FINA 351 – Managerial Finance, Ch. 10 (Ref 10c)

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FINA 351 – Managerial Finance, Ch. 10 (Ref 10c)
Refer to Section 10.6 of the chapter and the instructor notes.
1.
T or F: When a market is efficient, its prices will adjust quickly and accurately to new information.
2.
T or F: Competition among many knowledgeable investors makes stock markets efficient because any
mispriced stock is quickly identified and its price corrected, based on the rules of supply and demand.
3.
Suppose that negative information is publically released about a large, well-known corporation (e.g. Microsoft
announces its being investigated by the SEC for intentionally overstating net income).
(A) How long do you think it would take for the stock price to fully reflect this negative information?
(Seconds? Minutes? Hours? Days?)
(B) Do you think the stock price would initially drop to exactly the right level supported by the new
information, or do you think the price would overreact and have to correct itself? (Hint: see Figure 10.14).
4.
Read the story at the end of this assignment (Emulex Hoax) and then answer the following questions:
(A) How much did Mark Jakob make from his fraudulent scheme?
(B) What does it mean to sell short?
(C) Exactly how did Mark make these profits?
(D) How does this story illustrate market efficiency?
5.
(A) Refer to the “Finance Matters” box in your chapter. Do most mutual fund managers earn their keep? In
other words, would they perform better if they simply dumped their clients’ money in an index fund and went
out to play golf?
(B) The chart below shows how many times investment managers beat the S&P500. In how many of the 25years did more than half of the investment managers beat the S&P500 (i.e. > 50%)?
(C) T or F: The so-called “pros” might be able to beat the market for short periods of time (i.e. they got lucky)
but it is very difficult to consistently beat the market over a long period (unless they’re Warren Buffet).
(D) T or F: The EMH is supported by the fact that investment managers can’t consistently beat the market.
6.
For this question, refer to the information at the end of the instructor notes entitled Passively-Managed Index
Funds vs. Actively-Managed Funds. As you know, a mutual fund is created when people pool their money
together and hire someone to invest it for them. An index mutual fund is one that simply buys and holds the
stocks in an index, such as the S&P500 or DJIA. On the other hand, an actively-managed fund has a
professional manager who supposedly picks the hottest performing stocks on your behalf.
(A) Summarize the five advantages for investing in index mutual funds as opposed to actively-managed funds.
(B) Who is John Bogle and what does he say about the importance of minimizing expense ratios funds?
(C) It is almost certain that your retirement funds accumulated as an employee will be invested in mutual funds.
Assuming you will be an employee at some point in your life, will you choose index funds or actively managed
funds? Why?
7.
Suppose a fellow student says: “If the market is efficient, then it doesn’t matter where you invest your money in
the market- - selecting stocks by throwing darts at the Wall Street Journal will work just fine.” According to
your textbook, what would be your response?
8.
The evidence indicates that markets are most closely aligned with which form of EMH?
9.
What evidence indicates that the strong form of EMH cannot be true?
10.
Technical or quantitative analysts use past stock prices and various charting techniques to determine future
prices. Technical analysts focus on short-term price movements, which is much different than fundamental
analysts, who actually look at underlying fundamental indicators and focus on longer-term trends (e.g. Warren
Buffet).
To illustrate technical analysis, go to http://finance.yahoo.com and enter the ticker of MSFT. On the left menu
under Charts, click on Interactive. Use the Indicator pull-down menu to add the following technical analysis
indicators to your chart:
--Click on Simple Moving Average (SMA)
--Click on Exponential Moving Average (EMA)
--Click on MACD (which is the moving average convergence/divergence, measuring changes in strength,
momentum, direction and duration).
--Click on Bollinger Bands (which indicate how high or low the stock price could go, based on previous trades).
--Click on Stochastic (these models attempt to make sense out of seemingly random behavior).
Questions:
(A) Do you think you could make a quick buck using all these pretty charts and graphs (which is what daytraders do as they try to predict the price two minutes from now by tracking momentum)?
(B) What is the difference in focus between technical and fundamental analysts?
(C) Does Warren Buffet support technical or fundamental analysis?
(D) How well do you think technical analysts predict stock prices (i.e. do they make any money)?
11.
High frequency trading (HFT) occurs when powerful computers, connected to high-speed fiber optic cables,
execute large trades of stock in milliseconds, based on complex algorithms that analyze price trends in multiple
markets. The traders who receive and process the information a millisecond ahead of everyone else have the
advantage and can make millions of dollars. HFT is very controversial; some even claim it rigs the stock
market (see Michal Lewis’ bestseller “Flash Boys”). Others say it merely brings about faster price discovery
and efficiency. Watch the 3-minute video linked below and answer the following questions: Do you think HFT
is an overall positive or negative phenomenon?
https://www.youtube.com/watch?v=N34ziSFAfqM
12.
