Question

Are the following statements true or false? Briefly explain your answers. [Hint: State your        conclusion and then briefly explain (preferably in no more than a few lines).]

        (a)   If a firm announces an unexpectedly large cash dividend, the EMH would predict a gradual price change to occur for several weeks after the announcement.

       (b)   If the ROE of a company is higher than its discount rate r, it would be in shareholders’ interest to retain earnings in the company.                                    

       (c)   “Duration is a good measure of interest rate risk if change in yield is small and rates change     in a parallel fashion. Satisfying these two assumptions imply that two portfolios with the    same duration will react in exactly the same way to a given change in yield.” True or false?         Briefly explain your answer.                                  

Answer 1

Question a: the statement is false:

• The philosophy of EMH is based on the principle that the all the relevant information is captured in the stock price such that the stock is correctly priced. Since the company declares a large unexpected dividend, as per EMH the stock price would adjust immediately as per EMH to reflect the true price of stock after dividend.

Question b: the statement is true:

• If return on equity (ROE) is greater than the discount rate i.e., required return of the shareholders, it is better for shareholders to retain the stock since the stock is providing returns greater than expectation of the shareholders.

Question c: the statement is true:

• Immunization is a popular strategy for “locking in” a guaranteed rate of return over a particular time horizon. We got to earn a target rate of return over a horizon period. The whole focus of immunization strategy is to make the price effect (discounting) and income effect (compounding i.e., reinvestment effect) to cancel out each other at our investment horizon in case of change in interest rates