For each of the following scenarios, discuss whether profit opportunities exist

Question

For each of the following scenarios, discuss whether profit opportunities exist from trading in the shares of the firm under the conditions that: (1) the market is not weak-form efficient; (2) the market is weak from efficient but not semi- strong form efficient; (3) the market is semi strong-form efficient but not strong-form efficient and (4) the market is strong-form efficient a. The share price has risen steadily each day for the past 30 days. b. The financial statements for a company were released three days ago, and your believe you have uncovered some anomalies in the company's inventor)y and cost control reporting techniques that are causing the firm's true liquidity strength to be understated. c. You observe that the senior management of a company has been buying a lot of the company's shares on the open market over the past week.

Explanation / Answer

5. a) The share price has risen steadily each day for past 30 days:

If the market is not weak form efficient, this information could be acted on and a profit could be earned from following the price trend. Under (2), (3), and (4), this information is fully impounded in the current price and no abnormal profit opportunity exists.

5. b) The Financial Statements for a company were released 3 days ago, and you believe that you have uncovered some anomalies in the company's inventory and cost control reporting techniques that are causing the firm's true liquidity strength to be understated:

Under (2), if the market is not semi-strong form efficient, then this information could be used to buy the stock cheap before the rest of the market discovers the financial statement anomaly. Since (2) is stronger than (1), both imply that a profit opportunity exists; but under (3) and (4), this information is fully impounded in the current price and no profit opportunity exists.

5. c) You observe that the senior management of a company has been buying a lot of the company's shares on the open market over the past week:

Under (3), if the market is not strong form efficient, then this information could be used as a profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock is underpriced or that good news is imminent. Since (1) and (2) are weaker than (3), all three imply that a profit opportunity exists. Note that this assumes the individual who sees the insider trading is the only one who sees the trading. If the information about the trades made by company management is public information, it will be discounted in the stock price and no profit opportunity exists. Under (4), this information does not signal any profit opportunity for traders; Therefore, any pertinent information the manager-insiders may have is fully reflected in the current share price.

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