FM300: Corporate Finance, Investments, and Financial Markets

Section A - Michaelmas Term

Classwork 5
Answer key

1.
Buy. In your view, the firm is not as bad as everyone else believes it to be.
Therefore, you view the firm as undervalued by the market. You are less pessimistic
about the firm’s prospects than the beliefs built into the stock price.

2. (from BKM)
If everyone follows a passive strategy, sooner or later prices will fail to reflect new
information. At this point there are profit opportunities for active investors who
uncover mispriced securities. As they buy and sell these assets, prices again will be
driven to fair levels.

3.
Calculate and plot the cumulative abnormal return:

Average CAR
-2 -0.0185 -0.0185
-1 0.0976 0.0791
0 0.2528 0.3319
1 -0.0242 0.3077
2 -0.0366 0.2712

CAR

0.35

0.3

0.25

0.2

0.15

0.1

0.05

0
-2 -1 0 1 2
-0.05
t

There is evidence of a pre-announcement upward drift: this is typically due to leakage

of information.
There is also a post-announcement downward drift: this could be interpreted as
evidence of market inefficiency.
The CAR follows a reversal pattern. One behavioral explanation that is consistent
with this pattern is that investors over-react to news (e.g. they over-extrapolate the
good news contained in the dividend announcements). Subsequently, the price
converges to the true value of the stock and the return undergoes a correction phase.

4.

Var(Rt) = [a2+(1-a)2] σ2

Corr(Rt,Rt-1) = a(1-a) / [a2+(1-a)2]

a = 1/3 :
autocorrelation = 2/5.
Underreaction implies positive autocorrelation at one lag.

a = -1/3:
autocorrelation = -4/17.
Overreaction implies negative autocorrelation at one lag.