Question

Assume that you recently graduated with a degree in finance and have just reported to work as an investment adviser at the brokerage firm of Smyth Barry and Co. Your first assignment is to explain the nature of the U.S financial markets to Michelle Varga, a professional tennis player who recently came to the United States from Mexico. Varga is a highly ranked tennis player who expects to invest substantial amounts of money through Smyth Barry. She is very bright; therefore, she would like to understand in general terms what will happen to her money. Your boss has developed the following questions that you must use to explain the U.S financial system to Varga.

g. If Apple Computer decided to issue additional common stock, and Varga purchased 100 shares of this stock from Smyth Barry, the underwriter, would this transaction be a primary or a secondary market transactions? Would it make a difference if Varga purchased previously outstanding Apple stock in the dealer market? Explain.

h. What is an initial public offering (IPO)?

i. What does it mean for a market to be efficient? Explain why some stock prices may be more efficient than others.

j. After your consultation with Michelle, she wants to discuss these two possible stock purchases:

1. While in the waiting room of your office, she overheard an analyst on a financial TV network say that a particular medical research company just received FDA approval for one of its products. On the basis of this “hot” information, Michelle wants to buy many shares of that company’s stock. Assuming the stock market is highly efficient, what advice would you give her?

2. She has read a number of newspaper articles about huge IPO being carried out by a leading technology company. She wants to purchase as may shares in the IPO as possible and would even be willing to buy the shares in the open market immediately after the issue. What advice do you have for her?

k. How does behavioral finance explain the real world inconsistencies of the efficient markets hypothesis (EMH)?

Answer 1

G) Once the shares issued in primary market through IPO, then post that any additional share offering is done through secondary market only. The dealer is just a mediator in secondary market who post prices at which they will buy or sell a specific security of instrument.

H) Initial public offering(IPO) an act of offering the stock of a company on a public stock exchange for the first time.

I) A market is said to be efficient where the market is large and liquid and there is no arbitrage opportunities available. The stock price is trading at intrinsic price and where all information in a market, whether public or private, is accounted for in the price. The weak efficiency in market is there when companies are not transparent and information flow is not efficient, investment strategies intended to take advantage of inefficiencies are actually the fuel that keeps a market efficient.

J) 1) As the market is highly efficient then there is no scope of arbitrage and the news is already factored in the current stock price. So in an efficient market its very difficult to gain from news and events.

J) 2) If the stock is over subscribed in the market it generally carries premium with it and gets listed at a higher than expected price. If she gets the share in IPO then its great, she should hold on to that share. Depending upon the secondary market price and valuation (P/B and P/E ratios), further purchase should be done.

K) Behavioural finance borrows insights from psychology to better understand how irrational behaviour can be sustained over time. In a market there are buyers and sellers, with buying and selling rationales, based on their analysis and views of the market. Some see the market in its bull run whereas some see the bearish run. So these experiments indicate that investors and managers behave differently in down markets than they do in up markets. Moreover, at many times individual makes a subjective call on the basis of a biased mind-set.