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1 CHAPTER 8 Bond Valuation and the Structure of Interest Rates Critical Thinking Questions8.1You believe that you can make abnormally profitable trades by observing that the CFO of a certain company always wears his green suit on days that the firm is about to release positive information about his company. Describe which form of market efficiency is consistent with your belief. You believe that the stock price of this company is affected by the choice of the CFO’s wardrobe and that this private information will grant you abnormally high returns. Therefore, your belief is consistent with the semistrong form of market efficiency, according to which it is possible to earn abnormally high returns by trading on private information. 8.2Describe the informational differences that separate the three forms of market efficiency. The strong-form of market efficiency states that all information is reflected in the security’s price. In other words, there is no private or inside information that, if released, would potentially change the price. The semistrong-form holds that all public information available to investors is reflected in the security’s price. Therefore, insiders with access to private information could potentially profit from trading on this knowledge before it becomes public. Finally, the weak form of market efficiency holds that there is both pubic and private information that is not reflected in the security’s price and having access to it can lead to abnormal profits. 8.3What economic conditions would prompt investors to take advantage of a bond’s convertibility feature? A bond’s convertibility feature becomes attractive when the company’s stock price rises above the bond’s price. This usually happens in times of economic expansion when the stock market is booming and interest rates are decreasing, hence lowering the bond’s price. 8.4Define yield to maturity. Why is it important?Yield to maturity (YTM)is the rate of return earned by investors if they buy a bond today at its market price and hold it to maturity. It is important because it represents the opportunity cost to the investor or the discount rate that makes the present value of the bond’s cash flows (i.e., its coupons and its principal) equal to the market price. So, YTM is also referred to as the going market rate or the appropriate discount rate for a bond’s cash flows.