Financial Economics 2023 - I

Final Project

1. The following table provides information about the performance of four mutual funds
available for investment in the US market.

You have been hired by an investor to select a fund to invest 1000 USD. What would you
recommend to the investor?

2. This article is about a former asset manager at Swiss investment bank UBS that quit his job
ten years ago to live off dividends paid by ETFs. He claims that if investor don’t have time to
watch the market, they should focus on ETFs rather than individual stocks.
Look up the definition of ETF. Do you agree with this assertion? Are there any theoretical
results from Financial Economics that support this statement?

3. Suppose that the future cash flows of an asset are accurately estimated. The asset trades in
a market that you believe is efficient based on most evidence, but your estimate of the
asset’s intrinsic value exceeds the asset’s market value by a moderate amount.

What can you conclude about your estimation of the asset’s risk?
4. What is the most likely expected effect on market efficiency of opening a securities market
to trading by foreigners?

5. In early 2021, U.S. investors started buying so many shares of American video game,
consumer electronics, and gaming merchandise retailer GameStop, that they made its stock
price soar into the clouds, causing major financial consequences for certain hedge funds and
large losses for short sellers. Approximately 140 percent of GameStop's public float had
been sold short, and the rush to buy shares to cover those positions as the price rose caused
it to rise even farther: over January, the stock went up more than 1900%.

This so-called short squeeze was initially and primarily triggered by users of WallStreetBets
(WSB), an Internet forum on the social news website Reddit, although a number of hedge
funds also participated.

At its height, on January 28, the short squeeze caused the retailer's stock price to reach a
pre-market value of over USD $500 per share, nearly 30 times the $17.25 valuation at the
beginning of the month. The price of many other heavily shorted securities and
cryptocurrencies also increased. GameStop share prices were so volatile, that after hitting
its aforementioned peak, it fell 44% the next day, and went back to $325 the day after that.
At that point, there was no extra information as to why GameStop's stock flew like a bird
into the sky. It was simply a bunch of people on Reddit who decided that making the stock
soar would be a great way to disrupt the status quo.

In summary, the stock went from $17 to $325 to $90 in a matter of days, but only one of
those valuations should be correct. Do you think this is counterevidence that breaks the
efficient market hypothesis? Explain.

6. Suppose that a speculative-grade bond issuer announces, just before bond markets open,
that it will default on an upcoming interest payment. In the announcement, the issuer
confirms various reports made in the financial media in the period leading up to the
announcement.

Prior to the issuer’s announcement, the financial news media reported the following:

 Suppliers of the company were making deliveries only for cash payment, reducing
the company’s liquidity.

 The issuer’s financial condition had probably deteriorated to the point that it lacked
the cash to meet an upcoming interest payment.

 Although public capital markets were closed to the company, it was negotiating
with a bank for a private loan that would permit it to meet its interest payment and
continue operations for at least nine months.
 If the issuer defaults on the bond, the consensus opinion of analysts is that bondholders will
recover approximately $0.36 to $0.38 per dollar face value. Assuming that the market for
the bond is efficient,

a. When will the bond’s market price most likely reflect the bond’s value after default?
Explain your answer.

 In the period leading up to the announcement.

 In the first trade prices after the market opens on the announcement day.
 when the issuer actually misses the payment on the interest payment date.

b. What will be the piece of information that bond investors most likely focus on in the
issuer’s announcement? Explain your answer.

 Issuer failed in its negotiations for a bank loan.

 Issuer lacked the cash to meet the upcoming interest payment.
 Issuer has been required to make cash payments for supplier deliveries.

7. Assume that the shares of a small market capitalization (cap) company trade on a public
stock exchange. Because of its size, it is not considered blue-chip1, so not many professional
investors follow the activities of the company.

A small-cap fund analyst reports that the most recent annual operating performance of the
company has been surprisingly good, considering the recent slump in its industry. The
company’s share price, however, has been slow to react to the positive financial results
because the company is not being recommended by the majority of research analysts. This
mispricing implies that the market for this company’s shares is less than fully efficient.

The small-cap fund analyst recognizes the opportunity and immediately recommends the
purchase of the company’s shares. The share price gradually increases as more investors
purchase the shares once the news of the mispricing spreads through the market. As a
result, it takes a few days for the share price to fully reflect the information.

Six months later, the company reports another solid set of interim financial results. But
because the previous mispricing and subsequent profit opportunities have become known
in the market, the number of analysts following the company’s shares has increased
substantially.

a. What do you think is the effect on the stock price, as soon as the unexpected information
about the positive interim results are released to the public?

b. How quick do you think the stock price will incorporate this information?

1
A “blue-chip” share is one from a well-recognized company that is considered to be high quality but low risk. This term generally
refers to a company that has a long history of earnings and paying dividends.
8. Consider the following example of a news item and its effect on a share’s price. The
following events related to Tesla, Inc. in August of 2018:

1 August 2018
After the market closes, Tesla, Inc., publicly reports that there was a smaller-than expected cash
burn for the most recent quarter.

2 August 2018
Elon Musk, Chairman and CEO of Tesla, Inc., notifies Tesla’s board of directors that he wants to
take the company private. This is not public information at this point.

7 August 2018
Before the market opens, the Financial Times reports that a Saudi fund has a $2 billion
investment in Tesla. During market trading, Musk announces on Twitter “Am considering taking
Tesla private at $420. Funding secured.” [@elonmusk, 9:48 a.m., 7 August 2018]

24 August 2018
After the market closed, Musk announces that he no longer intends on taking Tesla private.

The following chart depicts Open-High-Low-Close graph of Tesla, Inc. Stock from 31 July 2018 to
31 August 2018. White (resp. black) rectangles indicate upward (resp. downward) movement.

a. Is the fact that the price of Tesla moves up immediately on the day after the Q2 earnings
(the first day of trading with this information) indicative of efficiency regarding information?
Explain your answer.

b. Does the fact that the price of Tesla moves up but does not reach $420 on the day the going-
private Twitter announcement mean that investors underreacted? Explain your answer.

c. Does the fact that the market price of the stock declined well before the issue of going-
private was laid to rest by Musk mean that the market is inefficient? Explain.