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COMM 298
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Winter 2024
Midterm Exam Prep Booklet
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base or retrieval system, without the prior written permission of Wizedemy Inc.
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Table of Contents

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2.5.2. Example
Chapter 1. Introduction to Finance
1.1. Corporate Structures Chapter 3. Bond Valuation
1.1.1. Sole-proprietorships

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3.1. Introduction to Bonds
1.1.2. Partnerships 3.1.1. What is a Bond?
1.1.3. Corporations 3.1.2. Theory

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1.2. Financial Markets 3.2. Bond Valuation

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1.2.1. Financial Markets 3.2.1. Bond Valuation
1.3. The Principle-Agent Problem 3.2.2. Bond Valuation
1.3.1. The Agency Problem 3.2.3. Example

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3.2.4. Example
Chapter 2. Time Value of Money
3.3. Interest Rate Risk
2.1. Introduction to TVM
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3.3.1. The Yield Curve (Term Structure)
2.1.1. Theory 3.3.2. Pricing Sensitivity and Factors Affecting
n.
2.1.2. Theory Bond Yields
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2.2. Lump Sum Calculations 3.4. Realized Rate of Return

2.2.1. Theory 3.4.1. Realized Rate of Return
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2.2.2. Example 3.4.2. Example

2.3. Quoted vs Effective Rates
Chapter 4. Equity Valuation
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2.3.1. Theory
2.3.2. Example 4.1. Equity Basics
2.3.3. Example 4.1.1. Equity Basics
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4.1.2. Common Equity vs Preferred Equity

2.4. Annuities and Perpetuities
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2.4.1. New Lesson 4.2. Preferred Stocks

2.4.2. Example 4.2.1. Preferred Share Valuation
2.4.3. New Lesson 4.2.2. Example
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2.4.4. Example 4.3. Common Stocks

2.4.5. Theory 4.3.1. DDM
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2.4.6. Example 4.3.2. Example

2.4.7. Example 4.3.3. Example
2.5. Instalment Loans and Mortgages 4.3.4. Example
2.5.1. New Lesson 4.3.5. Ex-Dividend and Cum-Dividend Price
4.3.6. Example

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4.4. Price-Earnings Ratio 4.6.1. New Lesson

4.4.1. Theory 4.6.2. Weak Form Efficiency
4.4.2. Example 4.6.3. Semi-Strong Form Efficiency
4.5. Measuring Returns 4.6.4. Strong Form Efficiency
4.5.1. Measuring Returns 4.6.5. Understanding how the Levels are

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4.5.2. Example Related
4.6.6. Example: Efficient Market Hypothesis
4.6. The Efficient Market Hypothesis

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1. Introduction to Finance

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1.1 Corporate Structures

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1 .1 .1

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Sole-proprietorship
The most simple form of business organization is the sole-proprietorship, however, roughly 72% of

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businesses fall into this category.
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Characteristics of a Sole-proprietorship
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● Owned by a single individual

● The owner and the business are the same

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legal entity.
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● Income added to owner's personal income for

tax purposes.
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Advantages
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● Simple and inexpensive to set up.

● Owner receives all profits earned by the business.

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● Easily dissolvable
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Disadvantages

● Owner is personally responsible (liable) for the business's debts (unlimited liability).

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● Difficult to raise capital.

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1 .1 .2

Partnerships

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When two or more people wish to go into business together, the most basic form of corporate
organization available to them is a partnership.

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Characteristics of a Partnership

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● Owned by two or more people.
● No separate legal entity.

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● Formalized in a written partnership
agreement that describes:
○ Each partner's contribution

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○ How profits are shared
○ How to resolve disputes
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Advantages
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● Easy to form.
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● More capital available.

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Disadvantages

● Owners are personally responsible for obligations (unlimited liability)

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○ Except for limited/silent partners (limited liability)

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● Potential for conflicts

● Profit-sharing can be complicated.
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● Difficult to dissolve or to transfer ownership.

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1 .1 .3

Corporations

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Corporations account for less than 20% of all organizations' businesses, however, they are
responsible for over 80% of sales.

