Question a). Fairfux asks for information concerning the benefits of activing a

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a).     Fairfux asks for information concerning the benefits of activing a portfolio management. She is particularly interested in the question of whether active managers can be expected to consistently exploit inefficiencies in the capital markets to produce above average returns without assuming higher risk.

The semi strong form of the efficient market hypothesis (EMH) assets that all publicly available information is rapidly and correctly reflected in securities prices. This assertion implies that investors cannot expect to derive above average returns from purchases made after the information has become public because security prices already reflect the information

Identify and explain three examples of empirical evidence that tend to support the EMH implication stated above.           (9 marks)

ii)      Identify and explain three examples of empirical evidence that tend to refute the EMH implication stated above.                        (9 marks)

X Ltd recently paid an annual dividend on its stock of Shs.2 per share. The divided is expected to grow at Shs.l per share for the next four years. Thereafter the dividend is expected to grow at 5 % per year indefinitely. The required rate of return on stocks with similar risk is 12%. 'What is the intrinsic value of X Ltd.s stock? (6 marks)

Explanation / Answer

Solution:

a. The semi strong form of the efficient market hypothesis asserts that all publicly available information is correctly reflects the prices of securities. This indicates that investors cannot expect profits above average from purchases after information has become public because security price reflect the full available information.

ii.

Pricing and performance anomalies have been documented in a large number of studies. The ability to predict stock price performance depending on the publicly available information related to the company attributes or calendar effects is not consistent with the semi-strong form of EMH.

Calendar effects – various studies have documented seasonality to stock price performance. The January effect and various calendar effects seem to refute the semi-strong EMH, under which seasonalities would be reflected in market pricing.

Superior returns to small and neglected firms have been found to provide superior risk-adjusted returns relative to large stocks. Under the semi-strong EMH, public information regarding attributes would be reflected in pricing.

Given that D0 = 2, gn = 5 and k = 12%

Expected Dividend at the end of Year 1 (D1) = 2 + 1 = 3.

Expected Dividend at the end of Year 2 (D2) = 3 + 1 = 4.

Expected Dividend at the end of Year 3 (D3) = 4 + 1 = 5.

Expected Dividend at the end of Year 4 (D4) = 5 + 1 = 6

Expected Dividend at the end of Year 5 (D5) = 6*1.05 = 6.3

P4 = D5/(k – g)

P4 = 6.3/(0.12 – 0.05)

P4 = $90

P0 = D1/(1 + k) + D2/(1 + k)^2 + D3/(1 + k)^3 + (D4+P4)/(1 + k)^4

P0 = 3/1.12 + 4/1.12^2 + 5/1.12^3 + (6 + 90)/1.12^4

P0 = 70.44

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