Financial Theory and Corporate Policy Copeland 4th

Edition Solutions Manual

To download the complete and accurate content document, go to:

https://testbankbell.com/download/financial-theory-and-corporate-policy-copeland-4th
-edition-solutions-manual/
Financial Theory and Corporate Policy Copeland 4th Edition Solutions Manual

Chapter 11
Efficient Capital Markets: Evidence

1. Roll’s critique (1977) is based on the assumption that capital markets are in equilibrium. What
happens when the market is not in equilibrium? Suppose new information is revealed such that the
market must adjust toward a new equilibrium which incorporates the news. Or suppose that a new
security is introduced into the marketplace, as was the case of new issues studied in the Ibbotson
(1975) paper. Given such a situation, the abnormal performance of an asset can be measured by the
arbitrage profits available as its price is adjusted to a new market equilibrium. Before the
disequilibrium situation as well as afterward, Roll’s critique applies and we cannot expect to observe
any abnormal performance relative to an efficient index. However, the adjustment process itself can be
used to detect abnormal performance relative to the market index prior to equilibrium. In this way,
Ibbotson’s results can be interpreted either as 1) selection of an inefficient index, or 2) detection of
abnormal performance during disequilibrium.

2. (a) The securities market can be efficient even though the market for information is not. All that is
required for efficient securities markets is that prices fully reflect all available information. Should
an individual—for example, a corporate insider—have monopoly access to valuable information,
then the market cannot reflect the information because it is not publicly available. This is not a
deficiency in the securities market, but rather a deficiency in the market for information.
The quote taken from the special committee of the Securities and Exchange Commission is
correct when it says that the efficient markets theory is silent as to the optimum amount of
information required—that issue can be decided by better understanding of the supply of and
demand for information.
(b) Information is material if it has an impact on securities prices when it becomes publicly available
for the first time. If it has no impact on prices, it is largely irrelevant, although it may cause
portfolio adjustments that leave prices unchanged.

3. The empirical evidence on block trading is consistent with the semi-strong form of the efficient
markets hypothesis, because once the block trade becomes public information, it is not possible to earn
an abnormal return.
The evidence may or may not be inconsistent with the strong form of the efficient markets
hypothesis. If an individual can employ a strategy (using the –4.56 percent trading rule of Dann,
Mayers and Raab) where he purchases shares at the block price, then sells at the closing price, he can
earn a risk-adjusted abnormal return after transactions costs. However, the “abnormal return” is
defined relative to the risk-adjusted return which would be predicted by the capital asset pricing
model. It may be the case that the return is actually a fair return for the liquidity services rendered to
the individual who sold the block.

4. (a) As shown by the Ball and Brown study (1968), almost all of the “information” in an annual report
has already been discounted into the security price before the annual report is released. Therefore,
it is unlikely that the latest copy of the annual report will allow an investor to earn an abnormal
return.
(b) The evidence on block trading indicates that it is highly unlikely that anyone can react fast enough
to make a profit from the ticker tape announcement of a block trade.

Visit TestBankBell.com to get complete for all chapters

126 Copeland/Shastri/Weston • Financial Theory and Corporate Policy, Fourth Edition

(c) Empirical evidence of announcement abnormal returns for a pure split sample of stocks that had
not dividends indicates a significant positive return (Grinblatt, Masulis and Titman [1984]). Thus,
splits per se can be interpreted as good news about the future prospects of the firm. Brennan and
Copeland [1987] model splits as costly signals to show that they can convey information in a
rational expectations equilibrium.
(d) As indicated by the Ibbotson (1975) study, it is possible to earn large risk-adjusted abnormal
returns if you buy a new issue at the offering price and sell at the end-of-month market price.
However, as with block trades, this “abnormal” return may be simply a liquidity premium charged
for services provided by buyers of the stock to the owners of the ABC Company. After all, a large
new issue is also a large block.

5. Mr. A should not purchase the service. If he purchased it, he could be the victim of fraud. Consider the
following scheme. A solicitation is mailed out to 270,000 investors. Ninety thousand are told the
market will move up by more than 10 points, ninety thousnd are told it will stay within a 10 point
range, and the remainder are told it will fall by more than 10 points. After the first month the group of
ninety thousand which received the correct “forecast” is split into three groups. And finally, by the end
of the third month there remains a group of 10,000 investors who have received three successive
correct “predictions.”
It goes without saying that the “success” of the solicitation in predicting the market for three
months straight has absolutely nothing to do with their ability to forecast the next month’s index.
The same thing can be said of individual investors who point to their past success in the market as
evidence that they are clairvoyant. If there is a 50–50 chance of “winning” in the market during a
year’s time, then over a ten year interval, the probability of wining every year is
(1/2)10  .000977
If there are 10 million investors in the market, then approximately 9,770 of them will have beat the
market every year for ten years.

