The dividends on preferred stock cannot be deducted

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Unformatted text preview: s. Under the semi-strong form of market efficiency, all publicly-available information should be reflected in stock prices. The use of private information for trading purposes is illegal. 21. You should not agree with your broker. The performance ratings of the small manufacturing firms were published and became public information. Prices should adjust immediately to the information, thus preventing future abnormal returns. 22. Stock prices should immediately and fully rise to reflect the announcement. Thus, one cannot expect abnormal returns following the announcement. 23. a. b. No. Earnings information is in the public domain and reflected in the current stock price. Possibly. If the rumors were publicly disseminated, the prices would have already adjusted for the possibility of a merger. If the rumor is information that you received from an insider, you could earn excess returns, although trading on that information is illegal. No. The information is already public, and thus, already reflected in the stock price. c. 24. Serial correlation occurs when the current value of a variable is related to the future value of the variable. If the market is efficient, the information about the serial correlation in the macroeconomic variable and its relationship to net earnings should already be reflected in the stock price. In other words, although there is serial correlation in the variable, there will not be serial correlation in stock returns. Therefore, knowledge of the correlation in the macroeconomic variable will not lead to abnormal returns for investors. 25. The statement is false because every investor has a different risk preference. Although the expected return from every well-diversified portfolio is the same after adjusting for risk, investors still need to choose funds that are consistent with their particular risk level. 26. The share price will decrease immediately to reflect the new information. At the time of the announcement, the price of the stock should immediately decrease to reflect the negative information. 326 27. In an efficient market, the cumulative abnormal return (CAR) for Prospectors would rise substantially at the announcement of a new discovery. The CAR falls slightly on any day when no discovery is announced. There is a small positive probability that there will be a discovery on any given day. If there is no discovery on a particular day, the price should fall slightly because the good event did not occur. The substantial price increases on the rare days of discovery should balance the small declines on the other days, leaving CARs that are horizontal over time. 28. Behavioral finance attempts to explain both the 1987 stock market crash and the Internet bubble by changes in investor sentiment and psychology. These changes can lead to non-random price behavior. Solutions to Questions and Problems NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. To find the cumulative abnormal returns, we chart the abnormal returns for each of the three airlines for the days preceding and following the announcement. The abnormal return is calculated by subtracting the market return from a stock’s return on a particular day, Ri – RM. Group the returns by the number of days before or after the announcement for each respective airline. Calculate the cumulative average abnormal return by adding each abnormal return to the previous day’s abnormal return. Abnormal returns (Ri – RM) Days from announcement –4 –3 –2 –1 0 1 2 3 4 Delta –0.2 0.2 0.2 0.2 3.3 0.2 –0.1 –0.2 –0.1 United –0.2 –0.1 –0.2 0.2 0.2 0.1 0.0 0.1 –0.1 American –0.2 0.2 0.0 –0.4 1.9 0.0 0.1 –0.2 –0.1 Sum –0.6 0.3 0.0 0.0 5.4 0.3 0.0 –0.3 –0.3 Average abnormal return –0.2 0.1 0.0 0.0 1.8 0.1 0.0 –0.1 –0.1 Cumulative average residual –0.2 –0.1 –0.1 –0.1 1.7 1.8 1.8 1.7 1.6 327 Cumulative Abnormal Returns 2 1.5 1 0.5 0 -0.5 -4 -3 -2 -1 0 1 2 3 4 Days from announcement -0.1 -0.1 -0.1 1.7 1.8 1.8 1.7 1.6 CAR -0.2 The market reacts favorably to the announcements. Moreover, the market reacts only on the day of the announcement. Before and after the event, the cumulative abnormal returns are relatively flat. This behavior is consistent with market efficiency. 2. The diagram does not support the efficient markets hypothesis. The CAR should remain relatively flat following the announcements. The diagram reveals that the CAR rose in the first month, only to drift down to lower levels during later months. Such movement violates the semi-strong form of the efficient markets hypothesis because an investor could earn abnormal profits while the stock price gradually decreased. a. Supports. The CAR remained constant after the event at time 0. This result is consistent with market efficiency, because pric...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of Texas-Tyler.

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