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Characteristics of a Corporation

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● A separate legal entity from its owners

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(called shareholders)

● Can be public or private

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Advantages

● Owners are not personally responsible for

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business obligations (limited liability)
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● Indefinitely (Unlimited) legal life

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● Ownership is easily transferrable

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● Easier to raise capital

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Disadvantages

● More costly and more complex to set up than sole-proprietorships and partnerships.
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● Double taxation
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○ Corporation's income is taxed at the corporate level

○ Owners are taxed on dividends at the personal level
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1.2 Financial Markets

1 .2 .1

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Markets

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The Role of Financial Markets

● Brings buyers and sellers together:

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o Enables businesses to raise funding
o Enables investors to invest in financial assets and trade (buy/sell) financial assets

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● Provides liquidity
● Continuously values financial assets
● Enables transfer of risk through financial assets

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Primary Market
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n.
● “Original sale of securities”
o Issued by corporations (equity and bonds) or governments (bonds)
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o To initial investors (placement) / banks (bought-deal)

o Not actually a “market” as much as it is a description of individual transaction
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o Negotiated prices between the issuer and initial counterparty

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Secondary Market
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● “Where securities are bought and sold after the initial sale”
o Between investors/market makers/banks
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o Usually on organized private/public exchanges such as the NYSE (New York Stock Exchange)
and TSX (Toronto Stock Exchange)
o Market-established prices through demand/supply
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Major Assets
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● Real asset are tangible assets like buildings, vehicles, equipment and commodities.
● Financial assets are intangible like receivables, stocks, bonds and cash.

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1.3 The Principle-Agent Problem

1 .3 .1

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The Agency Relationship

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The Agent

An "agent" is a representative of a "principal" that acts on behalf of them. In business, the agents

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are the managers that run the company on behalf of the owners or shareholders (the principals).

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The Agency Problem

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When the agent does not act in the best interest of the principal and instead acts in his or her own
best interest.
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n.
Agency Costs
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Agency costs are costs that a company incurs because of agency problems. There are two types:
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● Direct: Costs incurred when the manager acts in their own best interest. E.g. Using the
corporate jet to take a personal vacation or accepting a deal that would increase their bonus
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despite it being a bad deal for the company.

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● Indirect: Costs incurred in order to prevent direct agency costs. This includes costs that arise
from any restrictions placed on actions of management, costs associated with monitoring
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management, and costs associated with compensation schemes that will provide managers
with incentives to act in the shareholders' best interests.
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How to Resolve the Agency Problem

The best way to resolve the agency problem and to align managers' interests with those of the
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shareholders is to remove financial incentives that encourage conflicts of interest and to instead
use a stock-based compensation scheme which would effectively turn the managers into
shareholders as well.

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2. Time Value of Money

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2.1 Introduction to TVM

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● The idea that money has more value today because time will allow for it to earn interest.
● Because of interest, the value of a dollar amount is different depending on the point in time it is
paid or received.

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○ For example, $5 received today is worth more than $5 received at any point in time in the
future because the $5 today can earn interest. iq
TVM Variables
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2 .1 .2

Interest
Percentage paid when money is borrowed or received when money is saved.

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Simple Interest

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● Interest on the principal amount only
● Does not include interest-on-interest

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Compound Interest
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● Interest on the principal and previous interest payments (interest-on-interest)

● Most widely used form of interest
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Discounting and Compounding

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Discounting: The process of determining the present value (PV) of a lump sum or a stream of
payments that is to be received in the future (FV).

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Compounding: The process of determining the future value (FV) of a lump sum or a stream of
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payments that is to be received in the past or present (PV).
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2.2 Lump Sum Calculations

2 .2 .1

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● Calculations involving only a single number
● Present and future values are lump sums

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Present Value Formula

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Future Value Formula

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2 .2 .2

Example: Lump Sum Calculations

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You just inherited $5,000 and plan to invest it. The investment will earn 6% per year. How much will
you have in 7 years?

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Example: Lump Sum Calculation
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You plan to purchase a new car in 2 years and expect for it to cost $40,000. How much should you
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save today if your savings account earns 6% per year, compounded monthly?
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Example: Lump Sum Calculation

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How long will it take to double your money at 8% interest per year?

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Example: Lump Sum Calculation
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If you have $1,000 today and wish for it to grow to $4,500 in 4 years. At what annual rate should
you invest it?
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Example: Lump Sum Calculation

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Today you will deposit $5,000 into an account earnings 8% interest per year. You will deposit $6,000
more in 2 years and $8,000 more in 5 years. How much will you have saved up in 10 years?