6. Ponzi frauds follow the adage “you can fool some of the people some of the time.” The plan described
has paid out 2 percent per month for 18 months. It would operate as follows:
If the first participant put in $1,000, his first dividend would be paid out of the money he put in. If
no one else joined the “fund,” the first individual would be paid $20 per month out of his original
$1,000, until the money was gone and the fund was declared officially bankrupt. This would take
50 months if the perpetrators of the scheme kept their portion of the capital equal to zero. The
investor’s loss can be determined as follows:
If he had originally invested his $1,000 in the risk-free asset, he would have
$1,000(1 + Rf)T
where T = time until declaration of the Ponzi Fund’s bankruptcy.
If X were the amount extorted by the founders of the Ponzi fund, and $20 per month was paid as
“dividends,” the time until bankruptcy would be
1,000 − X
T=  50
20
If the investor participated in the Ponzi Fund, and immediately reinvested all dividend payments in
the risk-free asset, his earnings would be
20(1 + Rf)T–1 + 20(1 + Rf)T–2 + · · · + 20
Financial Theory and Corporate Policy Copeland 4th Edition Solutions Manual

Chapter 11 Efficient Capital Markets: Evidence 127

where the first term represents the earnings from his first dividend paid, and the last term, 20 = 20(1 +
Rf)T–T, represents his last dividend. Thus, his total loss would be
T
–$1,000(1 + Rf)T + 
t =1
20(1 + Rf)T–t < 0

However, if enough new people joined the Ponzi Fund over time, it could go on indefinitely. When the
scheme could not attract new participants, it would quickly go bankrupt. An individual investor who
could accurately predict the time until bankruptcy, T, may be able to profit from the investment if the
dividends paid to him (after his initial investment was recovered) exceeded the amount he would have
received had be initially invested in a legitimate asset of equal risk. In this instance, the risk involved
is his ability to predict the fraud’s demise. In the aggregate, of course, the fund’s investors lose money
because no investments in real assets are being made.

7. Mutual funds do, in fact, attract more customers in a year which follows abnormal performance. The
mystery is why. If investors are rational, then they should know that last year’s performance is
typically unrelated to this year’s performance. Therefore, at any point in time their choice of a mutual
fund should be a matter of indifference. But it isn’t.
Either way, their behavior is not inconsistent with efficient capital markets. It simply doesn’t make
any difference. The flows of dollars which they provide to mutual funds will not affect the way in
which security prices adjust to new information.

8. The major problem is that the portfolios’ performances in Figure Q11.8 have not been adjusted for
risk. If portfolio 1 is riskier than the other portfolios, then one would expect it to have higher returns
also. What should be reported is risk-adjusted abnormal rates of return. A second problem is that
returns are reported without subtracting the transactions costs involved in readjusting the portfolios
each week. Third, the chart does not say whether or not the returns recorded there include dividends as
well as capital gains. Fourth, any differential effects of taxation are unaccounted for.
It is not possible to discern whether or not the portfolios’ actual performances are consistent with
the efficient securities market until we test for abnormal performance based on net cash flows (i.e.,
capital gains plus dividends, net of taxes and transactions costs).

9. (a) A selection bias discredits any results implied by this study. Firms continuously listed on
Compustat tapes from 1953 to 1973 are firms that, by definition, have not failed, since the records
of bankrupt firms are completely deleted from the tape.
(b) It is not surprising that stock brokers’ preferences are correlated with rate of return differences
across industries. It would be surprising if their preferences can be used to predict rate of return
differences. If the information is predictive, then, on average, brokers can beat the market.
(c) The results of this research provide evidence against capital market efficiency because past,
publicly available data provides predictive power for future price changes. A study of this nature,
by Niederhoffer, is reported in The Journal of Business, April, 1971.
(d) The evidence is not creditable because the model has not been tested on independent date. Any
model can be worked over to fit a set of data if enough variables are allowed. The relevant test
would be in the model’s predictive ability.

Visit TestBankBell.com to get complete for all chapters