CURRENT ISSUES IN FINANCIAL MANAGEMENT

CURRENT ISSUES IN FINANCIAL MANAGEMENT

Tutorial 1 Market Efficiency

1. DMSE 100 is an index composed of the 100 largest companies listed on the

Dummy Stock Exchange. The following diagram shows the probabilities that   Page | 1

DMSE 100 will go up or down in the next four trading days. Suppose these probabilities reflect accurately the movement of the market for the foreseeable future. Is this an efficient market? Explain.

No. it is not.

An efficient market is fair to all players, i.e. the probability of being a loser or winner is equal.

In the above market, however, you are more likely to lose than to win.

Georgia Michelakos is a seasoned investor. She is planning to increase her holdings of some blue-chip stocks. Having analyzed the information on the stock market and the companies she is considering investing in, Georgia decides that she should wait for a better time to enter the market as she believe that the stocks are over-priced now.

Page | 2

1. If Georgia is correct in her assessment of the stock market, is the market efficient? Explain your answer using appropriate theories.

1. How would Georgia, by her information gathering and exploitation, contribute to the efficiency of the stock market?

1. Give three reasons, together with explanations, why information efficiency is a desirable attribute of the asset market.

1. When a market is efficient, the expected gain from waiting is zero.
2. If her information is correct, i.e. the stock is over-priced, her decision to postpone buying would depress the current price, making the price more reflective of the information available on the market.
3. In an efficient market, prices will always reflect the information available. Prices are therefore the best information. Consequently, there is no need for financial managers to devote valuable resources (e.g. manpower) in information gathering. Investors are also more likely to participate in an efficient market as any risk they take is reflected in the market price already. More importantly, prices in an efficient market guide scarce economic resources to be allocated to the best possible use.

The following table shows the returns on Summer plc and Winter plc together with market return before and after date 0 when devastating news regarding the prospects of the food industry hit the market.

 Summer Winter FTSE100 -4 -0.6% 11.0% -0.7% -3 0.0% -1.5% -0.7% -2 -2.4% -0.6% -1.4% -1 -3.0% -0.6% -0.7% 0 -1.8% 0.3% 0.0% 1 2.4% -11.6% -2.1% 2 1.8% -16.0% 0.0% 3 1.2% 4.5% -1.4% 4 0.0% 9.6% 0.7%  -0.01 0.01  -0.43 2.71

Page | 3

1. Calculate the expected returns for both companies using the market model.

1. Calculate the average abnormal returns of the two companies from date -4 to date 4 based on results from (a).
2. Calculate and plot the cumulative abnormal returns for these two companies.
3. Comment on the graph in terms of market efficiency.

Formulae:

∑   (𝑥 − 𝑥̅)(𝑦 − 𝑦)

𝛽 =

∑ (𝑥 − 𝑥̅)

𝛼 = 𝑦 − 𝛽𝑥̅

1. Calculate the expected returns for both companies using the market model.

The market model. It is a variation of the CAPM, taking the form of: Page | 4 𝑹𝒊,𝒕 = 𝜶𝒊 + 𝜷𝒊𝑹𝒎,𝒕

 Summer 𝑹𝒊,𝒕 FTSE100 -4 -0.6% (- 0.01) + (- 0.43)x(- 0.7%)= – 0.699% -0.7% -3 0.0% -0.7% -2 -2.4% (-0.01) + (-0.43)x(-1.4%)= – 0.398% -1.4% -1 -3.0% -0.7% 0 -1.8% (-0.01) + (-0.43)x(0.0%)= – 1% 0.0% 1 2.4% -2.1% 2 1.8% 0.0% 3 1.2% -1.4% 4 0.0% (- 0.01) + (- 0.43)x( 0.7%)= – 1.301% 0.7%  – 0.01  – 0.43

 Winter 𝑹𝒊,𝒕 FTSE100 -4 11.0% ( 0.01) + (2.71)x(- 0.7%)= – 0.897% -0.7% -3 -1.5% -0.7% -2 -0.6% ( 0.01) + (2.71)x(- 1.4%)= -2.794% -1.4% -1 -0.6% -0.7% 0 0.3% ( 0.01) + (2.71)x(0.0%)= 1% 0.0% 1 -11.6% -2.1% 2 -16.0% 0.0% 3 4.5% -1.4% 4 9.6% ( 0.01) + (2.71)x( 0.7%)= 2.897% 0.7%  0.01  2.71