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2.3 Quoted vs Effective Rates

2 .3 .1

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● When PV and FV, you always use the effective interest rate between the recurring
cash flows.
● Nominal interest rate (APR or QR): An interest rate that does not include and consideration of

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compounding, also called quoted rate or stated rate. Typically an annual rate.
● Effective Rate: The actual growth rate at which a dollar invested will grow over a given period.

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For annual periods, Annual effective rate (EAR).

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m: the number of compounds per year
k: the number of periods (payments) per year / number of effective periods

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Effective Annual Rate
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Effective Periodic Rate

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Effective-to-Effective
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Effective Annual Rate with Continuous Compounding

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WIZ E TIP

The effective rate frequency should match the frequency of the payments. For example, if a
payment is made monthly, you need an effective monthly rate.

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2 .3 .2

Example: Effective Rates

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1. Convert 6% compounded weekly to an effective annual rate.

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2. Convert 8% compounded monthly to an effective weekly rate.

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3. Convert 9% compounded semi-annually to an effective semi-annual rate.
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4. Convert 7% compounded continuously to an effective daily rate.

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5. Convert an effective weekly rate of 0.1153% to an effective monthly rate.

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2 .3 .3

Example: Effective Rates

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WIZE Bank currently offers its clients a savings account that pays 5% interest compounded semi-
annually. If it would like to offer an account with the same return but compounded daily, what rate
should the new account quote?

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2.4 Annuities and Perpetuities

2 .4 .1

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Annuities

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● Recurring cash flow with the following characteristics:
○ Constant payment value
○ Constant discount rate

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○ Equal time between payments

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○ Finite number of payments

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● Timing of payment can vary:
○ Beginning of period payments = Annuity-due iq
○ End of period payments = Ordinary Annuity
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● Present value of an annuity equals sum of present value of each payment.

● Future value of an annuity equals sum of future value of each payment.
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Present Value of an Ordinary Annuity

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Future Value of an Ordinary Annuity

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Present Value of an Annuity-due
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Future Value of an Annuity-due

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2 .4 .2

Example: Annuities

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You plan to deposit $500 per month into account earning 8% interest compounded semi-annually.
How much will you have in your account in 2 years?

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Example: Annuities
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You just rented a new condo at a rate of $1,000 per month, paid at the beginning of every month.
How much should you have in your account today to have enough money available to pay your rent
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for the next 2 years. Your account earns 5% interest compounded monthly.
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2 .4 .3

Perpetuity

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● Recurring cash flow with the following characteristics
○ Constant payment value
○ Constant discount rate

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○ Equal time between payments
○ Infinite number of payments

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● Timing of payment can vary:

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○ Beginning of period payments = Perpetuity-due
○ End of period payments = Ordinary Perpetuity

● Present value of a perpetuity equals sum of present value of each payment.

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● Perpetuities do not have a future value. iq
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Present Value of an Ordinary Perpetuity

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Present Value of a Perpetuity-due

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2 .4 .4

Example: Perpetuities

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You just made an investment that will return $1,000 every 1.5 years. What is the value of your
investment today if your opportunity cost is 7% compounded quarterly.

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Example: Perpetuities
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Your aunt has promised to give you $10,000 per year forever, starting today. If your discount rate is
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6% per year, what is the value of the gift?

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2 .4 .5

Moving Annuities and Perpetuities

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A series of cash flows that begin in some future period (not time 1). Solving these timelines requires 2
steps

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1. Compute P Vt−1 where t is the period of the first payment.
​

2. Discount P Vt−1 to the desired period (usually t = 0)

​

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2 .4 .6

Example: Moving Annuities and Perpetuities

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You wish to set up a scholarship of $100,000 per year. The first scholarship is to be awarded in 5
years. How much should you donate today if the appropriate discount rate is 6%?

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Example: Moving Annuities and Perpetuities

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You will begin receiving $X every two years, starting one year from today. If the present value of this
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cash flow is $800, what is the value of X if your account earns 9% annually?
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2 .4 .7

Example: Retirement Problem

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You plan to retire in 25 years and wish to save up enough money so that you can start withdrawing
$1 million per year forever starting the year after you retire. Your retirement account earns 6%
interest compounded monthly. How much should you save today in order to meet your retirement

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goals?

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2.5 Instalment Loans and Mortgages

2 .5 .1

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Amortized Loans (Instalment Loans)

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● A loan that is paid off in equal payments throughout the term of the loan.
● Each payment consists of an interest portion and a principal portion.

