MANCOSA: BCOM FINANCIAL MANAGEMENT YEAR 3 58 QUESTION 4 4.1 Doe s market efficie

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MANCOSA: BCOM FINANCIAL MANAGEMENT YEAR 3 58 QUESTION 4 4.1 Doe s market efficiency mean you can randomly pick stocks from a stock exchange to form your portfolio? (20) 4.2 The law strictly forbids insider trading. There has been regular prosecution against individuals who have traded with insider information about their own firms. What conclusion can you draw from this, and how does this information affect which form of the market efficiency hypothesis you might adopt? 4.3 Aerotech, an aerospace technology research firm, announced this morning that it has hired the world's most knowledgeable and prolific space researchers. Before today, Aerotech's stock had been selling for R100. Assume that no other information is received over the next week and the stock market as a whole does not move. 4.3.1 What do you expect to happen to Aerotech's stock? 4.3.2 Consider the following scenarios: (i) The stock price jumps to R118 on the day of the announcement. In subsequent days it floats up to R123,then falls back to R116. (i) The stock price jumps to R116 and remains at that level. (ii) The stock price gradually climbs to R116 over the next week. Which scenario(s) indicate market efficiency? Which do not? Why? 4.4 Proponents of EMH typically advocate: A. an active trading stratergy B. investing in an index fund C. a passive investment strategy D. A and B E. B and C ns from A to E above is most correct? Provide a motivation to support your answer (4) Which of the optio

Explanation / Answer

4.1 Market efficiency means a scenario where the prices of the stock are not expected to be equal to their fair values all the time. Prices may be over or undervalued only in random occurrences, so they eventually revert back to their mean values. As the deviations from a stock's fair price are random, investment strategies that result in beating the market cannot be a consistent phenomena. Choosing stock randomly doesnot mean that the market are efficient. We need to choose those stock which we think will perform better and will generate profits in the future.

4.2 The senior management has direct access to inside information. Strong market efficiency forbids insiders to trade on such sensitive information to earn abnormal returns and profits. This compromises the Strong form Market efficiency.

4.3.1 The price of the Aerotech's stock will rise as people will start buying the stock and demand for the stock will lead to increase. This is because the hiring of the world's best researchers will increase the confidence of the people in the company's stock and the price of the stock will tend to rise.

4.3.2 Scenario (ii) and (iii) are not a market efficient scenario as the price is rising to the fair value suddenly in case of (ii) and then remains constant at that level. Also, in case (iii) the price is not showing any change in response to the news announcement and is gradually increasing to fair value, this is not possible in an efficient market. Scenario (i) is a possible scenario of an effiicient market. As per (i), it might be possible that price jumps to 118 as a result of announcement and then gradually increasing as the demand for stock increased and then returning to the mean/fair value gradually.

4.4. EMH (Efficient-market hypothesis) is a theory that states that asset prices fully reflect all the available market information. It depicts a situation where it is impossible to consistently "beat the market" on a risk-adjusted basis. Market prices are volatile and react to every piece of new information.

Proponents of EMH typically advocate: investing in an index fund and a passive investment strategy. So, option (E) is the correct answer. A person who believes market to be effiecient (where the information is evenly distributed and a person cannot consistently beat the market) will invest in an index fund to replicate the returns of the index and bear only that amount of risk which is involved in the index and form a passive investment strategy to replicate that index and earn some profit.

  

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