Banking and Finance
Topic 8
Tutorial Solutions
BFC3241
Equities and Investment Analysis
Semester 2, 2018
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BFC3241 Equities and Investment Analysis
WEEK Starting LECTURE TOPIC ASSIGNED READING TUTORIAL TOPIC
1 23 Jul Assets and Investments BDBKM, Ch. 3, 5.1 to 5.2 Open Discussions
2 30 Jul Portfolio Theory BDBKM, Ch.5 (from 5.5) Assets and
and Ch.6. Investments
3 6 Aug Asset Pricing Models BDBKM, Ch. 7 Portfolio Theory
4 13 Aug Equity Analysis I – Pearce & Robinson, Ch.4 Asset Pricing
Macro and Palepu et al., Ch.2 Models
Industry Analysis Porter (2008)
5 20 Aug Equity Analysis II Palepu et al., Ch. 5 Equity Analysis I
– Financial
Statement Analysis
6 27 Aug Equity Analysis III – Palepu et al., Ch. 6 Equity Analysis II
Financial Statement
Forecasting
7 3 Sep Equity Analysis IV – Palepu et al., Ch. 7 Equity Analysis III
Valuation BDBKM, Ch. 11
Implementation
8 10 Sep Market Efficiency and BDBKM, Ch. 8 Equity Analysis IV
Behaviour Finance I
9 17 Sep Market Efficiency and BDBKM, Ch. 8 Market Efficiency
Behaviour Finance II Nofsinger and Behaviour
Finance I
Mid Semester Break
10 1 Oct CFA Code of Ethics and CFA Standards of Practice Market Efficiency
Standards of Handbook and Behaviour
Professional Conduct Finance II
11 8 Oct Portfolio Management BDBKM, Ch. 16, 17 CFA Code of Ethics
–I and Standards of
12 15 Oct Portfolio Management BDBKM, Ch. 18 Portfolio
– II Management I
SWOT 22 Oct Portfolio
– VAC Management II
(Self Revision)
Mid Sem Break Mid Sem Test Group Presentations
Students are required to prepare answers for all questions. Due to time constraints,
students are encouraged to nominate the questions/problems for discussion at the
commencement of each tutorial. Solutions for all questions will be made available on
Moodle at the end of each week.
Tutorial 8 Week 9 – Market Efficiency & Behavioural
Finance I
Q.1. BDBKM Ch.8, CFA Q.6
a. Briefly explain the concept of the EMH and each of its three forms – weak,
semi- strong, and strong - and briefly discuss the degree to which existing
empirical evidence supports each of the three forms of the EMH.
b. Briefly discuss the implications of the EMH for investment policy as it applies to:
i. Technical analysis in the form of technical trading rules; and
ii. Fundamental analysis.
c. Briefly explain the roles or responsibilities of portfolio managers in an efficient
market environment.
Answer:
a. The EMH states that a market is efficient if security prices immediately and
fully reflect all available relevant information. If the market fully reflects
information, the knowledge of that information would not allow an investor to
profit from the information because share prices already incorporate the
information.
The weak form of the EMH asserts that stock prices reflect all the information
that can be derived by examining market trading data such as the history of past
prices and trading volume. A strong body of evidence supports weak-form
efficiency in the major US securities markets. For example, test results suggest
that technical trading rules do not produce superior returns after adjusting for
transaction costs and taxes.
The semi-strong form states that a firm’s stock price reflects all publicly
available information about a firm’s prospects. Examples of publicly available
information are company annual reports and investment advisory data. Evidence
strongly supports the notion of semi-strong efficiency, but occasional studies
(e.g. those identifying market anomalies such as the small-firm-in-January or
book-to-market effects) and events (e.g. the market crash of 19 October 1987)
are inconsistent with this form of market efficiency. However, there is a question
concerning the extent to which these ‘anomalies’ result from data mining.
The strong form of the EMH holds that current market prices reflect all
information (whether publicly available or privately held) that can be relevant to
the valuation of the firm. Empirical evidence suggests that strong-form
efficiency does not hold. If this form were correct, prices would fully reflect all
information. Therefore even insiders could not earn excess returns. But the
evidence is that corporate officers do have access to pertinent information long
enough before public release to enable them to profit from trading on this
information.
b.
