IB253 Principles of Finance 1

Seminar 7, Autumn Term

IB253 Principles of Finance 1

Seminar 7, Autumn Term

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Problems
Theory T1. Which form of the Efficient Markets Hypothesis is upheld if security prices reflect: (a) (b) (c) (d) a firms quarterly earnings report? data released by the Government regarding the money supply? information released by the Financial Services Authority on insider trading? confidential discussions of a firms board of directors on dividend policy? E3. FFJR interpreted their results as evidence in support of the Efficient Markets Hypothesis. Do their results support a particular form of the EMH?

Market Efficiency

Evidence E1. What are the main steps in conducting an event study such as that performed by Fama, Fisher, Jensen & Roll (1969)?

All of the problems on this sheet are examinable. Attempt T3, T4, T5, T8, E2, E3, E4 and E7 in preparation for the seminar in Week 9.

E2. Were there any defects in the FFJR (1969) study? Explain.

T2.

If you believe that the market is semi-strong-form efficient, do you necessarily believe that the market is weak-form efficient as well? Is the converse true? Explain.

E4. The FFJR study focuses on the stock-market reaction to stock splits. Since stock splits do not alter the proportion of the company that is held by each investor, one could argue that shareholders should be unconcerned with stock splits. Why, then, might a stock split be considered to be an important event?

T3. If the market is strong-form efficient, is there any point in gathering and analysing data about companies?

E5. Rendleman, Jones & Latan (1982) focus on the stock-market reaction to earnings data. What is the specific event around which RJL take their measurements? What evidence does their study provide in support of the Efficient Markets Hypothesis?

T4. In an efficient market, there is no systematic relationship between todays price and tomorrows price. True or False? Explain.

E6. Basu (1977) found that the shares of firms with low PE-ratios tended to outperform the shares of firms with high PE ratios. Can you think of any reasons why this might be the case?

T5.

Suppose you detect a pattern of seasonal movements in share prices. observations consistent with the Efficient Markets Hypothesis?

Are these E7.

T6. Suppose that you uncover a systematic relationship between price-earnings ratio and share-price performance. In other words, knowledge of a firms price-earnings ratio can help you predict which stocks will exhibit superior performance. Is this evidence consistent with the Efficient Markets Hypothesis?

(a) (b) (c)

What is the small firm in January effect? Is this effect consistent with the Efficient Markets Hypothesis? Can you think of any possible explanations for this effect?

E8. What did Jensen (1968) find regarding the performance of US mutual-fund managers when management fees were: T7. Suppose you compare the performance of two recommended trading strategies over several years. Is the higher-return strategy necessarily the superior strategy? Explain. (a) (b) deducted from their returns? not deducted from their returns?

T8. Tests of market efficiency are often referred to as joint tests of two hypotheses. What are these two hypotheses? What difficulties do you think this poses for tests of market efficiency?