Corporate_Finance_9th_edition_Solutions_Manual_FINAL0

Therefore it may have been as difficult to examine

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Unformatted text preview: sly unsatisfied investor may pay extra for a specialized security catering to his or her needs. Corporations gain from developing unique securities by issuing these securities at premium prices. The three forms of the efficient markets hypothesis are: 1) Weak form. Market prices reflect information contained in historical prices. Investors are unable to earn abnormal returns using historical prices to predict future price movements. 2) Semi-strong form. In addition to historical data, market prices reflect all publicly-available information. Investors with insider, or private information, are able to earn abnormal returns. 3) Strong form. Market prices reflect all information, public or private. Investors are unable to earn abnormal returns using insider information or historical prices to predict future price movements. a. False. Market efficiency implies that prices reflect all available information, but it does not imply certain knowledge. Many pieces of information that are available and reflected in prices are fairly uncertain. Efficiency of markets does not eliminate that uncertainty and therefore does not imply perfect forecasting ability. True. Market efficiency exists when prices reflect all available information. To be efficient in the weak form, the market must incorporate all historical data into prices. Under the semistrong form of the hypothesis, the market incorporates all publicly-available information in addition to the historical data. In strong form efficient markets, prices reflect all publicly and privately available information. False. Market efficiency implies that market participants are rational. Rational people will immediately act upon new information and will bid prices up or down to reflect that information. False. In efficient markets, prices reflect all available information. Thus, prices will fluctuate whenever new information becomes available. 2. 3. b. c. d. e. True. Competition among investors results in the rapid transmission of new market information. In efficient markets, prices immediately reflect new information as investors bid the stock price up or down. 4. On average, the only return that is earned is the required return—investors buy assets with returns in excess of the required return (positive NPV), bidding up the price and thus causing the return to fall to the required return (zero NPV); investors sell assets with returns less than the required return (negative NPV), driving the price lower and thus causing the return to rise to the required return (zero NPV). The market is not weak form efficient. Yes, historical information is also public information; weak form efficiency is a subset of semistrong form efficiency. Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all have zero NPV. If trading costs exist, then these investors lose by the amount of the costs. Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators provide liquidity to markets and thus help to promote efficiency. The EMH only says, within the bounds of increasingly strong assumptions about the information processing of investors, that assets are fairly priced. An implication of this is that, on average, the typical market participant cannot earn excessive profits from a particular trading strategy. However, that does not mean that a few particular investors cannot outperform the market over a particular investment horizon. Certain investors who do well for a period of time get a lot of attention from the financial press, but the scores of investors who do not do well over the same period of time generally get considerably less attention from the financial press. If the market is not weak form efficient, then this information could be acted on and a profit earned from following the price trend. Under (2), (3), and (4), this information is fully impounded in the current price and no abnormal profit opportunity exists. Under (2), if the market is not semi-strong form efficient, then this information could be used to buy the stock “cheap” before the rest of the market discovers the financial statement anomaly. Since (2) is stronger than (1), both imply that a profit opportunity exists; under (3) and (4), this information is fully impounded in the current price and no profit opportunity exists. Under (3), if the market is not strong form efficient, then this information could be used as a profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock is underpriced or that good news is imminent. Since (1) and (2) are weaker than (3), all three imply that a profit opportunity exists. Note that this assumes the individual who sees the insider trading is the only one who sees the trading. If the information about the trades made by company management is public information, it will be discounted in the stock price and no profit opportunity exists. Under (4), this information does not signal any profit opportunity for traders; any pertinent information the manager-insiders may have is fully refle...
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