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i. Technical analysis involves the search for recurrent and predictable patterns
in stock prices in order to enhance returns. The EMH implies that
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technical analysis is without value. If past prices contain no useful
information for predicting future prices, there is no point in following
any technical trading rule.
ii. Fundamental analysis uses earnings and dividend prospects of the firm,
expectations of future interest rates and risk evaluation of the firm to
determine proper share prices. The EMH predicts that most fundamental
analysis is doomed to failure. According to semi-strong form efficiency,
no investor can earn excess returns from trading rules based on publicly
available information. Only analysts with unique insight achieve
superior returns.
In summary, the EMH holds that the market appears to adjust so quickly to
information about both individual stocks and the economy as a whole that no
technique of selecting a portfolio using either technical or fundamental analysis
can consistently outperform a strategy of simply buying and holding a
diversified portfolio of securities, such as those comprising the popular market
indexes.
Portfolio managers have several roles and responsibilities even in perfectly
efficient markets. The most important responsibility is to identify the risk/return
objectives for a portfolio given the investor’s constraints. In an efficient market,
portfolio managers are responsible for tailoring the portfolio to meet the
investor’s needs, rather than to beat the market, which requires identifying the
client’s return requirements and risk tolerance. Rational portfolio management
also requires examining the investor’s constraints, including liquidity, time
horizon, laws and regulations, taxes and unique preferences and circumstances
such as age and employment.
Q.2.
Examine the statements below. In each instance, discuss whether statement
necessarily represents a violation of the efficient markets hypothesis.
a. Healthy News Ltd today announced that it’s annual earnings had increased, yet
its stock price fell today. Is there a rational explanation for this phenomenon?
b. Fund managers that are able to outperform the market on a risk-adjusted basis
in a given year are likely to outperform the market in the following year.
c. A successful firm like Woolworths has consistently generated large profits
for years.
Answer:
a. The market may have anticipated even greater earnings. Compared to prior
expectations, the announcement was a disappointment.
b. Inconsistent. This would be the basis of an “easy money” rule: simply invest with last
year's best managers.
c. No. Woolworths’s continuing profitability does not imply that stock market investors
who purchased Woolworths shares after its success was already evident would have
earned an exceptionally high return on their investments. It simply means that
Woolworths has made risky investments over the years that have paid off in the form of
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increased cash flows and profitability. Woolworths shareholders have benefited from
the risk-expected return trade-off, which is consistent with the EMH.
Q.3. BDBKM Ch.8, Q. 12, 13
a. Steady Growth Industries has never missed a dividend payment in its 94-year
history. Does this make it more attractive to you as a possible purchase for your
stock portfolio? (Assuming your purpose is total returns, not regular incomes).
b. Suppose you later find that prices of the stock before large dividend increases
show on average consistently positive abnormal returns. Is this a violation of the
EMH?
Answer:
a. No, it is not more attractive as a possible purchase. Any value associated with
dividend predictability is already reflected in the stock price.
b. No, this is not a violation of the EMH. This empirical tendency does not provide
investors with a tool that will enable them to earn abnormal returns. In other
words, it does not suggest that investors are failing to use all available
information. An investor could not use this phenomenon to choose undervalued
stocks today. Rather, the phenomenon may reflect the fact that dividends occur
as a response to good performance. After the fact, the stocks that happen to have
performed the best will pay higher dividends, but this does not imply that you
can identify the best performers early enough to earn abnormal returns.
Q.4.
The Excel file [Link] contains historical data from three large Australian takeover
announcements: Shell’s announcement of a significant increase in their holding of
Woodside Petroleum (WPL) on 18 May 2000; AMP’s announcement of a takeover of
GIO Insurance (GIO) on 25 August 1998; and, Wesfarmers announcement of a takeover
bid for Howard Smith (SMI) on 13 June 2001. Each of these events were unexpected
good news for shareholders of the target firm, given the bid was above the current share
price. Using the data provided, perform an event study to examine whether the market
appears to have reacted in an efficient manner with respect to these takeovers. You
should undertake the following steps:
1) Calculate the daily stock and market returns around the announcement period. Use
this to also calculate the abnormal returns for each stock.
2) Calculate average abnormal returns across the three events for the period t=-10
to t=10.
3) Calculate and plot the cumulative average abnormal returns.
