Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

You are presented with the following different views of stock market behavior.

(1) If a company publishes an earnings figure that is better than the market expects, the shares of that company will usually experience an abnormally high return both on the day of the earnings announcement and over the two or three days following the date of the announcement.

(2) The return on professionally managed portfolios of equities is likely to be no better than that which
` could be achieved a naïve investor who holds the market portfolio.

(3) Share prices usually seem to rise sharply in the first few days of a new fiscal year. However, this can be explained the fact that many investors sell loosing stocks just before the fiscal year end in order to establish a tax loss for Capital Gains Tax purposes. This causes abnormal downward pressure which is released when the new fiscal year begins.

You are required:
(a) to describe the three forms of the Efficient Market Hypothesis;

(b) to discuss what each of the above three statements would tell you about the efficiency of the stock market. Where appropriate relate your comments to one or more forms of the Efficient Market Hypothesis.
ANSWER
(a) The weak form of the efficient market hypothesis states that the current share price reflects all information contained in the past price movements of that share. This implies that a study of the trends in share prices over a prior period will not help in predicting the way in which the value or price of those shares will move in the future. In other words there is no place for Chartism or technical analysis. Statistical evidence suggests that the efficient market hypothesis does hold in its weak form.

The semi-strong form of the efficient market hypothesis encompasses the weak form and adds that share prices also reflect all current publicly available information, for instance a detailed analysis of published accounts. If the semi-strong form holds, then a detailed analysis of published accounts will not assist in a prediction of future share price movements, since the share price already contains all relevant information shown in those accounts or made public since the issue of those accounts. As such it would only be possible to predict share price movements if unpublished information were known, in other words through insider information. Statistical evidence suggests that the semi-strong form of the efficient market hypothesis is valid.

The strong form of the efficient market hypothesis proposes that the current share price reflects all information relevant to the company, whether or not that information has been made public. If this is the case then it will never be possible to predict share price movements. The implication of this statement is that there would be no scope for gains to be made on share trading through the obtaining of inside (unpublished) information. Clearly this appears not to hold in practice, since legislation has been set to prevent insider dealing.

(b) Share price rises after announcement of high earnings.
The market will have assessed the likely level of the company‟s earnings from information which has been available to the public and the share price will be based on that assessment. If subsequent information suggests that the estimate of earnings was inaccurate the share price should adjust immediately under the semi-strong form of the efficient market hypothesis. In the situation described there was an immediate share price movement, but this continued over the following two or three days. This would suggest that the market is not absolutely efficient in the semi-strong form, because if it were the entire adjustment should have occurred immediately on announcement of the earnings figure.

It is also true that the market is not efficient in the strong form, otherwise the high earnings figure would have been known before it was published and as such reflected in the share price. Since the share price moved on announcement of the earnings, the strong form cannot hold.

Return on professionally managed portfolios
The suggestion that the return on professionally managed portfolios is likely to be no better than that which could be achieved any investor would be supported the strong form of the efficient market hypothesis. Assuming portfolio managers are not party to inside, unpublished information, this view would also be held the semi-strong form of the efficient market hypothesis. However, if this proposition were to be unduly accepted there would be no demand for professionally managed portfolios. Since this is not the case, investors must perceive some benefit of placing their funds in the hands of portfolio managers. This would therefore suggest that the market is not efficient in either the semi-strong or strong form.

Share price movements around the fiscal year end
The downward movement on share prices just before the year end followed a subsequent upward movement is due more to supply and demand effects than the efficient market hypothesis. There is no information specific to a particular security which causes the managers of portfolios or other investors to sell and then re- buy: it is simply the result of tax effects which apply universally to all shares across the market.

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