Investment Theory PS8

Joseph Henri Safdie

Market Efficiency Questions (Topic 7)

1. Which of the following statements are true about the efficient market
hypothesis (EMH)?
b. It implies that prices reflect all available information.
True. This is a core tenet of EMH.

e. It results from keen competition among investors.

True. Keen competition among investors helps ensure that prices reflect all available
information.

2. Does the success of celebrated investors invalidate the EMH?

No, the success of a few investors does not invalidate the EMH. According to EMH, while it is
possible for investors to achieve above-average returns due to luck or access to private
information, it does not mean that the market is inefficient. The presence of a few successful
investors is consistent with a market that is generally efficient.

3. Market efficiency 100 years ago vs. now

A hundred years ago, with less publicly available information and less transparency,
markets were likely less efficient compared to today. In a semistrong form efficient market,
all publicly available information is reflected in stock prices. The increased availability of
information now makes the market more efficient than it was 100 years ago.

4. Aerotech stock scenarios and market efficiency

a. With the announcement of hiring top researchers, Aerotech's stock is expected to
increase as the market incorporates this positive information.

b.
i. This suggests possible initial overreaction followed by correction, which does not indicate
strong form efficiency but could be consistent with semistrong form efficiency.
ii.This suggests a quick incorporation of information, consistent with market efficiency.
iii. This indicates a delayed reaction, which is inconsistent with semistrong form efficiency.

5. Cumulative abnormal returns (CAR) diagram for oil companies

As CAR doesn’t show immediate and sustained changes following the announcement of oil
discoveries, it is not consistent with market efficiency. It is therefore inneficient
6. CAR studies and semistrong form efficiency
a. Supports semistrong form efficiency as the market reacts quickly and accurately to new
information.

b. Rejects semistrong form efficiency because the market's reaction was delayed.

c. Supports semistrong form efficiency as the market efficiently incorporated the new
information.

d. Inconclusive. The event may have been expected and already reflected in the stock price,
or the event might not have been significant enough to impact the stock price.

Questions – Topic 8

8. Bond calculation questions

a. Calculate the duration of the bond if the YTM is 5%.

Duration Calculation:
Cash flows: [8, 8, 8, 8, 108]
Discount factors for YTM of 5%: [1.05, 1.1025, 1.1576, 1.2155, 1.2763]
Present values of cash flows: [7.62, 7.25, 6.91, 6.58, 84.61]
Duration: (1*7.62 + 2*7.25 + 3*6.91 + 4*6.58 + 5*84.61) / (7.62 + 7.25 + 6.91 + 6.58 +
84.61) = 4.36 years

b. Duration of the bond after the first interest payment.

Duration Calculation after first payment:

Cash flows: [8, 8, 8, 108]
Discount factors for YTM of 5%: [1.05, 1.1025, 1.1576, 1.2155]
Present values of cash flows: [7.62, 7.25, 6.91, 88.84]
Duration: (1*7.62 + 2*7.25 + 3*6.91 + 4*88.84) / (7.62 + 7.25 + 6.91 + 88.84) = 3.60 years

c. Price change in percentage after YTM falls from 5% to 3%.

Price Calculation before YTM change:

Price: (8/1.05 + 8/1.1025 + 8/1.1576 + 8/1.2155 + 108/1.2763) = 110.64

Price Calculation after YTM change:

Price: (8/1.03 + 8/1.0609 + 8/1.0927 + 8/1.1255 + 108/1.1593) = 118.59
Percentage price change using duration: -Duration * (YTM_new - YTM_initial)
Percentage price change: -3.60 * (0.03 - 0.05) = 7.20%