medium Solution: D 2. Section: 10.3 The Efficient Market Hypothesis (EMH) Learning Objective: 10.3 Level of difficulty: Easy Solution: C. The three forms of EMH are weak, semi-strong (not semi-weak), and strong. 3. Section: 10.3 The Efficient Market Hypothesis (EMH) Learning Objective: 10.3 Level of difficulty: Medium Solution: C 4. Section: 10.6 Implications of Market Efficiency Learning Objective: 10.6 Level of difficulty: Medium Solution: D. Insider information is considered private information, which is only reflected in the strong form of EMH. Semi-strong form of EMH includes all publicly known and available information. Therefore, trading on past and current published stock price changes, trading volume and earnings projections is futile because that information is all reflected in the stock price assuming semi-strong form of EMH. Please note that insider trading is not permitted in order to protect the general investing public. 5. Section: 10.3 The Efficient Market Hypothesis (EMH) Learning Objective: 10.3 Level of difficulty: Medium Solution: B. Strong form of EMH encompasses both weak and semi-strong form of EMH. Semistrong form of EMH encompasses weak form of EMH. 6. Section: 10.1 The Importance of Market Efficiency Learning Objective: 10.1 Step 1: Concept of market efficiency Level of difficulty: Medium Solution: C 7. Section: 10.4 Empirical Evidence Regarding Market Efficiency Learning Objective: 10.4 Level of difficulty: Medium Solution: C 8. Section: 10.2 Defining Market Efficiency

Solutions Manual 1 Chapter 10 Copyright 2010 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Introduction to Corporate Finance, Second Edition

Booth, Cleary

Learning Objective: 10.2 Level of difficulty: Medium Solution: D 9. Section: 10.4 Empirical Evidence Regarding Market Efficiency Learning Objective: 10.4 Level of difficulty: Medium Solution: D 10. Section: 10.4 Empirical Evidence Regarding Market Efficiency Learning Objective: 10.4 Level of difficulty: Medium Solution: D 11. Section: 10.6 Implications of Market Efficiency Learning Objective: 10.6 Level of difficulty: Medium Solution: B. The investor should short sell the stock because stocks displaying superior performance over the past three to five years tend to under-perform in the future if the investor is exploiting a contrarian strategy. 12. Section: 10.4 Empirical Evidence Regarding Market Efficiency Learning Objective: 10.4 Level of difficulty: Difficult Solution: C. Value stocks have consistently outperformed growth stocks. 13. Section: 10.4 Empirical Evidence Regarding Market Efficiency Learning Objective: 10.4 Level of difficulty: Difficult Solution: D. The others are all characteristics of value stocks. 14. Section: 10.6 Implications of Market Efficiency Learning Objective: 10.6 Level of difficulty: Difficult Solution: A. It supports semi-strong form of EMH and therefore supports weak form of EMH because investors could not earn abnormal returns after the information is made public. However, it contradicts strong form of EMH because some investors profit from the private information prior to the announcement. 15. Section: 10.6 Implications of Market Efficiency Learning Objective: 10.6 Level of difficulty: Medium Solution: D 16. Section: 10.4 Empirical Evidence Regarding Market Efficiency Learning Objective: 10.4

Solutions Manual 2 Chapter 10 Copyright 2010 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Introduction to Corporate Finance, Second Edition

Booth, Cleary

Level of difficulty: Medium Solution: C Practice Problems 17. Section: 10.1 The Importance of Market Efficiency Learning Objective: 10.1 Level of difficulty: Easy Solution: a. This market is likely to suffer from operational inefficiency due to high transaction costs and frequent loss of records. b. This market is likely to suffer from allocational inefficiency as firms have a limited range of securities that they can issue (i.e., limited ways to share risk). c. This market is likely to suffer from informational inefficiency as the stock prices cannot quickly respond to news due to trading limitations. 18. Section: 10.1 The Importance of Market Efficiency Learning Objective: 10.1 Level of difficulty: Easy Solution: a. Yes. All I have to do to consistently beat the market is do the opposite of what my broker advises. b. No. Im very slow on doing the analysis and there is no reason to expect that every other investor interested in Canada Bank wont have done their analysis before me. I would expect the stock price to already reflect the information contained in the financial statements and therefore, it is no surprise that I rarely make money. This is an example of semi-strong form efficiency. c. Yes. Im trading based on past price behaviour. If the market is weak form efficient, I should not be able to consistently make money (on a risk adjusted basis). d. Yes. The CEO has access to private information and the fact that nearly all of the time he is making money trading on private information suggests that the market is strong form inefficient. e. No. The fact that a skillful analysis completed before anyone else does not suggest that the market is semi-strong form inefficient. Rather, the money I make is a fair compensation for my skill and speed. 19. Section: 10.4 Empirical Evidence Regarding Market Efficiency Learning Objective: 10.4 Level of difficulty: Easy Solution: Statistical significance simply asks whether or not the observations are likely under the null hypothesis. Economic significance, in contrast, asks if the observed relationship is large enough that you can make money from it. For example, a February temperature of -25 C might be significantly warmer than normal; but, it is still too cold for shorts and a t-shirt. 20. Section: 10.2 Defining Market Efficiency Learning Objective: 10.2 Level of difficulty: Easy Solution: A sell-side analyst works for the investment banks and brokerage houses who are trying to sell the securities; consequently they are most likely to offer their recommendations