1. Calculate the average abnormal returns of the two companies from date -4 to date 4 based on results from (a).

𝐴𝑅 ,                                                                                   = 𝑅 , − 𝑅 ,                                                          Page | 5

 Summer 𝑹𝒊,𝒕 𝑨𝑹𝒊,𝒕 -4 -0.6% -0.699% (- 0.6%) – (- 0.699%) = 0.099% -3 0.0% -0.699% 0.0% – (- 0.699%) = 0.699% -2 -2.4% -0.398% (- 2.4%) – (- 0.398%) = – 2.002% -1 -3.0% -0.699% 0 -1.8% -1.000% 1 2.4% -0.097% 2 1.8% -1.000% 3 1.2% -0.398% 4 0.0% -1.301%  – 0.01 -0.699%  – 0.43 -0.699%

 Winter 𝑹𝒊,𝒕 𝑨𝑹𝒊,𝒕 -4 11.0% -0.897% 11.0% – (-0.897%) = 11.897% -3 -1.5% -0.897% (- 1.5%) – (- 0.897%) = – 0.603% -2 -0.6% -2.794% (- 0.6%) – (- 2.794%) = 2.194% -1 -0.6% -0.897% 0 0.3% 1.000% 1 -11.6% -4.691% 2 -16.0% 1.000% 3 4.5% -2.794% 4 9.6% 2.897%  0.01 -0.897%  2.71 -0.897%

1. Calculate the cumulative abnormal returns for these two companies.

1

𝐴𝑣𝑒. 𝐴𝑅                                                            = 𝐴𝑅 ,

𝑛

Page | 6

𝐶𝐴𝑅  =                                                     𝐴𝑣𝑒. 𝐴𝑅

 𝑨𝑹𝒊,𝒕 Summer 𝑨𝑹𝒊,𝒕 Winter 𝐴𝑣𝑒. 𝐴𝑅 𝐶𝐴𝑅 -4 0.099% 11.897% (0.099% + 11.897% )/2= 5.998% 5.998% -3 0.699% -0.603% [0.699% + (-0.603%)]/2 = 0.048% 5.998% + 0.048% = 6.046% -2 -2.002% 2.194% [(-2.002%) + 2.194%]/2 = 0.096% 6.064% + 0.096% = 6.142% -1 -2.301% 0.297% -1.002% 6.142% + (−1.002%) = 5.140% 0 -0.800% -0.700% -0.750% 4.390% 1 2.497% -6.909% -2.206% 2.184% 2 2.800% -17.000% -7.100% -4.916% 3 1.598% 7.294% 4.446% -0.470% 4 1.301% 6.703% 4.002% 3.532%

1. Plot the cumulative abnormal returns graph. Comment it in terms of market efficiency.

The graph indicates large abnormal returns in days immediately after the event. The picture does not fit into that of the theoretical efficient market which requires the information to be incorporated instantaneously and fully.

Extra Q: what if the expected return is calculated using the mean adjusted model?

1

𝑅 =                                                               𝑅 ,

𝑚

Page | 8

 Summ er 𝑅 Summer -4 (      . %)       . %    (      . %)    (      . %) = – 1.5% -0.6% -3 0.0% – 1.5% -2 -2.4% – 1.5% -1 -3.0% – 1.5% 0 -1.8% – 1.5% 1 2.4% – 1.5% 2 1.8% – 1.5% 3 1.2% – 1.5% 4 0.0% – 1.5%

 Winte r Winter 𝑅 -4 %   (      . %)    (      . %)    (      . %) = 2.075% 11.0% -3 -1.5% 2.075% -2 -0.6% 2.075% -1 -0.6% 2.075% 0 0.3% 2.075% 1 -11.6% 2.075% 2 -16.0% 2.075% 3 4.5% 2.075% 4 9.6% 2.075%

CURRENT ISSUES IN FINANCIAL MANAGEMENT

Tutorial 1 Market Efficiency

1. DMSE 100 is an index composed of the 100 largest companies listed on the

Dummy Stock Exchange. The following diagram shows the probabilities that   Page | 1

DMSE 100 will go up or down in the next four trading days. Suppose these probabilities reflect accurately the movement of the market for the foreseeable future. Is this an efficient market? Explain.