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○ Interest portion: The interest on the remaining balance that has accumulated since the

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previous payment.
○ Principal portion: The amount of the payment that is used to reduce the debt owing.

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Mortgages iq
● A mortgage is an instalment loan specifically used to purchase real estate properties, like
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houses, condos, cottages, revenue properties.
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● In Canada, mortgages are compounded semi-annually.

● In the US, mortgages are compounded monthly.
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Interest and Principal

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● The payment remains constant each period.
● The interest portion decreases with each payment because the remaining balance of the debt

decreases.

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● The principal portion increases with each payment because the payment is constant and

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interest decreases.

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Amortization Schedule

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2 .5 .2

Example: Mortgages

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You just purchased a new condo in Burnaby for $800,000. You put a 10% down payment and
borrowed the rest. The mortgage rate is 2.5%, and you will make monthly payments. The term of the
mortgage is 5 years and the amortization period is 30 years.

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a) What are your monthly mortgage payments?

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b) How much money will you still owe after 4 years?
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c) What is the principal and interest portion of your 49th payment?

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3. Bond Valuation

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3.1 Introduction to Bonds

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3 .1 .1

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What is a Bond?
A bond is a long-term debt instrument that promises fixed payments and has a maturity of more

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than 10 years. Bonds are issued by corporations that require funding for future projects.
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Basic Structure of Bond

The issuer (seller) agrees to pay periodic payments to the holder (buyer) in the form of
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coupons/interest and repays the principal amount at the maturity date (balloon/bullet payment).

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Bond Components

● Face Value: The principal amount of the bond that the investor (lender) will receive from the

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issuer (borrower) when the bond matures. This is typically $1,000.
● Coupon Rate: The annual interest rate paid to the investor expressed in percentage.

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● Coupon Payment: The annual interest paid to the investor expressed in dollars.
● Maturity: The length of time before the bond will be paid and the interest payments will stop.
● Yield to Maturity: The annual rate of return earned by a bondholder if the bond is held until

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maturity. It is also the discount rate used to value bonds.

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Types of Bonds

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● Debenture: Bond that is unsecured by collateral.
● Secured Bonds: Bond that is secured by assets belonging to the issuer
● Callable Bonds: Bond that the issuer may redeem, or call back, before it reaches the stated

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maturity date. A callable bond allows the issuing company to pay off its debt early.
● Convertible Bonds: A bond that the holder can convert into a specified number of shares of

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common stock in the issuing company or cash of equal value.

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3 .1 .2

Bond Credit Ratings

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3.2 Bond Valuation

3 .2 .1

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Bond Valuation

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Bond Price

● Price that an investor will pay to purchase a bond.

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● Present value of all future coupon payments and the face value.

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Current Yield
The return on investment an investor expects to earn if the owner purchased the bond and held it for
one year.

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Comparing the Coupon Rate and Yield to Maturity

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● If Coupon Rate > Current Yield > YTM: Bond is sold at a premium (Price > Face Value)
● If Coupon Rate < Current Yield < YTM: Bond is sold at a discount (Price < Face Value)
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● If Coupon Rate = Current Yield = YTM: Bond is sold at par (Price = Face Value)
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3 .2 .2

Bond Valuation

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The coupon payment is the periodic interest payment the bondholder (investor) will receive from the
issuer (borrower). This is calculated by multiplying the coupon rate by the face value of the bond and

l.c
then dividing it by the number of payments per year (typically annual or semi-annual).

ai
Step 1: Compute the periodic coupon payment

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Where:
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I = coupon payment (in dollars)
n.
F = Face value of the bond
CR = coupon rate (in %)
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k = number of payments per year

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WIZ E TIP
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Step 2: Computing the Periodic Discount Rate

The discount rate used to compute the price of the bond is the yield to maturity (YTM) divided by the
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number of coupon payments per year.

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Step 3: Compute the Present Value of the Coupon Payments and the Present Value of the Face
Value

Using the Formula

Structurally a bond is nothing more than a stream of equal coupon payments (annuity) and a face

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value amount at the maturity date (future value)

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Bonds Without Maturities (Consol)

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A bond that never matures is a bond that continues paying coupons perpetually (forever). To
compute the price of this bond, the following formula is used:

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3 .2 .3

Example: Calculating the Price of a Bond

om
Compute the price of a five-year semi-annual bond with a face value of $1,000 and a 6% annual
coupon and yield to maturity of 7%.

