7SSMM701 Tutorial 5 Solutions
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yuvrajwilson7SSMM701 Tutorial 5 Solutions
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yuvrajwilsonTutorial 5
Question 1
If markets are efficient, what should be the correlation coefficient between stock returns for
two non-overlapping time periods?
Answer 1
The correlation coefficient between stock returns for two non-overlapping periods should
be zero. If not, returns from one period could be used to predict returns in later periods and
make abnormal profits.
Question 2
A successful firm like Microsoft has consistently generated large profits for years. Is this a
violation of the Efficient Market Hypothesis (EMH)?
Answer 2
No. It means that Microsoft has made risky investments over the years that have paid off in
the form of increased cash flows and profitability. Microsoft shareholders have benefited
from the risk-expected return trade-off, which is consistent with the EMH.
In relation to the following Problem Sets
Chapter 11 is a chapter of Title 11 of the United States Bankruptcy Code, which permits
reorganization under the bankruptcy laws of the United States. Chapter 11 bankruptcy is
available to every business and to individuals, although it is most prominently used by
corporates. Chapter 11 allows the debtor to restructure its business. The debtor can acquire
financing and loans on favourable terms by giving new lenders first priority on the
business's earnings. Debtors are also protected from other litigation against the business
through the imposition of an “automatic stay”. While the “automatic stay” is in place,
creditors are stayed from any collection attempts or activities against the debtor, and
most litigation against the debtor is stayed, or put on hold, until it can be resolved in a
bankruptcy court.
1
Problem Set 1
In practise, when a company is under creditor protection regime (Chapter 11) typically the
Discounted Cash Flow (DCF) analysis is taken into consideration by the bankruptcy court.
What view would:
a) The expert/analyst hired by the creditors is likely to take regarding the value of the
company. Could he/she manipulate the DCF analysis to suit his/her purpose? If yes how?
(b) The expert/analyst hired by the debtor/corporate is likely to take regarding the value of
the company. Could he/she manipulate the DCF to suit his/her purpose? If yes how?
Problem Set 1 Solution
“An experienced analyst can of course manipulate the DCF analysis outcome. This can easily
be done by selectively using certain projections that suit his purposes better. Similarly the
terminal value can be manipulated by choosing a growth rate leading to the “desired”
outcome. This can be done by selecting a growth rate that is similar to the historical growth
rate of the company, the industry, or even the broader economy, whatever works better!”
(P. Koulafetis (2017), Credit Risk Management, Theory and Practise, Palgrave Macmillan)
The expert/analyst hired by the creditors will typically use a high discount rate and low
projections, whereas on the other hand the expert/analyst for the shareholder will typically
use a low discount rate and high projections.
In relation to the following Problem Set
Problem Set 2
You have a portfolio of five stocks (i.e. Stock 1, Stock 2, Stock 3, Stock 4 and Stock 5). Table 1
shows their Actual Return (Rstock) during their earnings’ announcements, their alpha (a),
beta (b) and the weight of each stock in your Portfolio. The return on the market index is
2%.
2
Estimate the Weighted Average Portfolio Abnormal Return.
Table 1
Actual Return R alpha (a) beta (b) Weight
Rstock 1 8% a1 0.01 b1 0.5 60%
Rstock 2 9% a2 0.02 b2 0.6 20%
Rstock 3 10% a3 0.03 b3 0.7 10%
Rstock 4 11% a4 0.04 b4 0.9 5%
Rstock 5 12% a5 0.05 b5 1.1 5%
Problem Set 2 Solution
bxRmarket
1.0%
1.2%
1.4%
1.8%
2.2%
a+(bxRmarket)
2.0%
3.2%
4.4%
5.8%
7.2%
Abnormal Return Weight
6% 60%
6% 20%
6% 10%
5% 5%
5% 5%
WA Abnormal Return 5.82%
3
Problem Set 3
In a recent closely contested lawsuit, Apex sued Bpex for patent infringement. The jury
came back today with its decision, after this the rate of return on Apex was rA = 3.9%. The
rate of return on Bpex was rB = 3.3%.
The market return, rM = 3.6%. The historical relationship between returns on these stocks
and the market portfolio has been estimated with the following model as:
On the basis of this data, which company do you think won the lawsuit?
Problem Set 3 Solution
Using the model provided, we predicted returns on the two stocks would be:
Apex: 0.5% + (1.2 × 3.6%) = 4.8%
Bpex: –0.1% + (0.6 × 3.6%) = 2.1%
Apex underperformed this prediction; Bpex outperformed the prediction. We conclude that
Bpex won the lawsuit.