No. it is not.

An efficient market is fair to all players, i.e. the probability of being a loser or winner is equal.

In the above market, however, you are more likely to lose than to win.

Georgia Michelakos is a seasoned investor. She is planning to increase her holdings of some blue-chip stocks. Having analyzed the information on the stock market and the companies she is considering investing in, Georgia decides that she should wait for a better time to enter the market as she believe that the stocks are over-priced now.

Page | 2

1. If Georgia is correct in her assessment of the stock market, is the market efficient? Explain your answer using appropriate theories.

1. How would Georgia, by her information gathering and exploitation, contribute to the efficiency of the stock market?

1. Give three reasons, together with explanations, why information efficiency is a desirable attribute of the asset market.

1. When a market is efficient, the expected gain from waiting is zero.
2. If her information is correct, i.e. the stock is over-priced, her decision to postpone buying would depress the current price, making the price more reflective of the information available on the market.
3. In an efficient market, prices will always reflect the information available. Prices are therefore the best information. Consequently, there is no need for financial managers to devote valuable resources (e.g. manpower) in information gathering. Investors are also more likely to participate in an efficient market as any risk they take is reflected in the market price already. More importantly, prices in an efficient market guide scarce economic resources to be allocated to the best possible use.

The following table shows the returns on Summer plc and Winter plc together with market return before and after date 0 when devastating news regarding the prospects of the food industry hit the market.

 Summer Winter FTSE100 -4 -0.6% 11.0% -0.7% -3 0.0% -1.5% -0.7% -2 -2.4% -0.6% -1.4% -1 -3.0% -0.6% -0.7% 0 -1.8% 0.3% 0.0% 1 2.4% -11.6% -2.1% 2 1.8% -16.0% 0.0% 3 1.2% 4.5% -1.4% 4 0.0% 9.6% 0.7%  -0.01 0.01  -0.43 2.71

Page | 3

1. Calculate the expected returns for both companies using the market model.

1. Calculate the average abnormal returns of the two companies from date -4 to date 4 based on results from (a).
2. Calculate and plot the cumulative abnormal returns for these two companies.
3. Comment on the graph in terms of market efficiency.

Formulae:

∑   (𝑥 − 𝑥̅)(𝑦 − 𝑦)

𝛽 =

∑ (𝑥 − 𝑥̅)

𝛼 = 𝑦 − 𝛽𝑥̅

1. Calculate the expected returns for both companies using the market model.

The market model. It is a variation of the CAPM, taking the form of: Page | 4 𝑹𝒊,𝒕 = 𝜶𝒊 + 𝜷𝒊𝑹𝒎,𝒕

 Summer 𝑹𝒊,𝒕 FTSE100 -4 -0.6% (- 0.01) + (- 0.43)x(- 0.7%)= – 0.699% -0.7% -3 0.0% -0.7% -2 -2.4% (-0.01) + (-0.43)x(-1.4%)= – 0.398% -1.4% -1 -3.0% -0.7% 0 -1.8% (-0.01) + (-0.43)x(0.0%)= – 1% 0.0% 1 2.4% -2.1% 2 1.8% 0.0% 3 1.2% -1.4% 4 0.0% (- 0.01) + (- 0.43)x( 0.7%)= – 1.301% 0.7%  – 0.01  – 0.43

 Winter 𝑹𝒊,𝒕 FTSE100 -4 11.0% ( 0.01) + (2.71)x(- 0.7%)= – 0.897% -0.7% -3 -1.5% -0.7% -2 -0.6% ( 0.01) + (2.71)x(- 1.4%)= -2.794% -1.4% -1 -0.6% -0.7% 0 0.3% ( 0.01) + (2.71)x(0.0%)= 1% 0.0% 1 -11.6% -2.1% 2 -16.0% 0.0% 3 4.5% -1.4% 4 9.6% ( 0.01) + (2.71)x( 0.7%)= 2.897% 0.7%  0.01  2.71