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@
iq
n.
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Example: Calculating the Coupon Rate

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What is the coupon rate on a semi-annual bond with 7 years left until maturity. The bond has a face
value of $1,000 and is current priced at $895. The yield to maturity is 6%.
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3 .2 .4

Example: Pricing a Consol

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ABC Inc. just issued a consol with a face value of $1,000 and a 6% coupon rate paid annually. The
bond was sold at 87.5 of book value. What is the yield to maturity?

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3.3 Interest Rate Risk

3 .3 .1

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The Yield Curve (Term Structure)

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● Curve of interest rates for bonds with different maturities
● Typically upward sloping because bonds with longer maturities usually yield higher returns.

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@
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n.
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What the slope tells us:

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● Upward slope: short-term interest rates expected to remain the same in the future, economy is
growing quickly.
● Flat: short-term interest rates are expected to decrease in the future, economy is growing more
ad

slowly.
● Downward slope (inverted): short-term interest rates are expected to decrease significantly in
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the future, economy is headed to (or in a recession).

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3 .3 .2

Bond Price Sensitivity

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Market interest rates have an inverse relationship with bond prices, that is because if market interest
rates (YTM) rise, the present value of existing bonds will decrease. However not all bonds move
equally, some bonds are very sensitive to changes in interest rates, while others are less sensitive.

l.c
Sensitive bonds will decrease or increase in price by more than less sensitive bonds.

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What does the Price-Yield Curve tell us?

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● Bonds are more sensitive to change in interest rates when yields are lower.
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● Bonds are more sensitive when rates/yields decrease then when they increase.
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Characteristics that increase bond sensitivity

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● Long maturities
● Low coupons
● Low YTM

l.c
● Higher frequency of payments

ai
For Example:

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Consider the following two bonds, both have a face value of $1,000
Bond A: 10-year maturity, 5% coupons paid annually

@
Bond B: 30-year maturity, 5% coupons paid annually
iq
Bond A: When YTM = 6%, Bond A is priced at $926.40; if YTM increases to 7% the price decreases
by 7.21% to $859.53
n.
Bond B: When YTM = 6%, Bond B is priced at $862.35; if YTM increases to 7% the price decreases
by 12.82% to $751.82
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3.4 Realized Rate of Return

3 .4 .1

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Realized Rate of Return

l.c
Realized Rate of Return (ROR): Annual rate of return an investor actually earned during the holding
period (ie. when the investor actually owned the instrument).

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Holding Period Return (Total Return)

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@
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Annual Realized Rate of Return
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Where:
FVCR = Future Value of reinvested coupons
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n = number of years investor held the bond

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Real Rate

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● Return or interest rate adjusted for inflation.
● The approximate difference between nominal returns and real returns is the inflation rate.
● Exact real rate can be found using the Fisher equation.

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3 .4 .2

Example: Calculating the Return on Bond Investment

om
12 years ago you purchased a bond for $1,140.44. The bond has a coupon rate of 6% paid semi-
annually. The coupons were reinvested at 5% compounded semi-annually. Today the bond matured.
a. What is your ROR?

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b. What is your real ROR if the average inflation during your investment was 2% per year.

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4. Equity Valuation

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4.1 Equity Basics

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ai
4 .1 .1

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Equity Basics
Stocks

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● Are ownership positions in a corporation iq
● Payouts to common stock are dividends:
o Cash or Stock Dividends
n.
● Unlike bonds, payouts are uncertain in both magnitude and timing
● Like bonds, equity can be sold at any point in time.
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Legal Structure
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● Residual claimant to corporate assets (paid after bondholders)

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● Limited liability: worst-case scenario is not that extreme

● Voting rights on major corporate decisions
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Dividends
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● Profits that the company does not reinvest and instead distributes to the shareholders.
● The board of directors and management of the company determine how much they will pay to
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shareholders.
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4 .1 .2

Common Vs Preferred Equity

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4.2 Preferred Stocks

4 .2 .1

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Preferred Stock Valuation

l.c
Price of a preferred stock is based on dividend and required rate of return. Treat preferred shares as
ordinary perpetuities.