Solutions Manual 3 Chapter 10 Copyright 2010 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Introduction to Corporate Finance, Second Edition

Booth, Cleary

to the public. In contrast, the buy-side analyst works for an investor (usually a large institution) and will want to keep their recommendations private. 21. Section: 10.4 Empirical Evidence Regarding Market Efficiency Learning Objective: 10.4 Level of difficulty: Medium Solution: To test the weak form, one way is to test if price changes are independent of each other. One common test is the serial correlations test, which measures the correlation between successive price changes for various lags. Another method is the runs test, which classifies each price change by its sign, and tests if there are any runs in the series of signs. To test the semi-strong form, one way is to test the speed of adjustment of stock prices to a new information announcement, using an event study. Another way is to examine the performance of investors to see if they consistently generate abnormal risk-adjusted returns by using publicly available information. 22. Section: 10.2 Defining Market Efficiency Learning Objective: 10.2 Level of difficulty: Medium Solution: Assumption #1: A large number of rational, profit-maximizing investors exist who actively participate in the market by analyzing, valuing, and trading securities. The markets are assumed to be competitive. Assumption #2: Information is costless and widely available to market participants at the same time. Assumption #3: Information arrives randomly and therefore announcements are not related to one another. Assumption #4: Investors react quickly and fully to the new information, which is reflected in stock prices. 23. Section: 10.4 Empirical Evidence Regarding Market Efficiency Learning Objective: 10.4 Level of difficulty: Medium Solution: The momentum effect refers to the fact that stocks that have experienced high returns in previous three to 12 month periods tend to outperform in the subsequent three to 12 month periods. It contradicts weak form efficiency. 24. Section: 10.4 Empirical Evidence Regarding Market Efficiency Learning Objective: 10.4 Level of difficulty: Medium Solution: Weak form and semi-strong form efficiency are both well-supported. It is reasonable to conclude that markets are weak-form efficient; however, more contradictory evidence exists for the semi-strong form than for the weak form. Strong form efficiency is not very well supported by the evidence, and it is reasonable to conclude that markets are not strong form efficient in the strictest sense. 25. Section: 10.6 Implications of Market Efficiency

Solutions Manual 4 Chapter 10 Copyright 2010 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Introduction to Corporate Finance, Second Edition

Booth, Cleary

Learning Objective: 10.6 Level of difficulty: Medium Solution: The evidence may suggest that on average diet pill stocks do better in the spring, but she needs to keep in mind several things: On average does not mean always. There is still likely to be considerable variation in the performance of diet pill stocks in the spring. The general evidence indicates that trying to time the market is not successful. What will be the impact on the new product if she waits to raise the capital? For example, possible leaks of information? 26. Section: 10.6 Implications of Market Efficiency Learning Objective: 10.6 Level of difficulty: Medium Solution: Not necessarily. The Board should consider what other information or rumours are circulating. Perhaps the stock has risen sharply because another company is interested in buying UYT, which is no reason why the CEO should get a raise. 27. Section: 10.6 Implications of Market Efficiency Learning Objective: 10.6 Level of difficulty: Medium Solution: First: if the project is really secret (i.e. no one outside the company knows anything about it) then we wouldnt expect the market to react unless it was strong form efficient. As we know that the markets are not strong form efficient, it is not surprising that there has been no reaction. Second, if the project is not really all that secret (i.e. people outside the company know all about it) then we wouldnt expect much of a reaction. After all, what is new? The market will only react to new information not old information. 28. Section: 10.6 Implications of Market Efficiency Learning Objective: 10.6 Level of difficulty: Difficult Solution: For investors, technical and fundamental analysis both tend to be futile since weak form and semi-strong form of efficiency are both well-supported. Active trading strategies are unlikely to outperform passive portfolio management strategies on a consistent basis. Investors should focus on diversifying their portfolios and defining expected returns and acceptable risk levels. For corporate officers, it is unimportant to time security issues and repurchases. Moreover, they should monitor the market price of the firms security, which reflects market opinion of the companys outlook. 29. Section: 10.6 Implications of Market Efficiency Learning Objective: 10.6 Level of difficulty: Difficult Solution:

Solutions Manual 5 Chapter 10 Copyright 2010 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Introduction to Corporate Finance, Second Edition

Booth, Cleary

a. The markets are full of investors who are constantly analyzing a firms prospects (i.e., growth potential, general economic conditions, actions of competitors and suppliers etc.) and consequently, if the market is semi-strong form efficient, we expect that the stock price will, on average, reflect the prospects of a firm. Therefore, if the investors are becoming more pessimistic about the firms prospects, they will be selling and causing the stock price to decline. b. No, given the beta and the markets fall (assuming that the risk free rate hasnt changed) I would have expected the firms stock price to fall 6 percent. The fact that it has fallen less than the predicted 6 percent is actually relatively good news. 30. Section: 10.6 Implications of Market Efficiency Learning Objective: 10.6 Level of difficulty: Difficult Solution: (N.B. If you purchase the dividend on or after the ex-dividend date, you are no longer entitled to the dividend.) a. If the announcement is a surprise, I would expect a reaction on March 15. The sign of the reaction will depend on how the market interprets the news: does starting to pay dividends indicate that the firm has stopped its high growth period (negative) or does it mean that the firm is confident of high future cash flows (positive news)? In general, I would expect a positive reaction. b. I would not expect a reaction; everyone already knows this so the announcement provides no new information. c. The day that the firm goes ex-dividend I expect the stock price to drop by the amount of the dividend. Note that this is not a change in price due to information; everyone knows when the stock will go ex-dividend. Rather, it is a reaction to the fact that the buyer of the stock will no longer be entitled to the dividend and therefore is not willing to pay for it. 31. Section: 10.6 Implications of Market Efficiency Learning Objective: 10.6 Level of difficulty: Difficult Solution: a. The announcement is bad news that the market did not anticipate and therefore the market has to revalue the company. As there was fraud involved, you would expect that the financial statements have been massaged to look better than they should and the value of the firm should drop. Also, now the firm has to look for a new CEO which is always a difficult time for a company. b. The market already anticipated the event. Perhaps there had already been rumours and previous restatements of the financial statements. c. It is actually not uncommon for a stock to rise on bad news. The usual interpretation is that the market sees the news as not as bad as anticipated. For example, the market has been anticipating that the CEO will be arrested, the financials will be restated and the firm will announce that it has been hit by a massive lawsuit for defective steam engines. However, when the bad news is announced, the massive lawsuit is for $1,000 not $1 billion. Therefore, the news wasnt as bad as expected. An alternative interpretation is that the announcement of the actions indicates that the firm has recognized the problem and is doing something about it.

Solutions Manual 6 Chapter 10 Copyright 2010 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Introduction to Corporate Finance, Second Edition

Booth, Cleary

32. Section: 10.6 Implications of Market Efficiency Learning Objective: 10.6 Level of difficulty: Medium The efficiency of the market is based upon the continuing services of the analysts and portfolio managers to actively scout the market. If these players are removed from the market, the prices will cease to reflect all the available information. This will consequently lead to markets becoming inefficient. 33. Section: 10.5 Behavioural Finance Learning Objective: 10.5 Level of difficulty: Difficult Solution: a. This is an example where human emotions, more than fundamentals, of finance are at play in the market. At the time the incorrect news hit the market, the atmosphere was already volatile with the Lehman firm going bankrupt and Merrill Lynch in trouble. Investors had seen their investments in Lehman drop from $65 per share to 26 cents a share. The news of another big one falling must have caused a panic sale leading to the massive drop in the share prices. b. This is an open-ended question designed to force students to think outside the box. A possible explanation proposed by current research in the field is that investors tend to be more sceptic of bad news than of good news. In the above example, investors react strongly to the bad news by trying to sell the United shares, thereby pushing the prices down. Even after the truth is revealed, the scepticism lingers amongst the investors, resulting in relatively slower recovery. c. Yes, at least in the short run. The prices are seemingly driven by non-informational factors. 34. Section: 10.5 Behavioural Finance Learning Objective: 10.5 Level of difficulty: Difficult Solution: Investors are more likely to be overconfident when the economy is booming. Overconfidence often results from past success, even though the past result might have been reflective of the general state of the economy or even a result of random movements in the market. During a state of boom, investors often attribute the resulting gains to their better understanding of the market, which leads to overconfidence. 35. Section: 10.5 Behavioural Finance Learning Objective: 10.5 Level of difficulty: Difficult Solution: Investors tend to become more overconfident as they accumulate more information and develop seeming familiarity with a given financial asset. To that extent, access to Internet will, in general, lead to more overconfidence amongst investors.

Solutions Manual 7 Chapter 10 Copyright 2010 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.