On May 6, 2010, stock prices declined abruptly in what is now referred to as the “flash crash.” Stocks declined
by more than 9 percent (1000 points) before reversing and recovering most of those losses on that same day,
when more than 19 billion shares were traded. It appears that the flash crash was triggered by computerized
high-frequency trading from a small-time London trader, Navinder Singh Sarao, who made $40 million on the
flash crash. On April 21, 2015, Sarao was arrested for his manipulating the market. In your opinion, did Sarao
commit a crime?
13.
What do think the following expression means? “If you can’t beat the market, then join it.”
14.
Suppose you have a summer internship working in the finance office of Compusoft (CS), a software company
based in Portland. The company’s stock trades on the Nasdaq and is currently priced at about $30 per share.
One morning you overhear the VP of Finance excitedly talking about how Microsoft has just made a takeover
offer to the CS board in an effort to obtain the company’s software. You gather that this news has not been
publicly released yet, but you know that it will be shortly. You also know that for MSFT to wrestle control
away from current CS stockholders, it must buy the stock at a premium price, say $50 per share (a $20 premium
above the current price of $30). Therefore, because you expect the stock price to jump significantly, you
immediately get on E-Trade and buy as much CS stock as you can afford (and then on margin you buy more
than you can afford). The next day, the public announcement of the takeover offer sends the stock price
soaring, and you sell all of your CS shares for a huge, beautiful capital gain.
(A)
Did your actions violate insider trading rules?
(B)
Does the fact that you made a killing on insider information confirm or contradict the strong form of
efficient markets? How about the semi-strong-form?
(C)
Suppose you wait until the day after the public announcement to buy your shares. The stock price stays
around $50 for weeks and you make no extraordinary return. In this case, did you violate insider
trading rules?
(D)
Who else (other than a summer intern) might have access to the insider information about the MSFT
takeover? List at least six types of individuals. (Hint: You can start with the janitors who dust the
CEO’s desk and take out her/his trash. You could also include the CEO’s shrink/counselor who learns
all about her/his stresses in life. For that matter, you might as well include the CEO’s family and
friends. And why not Bill Gates while you’re at it?)
(E)
There are many who feel that insider trading harms no one and should be legalized. Do you personally
think that insider trading is unethical and should be prosecuted by the government? Why or why not?
Emulex Hoax and Market Efficiency
Mark Jakob, a 23-year-old community college student, described his hobbies as “Las Vegas, snowboarding, beach
dancing, and playing the market.” Mark especially loved playing the stock market and spent most of his free time day
trading. He learned a lot about stocks and their reaction to new information while working at Internet Wire, Inc., a press
release distribution wire service. But he decided to leave the company to further his education. His self-described
motto was “let it ride.” On August 31, FBI agents escorted Mr. Jakob on a ride to his arraignment in a Los Angeles
federal court. He was later sentenced to 44 months in prison.
On August 17, Mark Jakob sold short 3000 shares of Emulex, a
high-tech firm based in Costa Mesa, California. He was not a
stranger to this stock, which he had been trading since April. For
some reason, Mark was betting that the stock price would drop.
(Selling short occurs when you borrow shares from a broker, sell
them while the price is high, and then buy them back at a lower
price and return them to the broker plus a fee, thus pocketing the
difference.)
But Mark bet wrong and Emulex stock price rose instead. Mark waited until Aug. 24,
when his paper loss had reached $97,000. In desperation, he used a computer in the
library at El Camino Community College to send an e-mail message, instructing his
former employer, Internet Wire, Inc., to issue a press release the next day at 9:30am
EDT. The press release falsely stated that the SEC was investigating Emulex, that the
company’s CEO had resigned, and that the company was revising and lowering its
earnings for the preceding quarter and the previous two years. Immediately after
creating this bogus news release, Mark drove to Las Vegas and registered in the Luxor
Hotel.
The next day, on August 25, several news organizations republished the press release,
including Dow Jones News Wire and Bloomberg News. In a 16-minute period following
the release of the fake news, 2.3 million shares of Emulex stock were traded and the
price plummeted almost $61.00, from $103.94 to $43.00, resulting in Emulex losing $2.2 billion in market
capitalization. At this point, having achieved the desired result, Mark Jakob purchased 3000 shares at a cheap price to
cover his short trade, and netted a profit of $54,696. He then purchased another 3500 shares of Emulex at a price of
$51.82. Later in the day when the hoax was discovered, the price rebounded to $105.75, at which time Mark sold his
3500 shares, netting a profit of $186,815. Mark then made the first of six requests to withdraw $477,950, the total
amount in the brokerage account. He was able to get $71,184 in cash before the FBI caught up with him.
In the end, a federal judge in the SEC’s civil action entered an injunction against Jakob prohibiting him from trading
securities in the future. In August, Mark was sentenced to 44 months in prison. The court further ordered Mark to
repay all of his gains from his scheme, plus interest, and a civil penalty of $102,642, for a total amount (approx.) of
$353,000. Mark consented to the court order without admitting or denying the allegations. Mark’s family members are
still shocked by the chain of events. His sister-in-law says: “Mark is a good kid. He wouldn’t do anything wrong.”
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