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Preferred Stock Pricing

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● If dividend rate > required rate of return: Preferred shares are priced at a premium (Price >
Book Value)
● If dividend rate < required rate of return: Preferred shares are priced at a discount (Price <

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Book Value)
● If dividend rate = required rate of return: Preferred shares are priced at par (Price = Book Value)
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Computing the Dividend Payment
n.
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Based on the book value of the preferred shares and the dividend rate.
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Computing the Price of a Preferred Stock

● The present value of future dividends

l.c
● The required rate of return is used as the discount rate

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gm
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Where:
P = Price of the preferred share iq
D = Dividend
r = Required rate of return
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4 .2 .2

Example: Preferred Shares

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Wize Corporation has preferred shares outstanding with a book value of $80. The company pays a
5% dividend on these shares each year and investors require a return of 10%. What it the price of
these shares?

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4.3 Common Stocks

4 .3 .1

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The Dividend Discount Model (DDM)

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● Price of a stock is the present value of all future cash flows.

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○ This includes all future dividends and expected stock price in the future.
○ The price at any point (time = n) is equal to the present value of all dividends from time =

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n+1 to infinite.

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Constant Growth DDM
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● Used when dividends are expected to grow at a constant rate indefinitely.

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● Is treated as a growing perpetuity.

● In the constant growth DDM, the required rate of return (k) must be greater than the growth
rate (g).
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WATC H O UT!
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If you are given the current dividend (D0) in a question, you have to calculate the first future
dividend in order to calculate the price; but if you are given the first future dividend you can skip
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Estimating the Required Rate of Return

● Using the constant growth DDM we can estimate the required rate of return.

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● It is the sum of the dividend yield and the capital gain yield
○ capital gain yield and growth rate are the same thing

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4 .3 .2

Example: Common Stocks with Random Dividend

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Wize Corp. expects to issue a $3.00 dividend next year, $4.00 the year after and $5.00 in year 3.
Investors expect the stock price at the end of year 3 to be $60. If the risk-free rate is 3% and
investors require a risk premium of 10%, what is the value of the stock today?

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4 .3 .3

Example: Common Stocks with no Growth

Romeo Inc just paid a dividend of $2 per share and it is expected to keep the dividend constant
indefinitely.

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a) If the required rate of return is 8%, what is the stock's value today?

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b) If the stock is priced at $30 per share, what is the implied rate of return?

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4 .3 .4

Example: Common Stocks with Non-Constant Growth

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ABC Corp. just paid a dividend of $5.00 and plans to increase it by 40% per year for the next 3
years. After that, it will begin decreasing the dividend by 2% per year indefinitely. If the required rate
of return is 10%, what is the price of the stock today?

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4 .3 .5

Ex-Dividend Price

om
In most cases, a stock is priced based on all future dividends because the dividend being paid today
has already been paid, this is called a stock’s ex-dividend price

l.c
ai
gm
Cum-Dividend Price

@
iq
If a stock has not yet paid its current dividend, the price of the stock is higher because sellers are
factoring in the dividend, this is called a stock’s cum-dividend price and is computed by adding the
n.
amount of the current dividend to the ex-dividend price.
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4 .3 .6

Example: Common Shares with Constant Growth

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ABC Inc. just issued a $3.50 dividend and will increase the dividend by 8% each year. Investors
require a return of 12% on the company’s shares.

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a. What is the ex-dividend price of the stock?

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b. What is the cum-dividend price of the stock?

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4.4 Price-Earnings Ratio

4 .4 .1

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The Price-Earnings Ratio

l.c
● Ratio of the company's stock price to its earnings per share.
● Tells us how many times its profits is the company worth.
● Useful for identifying mispriced stock within an industry.

ai
○ Low ratio: low expected future growth, could be a sign of an undervalued stock

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○ High ratio: high expected future growth, could be a sign of an overvalued stock.

Price
PE Ratio = EPS

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4 .4 .2

Example: PE Ratio

The expected earnings for ABC Inc are $1 billion dollars. The company has 100 million outstanding

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shares and the industry P/E ratio is 6.7. If the stock is currently trading at $105 per share, is it
overpriced or underpriced?

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4.5 Measuring Returns

4 .5 .1

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Realized Rate of Return

● Measures the actual annual returned earned by an investor.

l.c
● FVRD: Future value of reinvested dividends

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gm
@
Expected Rate of Return iq
● Measures the expected annual returned earned by an investor.
n.
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4 .5 .2

Example: Realized Rate of Return

Three years ago you purchased shares in RBC for $103.89. The stock has paid an annual dividend of

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$4.10 and today you sold the stock for $141.05. What was is your realized rate of return?