Answer:
Cumulative
WPL GIO SMI Average Average
Event Abnorma Abnormal Abnormal Abnormal Abnormal
Date l Return Return Return Return Return
-10 -0.0175 -0.0100 -0.0299 -0.0191 -0.0191
-9 -0.0082 0.0240 0.0041 0.0067 -0.0125
-8 -0.0010 0.0524 0.0158 0.0224 0.0099
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-7 0.0191 -0.0626 0.0083 -0.0117 -0.0018
-6 0.0075 -0.0291 -0.0171 -0.0129 -0.0147
-5 0.0243 -0.0113 0.0165 0.0099 -0.0048
-4 0.0245 0.0012 0.0523 0.0260 0.0212
-3 0.0170 0.0259 -0.0274 0.0052 0.0263
-2 -0.0010 -0.0004 0.0000 -0.0005 0.0258
-1 0.0644 0.0005 -0.0140 0.0170 0.0428
0 0.0609 0.2759 0.2851 0.2073 0.2501
1 -0.0123 0.0007 0.0140 0.0008 0.2509
2 -0.0093 0.0115 0.0059 0.0027 0.2536
3 -0.0136 0.0075 -0.0163 -0.0074 0.2462
4 0.0335 0.0015 -0.0009 0.0114 0.2575
5 -0.0020 -0.0290 0.0011 -0.0100 0.2476
6 -0.0167 0.0121 0.0083 0.0012 0.2488
7 -0.0083 0.0052 0.0214 0.0061 0.2548
8 0.0112 0.0004 0.0346 0.0154 0.2703
9 0.0242 -0.0244 -0.0087 -0.0030 0.2673
10 -0.0062 0.0007 -0.0131 -0.0062 0.2611
Cumulative Average Abnormal Return
0.30
0.25
0.20
0.15
0.10
0.05
0.00
-0.05 -10 -8 -6 -4 -2 0 2 4 6 8 10
The market appears to have reacted instantaneously (ie on the event day) and without bias (no
post-event drift) to the announcements. Therefore, based on the evidence presented, it would
appear as though the market reacted efficiently to the release of this unexpected good news.
Q.5. BDBKM Ch.8, Q.15
Suppose that as the economy moves through a business cycle, risk premiums also
change. For example, in a recession when people are concerned about their jobs, risk
tolerance might be lower and risk premiums might be higher. In a booming economy,
tolerance for risk might be higher and risk premiums lower. Would a predictably
shifting risk premium such as described here be a violation of the EMH?
Answer:
If a shift were actually predictable, it would be a violation of the EMH. Such shifts
would be expected to occur as a result of a recession, but the recession is not
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predictable, thus it is not actually a violation of EMH. That being said, such a shift is
consistent with EMH since the shift occurs after a recession or recovery occurs. As the
news hits the market, the risk premiums are adjusted.
Q.6. BDBKM Ch.8, Q.22
What is meant by ‘limit-to-arbitrage’?
Answer:
Arbitrage assumes the ability to initiate profitable, risk-free trades based on market
information. Limits to arbitrage restrict the ability of market participants to profitably
exploit arbitrage opportunities in practice. Limits to arbitrage include; fundamental
risk, the risk that miss-priced assets move further away from, rather than closer to
fundamental value; implementation costs, the cost of the trading required to exploit the
arbitrage; and model risk, the risk that an arbitrage opportunity is incorrectly identified.
Q.7. Discuss the rationale for expecting a rational capital market. What factor would
you look for to differentiate the market for two alternative stocks? Specifically, why
should the efficiency of the markets for the stocks differ?
Answer:
There are several reasons why one would expect capital markets to be efficient, the
foremost being that there are a large number of independent, profit-maximizing
investors engaged in the analysis and valuation of securities. A second assumption is
that new information comes to the market in a random fashion; and the numerous
profit- maximizing investors adjust security prices rapidly to reflect this new
information. Thus, price changes would be independent and random. Finally, because
stock prices reflect all information, one would expect prevailing prices to reflect “true”
current value.
Capital markets as a whole are generally expected to be efficient, but the markets for
some securities might not be as efficient as others. Recall that markets are expected to
be efficient because there are a large number of investors who receive new information
and analyze its effect on security values. Firms with low analyst coverage are less
likely to be transparent (e.g. there is a higher chance that analysts improve the
dissemination of value relevant information held by firm management to the attention
of the investing public). Therefore, prices may not adjust as rapidly to new information
and the possibility of finding a temporarily undervalued stock are also greater.
Even if the two stocks are exposed to the same degree of informational inefficiency,
any difference in limits-to-arbitrage may result in the deviation in their overall
inefficiency. For example, of the two stocks that are subject to the same level of limited
attention by investors, one is subject to short-selling whereas the other is not. Hence,
the inefficiency of the latter is driven away while the former remains inefficient.
Finally, systematic behavioural biases by investors may also cause the market to stay
inefficient.