1. Calculate the average abnormal returns of the two companies from date -4 to date 4 based on results from (a).

𝐴𝑅 ,                                                                                   = 𝑅 , − 𝑅 ,                                                          Page | 5

 Summer 𝑹𝒊,𝒕 𝑨𝑹𝒊,𝒕 -4 -0.6% -0.699% (- 0.6%) – (- 0.699%) = 0.099% -3 0.0% -0.699% 0.0% – (- 0.699%) = 0.699% -2 -2.4% -0.398% (- 2.4%) – (- 0.398%) = – 2.002% -1 -3.0% -0.699% 0 -1.8% -1.000% 1 2.4% -0.097% 2 1.8% -1.000% 3 1.2% -0.398% 4 0.0% -1.301%  – 0.01 -0.699%  – 0.43 -0.699%

 Winter 𝑹𝒊,𝒕 𝑨𝑹𝒊,𝒕 -4 11.0% -0.897% 11.0% – (-0.897%) = 11.897% -3 -1.5% -0.897% (- 1.5%) – (- 0.897%) = – 0.603% -2 -0.6% -2.794% (- 0.6%) – (- 2.794%) = 2.194% -1 -0.6% -0.897% 0 0.3% 1.000% 1 -11.6% -4.691% 2 -16.0% 1.000% 3 4.5% -2.794% 4 9.6% 2.897%  0.01 -0.897%  2.71 -0.897%

1. Calculate the cumulative abnormal returns for these two companies.

1

𝐴𝑣𝑒. 𝐴𝑅                                                            = 𝐴𝑅 ,

𝑛

Page | 6

𝐶𝐴𝑅  =                                                     𝐴𝑣𝑒. 𝐴𝑅

 𝑨𝑹𝒊,𝒕 Summer 𝑨𝑹𝒊,𝒕 Winter 𝐴𝑣𝑒. 𝐴𝑅 𝐶𝐴𝑅 -4 0.099% 11.897% (0.099% + 11.897% )/2= 5.998% 5.998% -3 0.699% -0.603% [0.699% + (-0.603%)]/2 = 0.048% 5.998% + 0.048% = 6.046% -2 -2.002% 2.194% [(-2.002%) + 2.194%]/2 = 0.096% 6.064% + 0.096% = 6.142% -1 -2.301% 0.297% -1.002% 6.142% + (−1.002%) = 5.140% 0 -0.800% -0.700% -0.750% 4.390% 1 2.497% -6.909% -2.206% 2.184% 2 2.800% -17.000% -7.100% -4.916% 3 1.598% 7.294% 4.446% -0.470% 4 1.301% 6.703% 4.002% 3.532%

1. Plot the cumulative abnormal returns graph. Comment it in terms of market efficiency.

The graph indicates large abnormal returns in days immediately after the event. The picture does not fit into that of the theoretical efficient market which requires the information to be incorporated instantaneously and fully.

Extra Q: what if the expected return is calculated using the mean adjusted model?

1

𝑅 =                                                               𝑅 ,

𝑚

Page | 8

 Summ er 𝑅 Summer -4 (      . %)       . %    (      . %)    (      . %) = – 1.5% -0.6% -3 0.0% – 1.5% -2 -2.4% – 1.5% -1 -3.0% – 1.5% 0 -1.8% – 1.5% 1 2.4% – 1.5% 2 1.8% – 1.5% 3 1.2% – 1.5% 4 0.0% – 1.5%

 Winte r Winter 𝑅 -4 %   (      . %)    (      . %)    (      . %) = 2.075% 11.0% -3 -1.5% 2.075% -2 -0.6% 2.075% -1 -0.6% 2.075% 0 0.3% 2.075% 1 -11.6% 2.075% 2 -16.0% 2.075% 3 4.5% 2.075% 4 9.6% 2.075%

The rest of the steps are the same as above

The rest of the steps are the same as above