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4.6 The Efficient Market Hypothesis

4 .6 .1

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The Efficient Market Hypothesis

l.c
The EMH is a set of rules and beliefs about the market and the way information affects security
prices.

ai
● States that markets are efficient
○ Security prices at a particular point in time reflect all available information.

gm
● Investor's cannot consistently earn abnormal returns, they cannot "beat the market."

@
● The EMH is broken into three levels because not all investors have the same beliefs about the
market's level of efficiency and the type of information reflect in market prices.
iq
○ Weak form
○ Semi-strong form
n.
○ Strong form
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4 .6 .2

Weak Form Efficiency

om
The first level of the efficient market hypothesis is the weak form EMH, which is a set of beliefs
regarding what can and cannot be used to predict future security prices.

l.c
Technical Analysis

ai
● The study of historical trading and price information.
● Users try to identify patterns in past price changes in order to predict future price changes.

gm
What is the Weak Form Efficient Hypothesis?

● Security prices reflect all market data

@
○ Market data refers to all past price and volume information.
○ Historical price information cannot be used to predict future price changes.
iq
● Technical analysis is of no value.
n.
● Only public and private information can be used to predict future price changes and earn
ra

abnormal returns.
im

● Random walk hypothesis: theory that states that price changes follow a random walk,
meaning that security price changes over time are independent.
ad

● Empirical evidence supports the weak form efficient market hypothesis more than the other
forms.
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4 .6 .3

Semi-Strong Form Efficiency

om
The second level of the efficient market hypothesis is the semi-strong form EMH, which is a set of
beliefs regarding what can and cannot be used to predict future security prices.

l.c
Fundamental Analysis

ai
● Attempts to measure a security's value be analyzing economic and financial factors like
financial statements, earnings announcements, corporate press releases, economic indicators,

gm
consumer behavior, corporate strategy, etc.

● Uses information that is publicly available to try and predict the value of a company, this

@
information can then be used to make investment decisions.

What is the Semi-Strong Form Efficient Hypothesis?

iq
● The semi-strong form EMH includes the weak form EMH.
n.
● Security prices reflect all market data and public information.
ra

○ Public information refers to all new information that is legally available to the public.
im

● Technical analysis and fundamental analysis is of no value.

○ Technical analysis is the study of previous price, volume and patterns to predict future price
changes.
ad

● Only private information can be used to predict future price changes and earn abnormal
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returns.
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● The semi-strong EMH is well supported by empirical evidence, however there is more
contradicting evidence for this form than there is for the weak form.
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4 .6 .4

Strong Form Efficiency

om
The third level of the efficient market hypothesis is the strong form EMH, which is a set of beliefs
regarding what can and cannot be used to predict future security prices.

l.c
What is the Strong Form Efficient Hypothesis?

ai
● The strong form EMH includes the weak and semi-strong form EMH.

● Security prices reflect all information (market data, public and private)

gm
○ Private information is information that has not been announced and is only known by
company insiders.

@
● Technical analysis, fundamental analysis and insider information are of no value.
iq
● No information can be used to predict future price changes and earn abnormal returns.
n.
● The strong form EMH is not very well supported by empirical evidence.
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4 .6 .5

Understanding how the Levels are Related

om
When a form of efficiency is true

● If the market is strong form efficient, it is automatically semi-strong and weak.

l.c
● If the market is semi-strong form efficient, it is automatically weak, but not necessarily strong.

ai
● If the market is weak form efficient, it is not necessarily semi-strong or strong.

gm
When a form of efficiency is violated

● When the weak form is violated, the semi-strong and strong are automatically violated as well,

@
this is called weak-form inefficient.
iq
● When the semi-strong form is violated, the strong form is automatically violated, but this is not
necessarily a violation of the weak form. This is called semi-strong form inefficient.
n.
● When the strong form is violated, it does not necessarily mean that the semi-strong and weak
ra

forms are violated. This is called strong form inefficient.

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4 .6 .6

Example: Efficient Market Hypothesis

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ABC Inc. just paid a dividend of $3 per share in 2021. The market belief regarding the growth rate is
equally divided with half expecting a growth rate of 2% and the other half a growth rate of 4%. The
required rate of return on this stock is 12%.

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In January of 2022 the company announces that it will grow its dividend by 5% and the stock price
increases to $53.

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a. What should the stock price be in January of 2022?

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b. Comment on the $53 stock price.
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