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 & 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. After your consultation with Michelle, she asks to discuss these two scenarios with you:

a. 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?

b. She has read a number of newspaper articles about a huge IPO being carried out by a leading technology company. She wants to get as many 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?

Answer 1

A. Assuming that stock markets is highly efficient, this would mean that information which becomes public is already priced in the price of share. Therefore the effect of the approval of FDA is already priced in the share of such medical company and Michelle would not be able to profit from such information. Therefore as investment advisor I would not recommend her to buy shares just based on some hot information.

B. As investment advisor I will make my client aware about the risks and rewards of investing in hot tech stocks as there may be a tendency for prices to go haywire and quite away from the fundamentals (therefore returns may be quite positive or negative). So these investment would carry high risk in terms of risk and rewards ratio. If based on client's investment objective this risk is acceptable then I would advise her to invest but within the risk limits set by discussing with her objectives.

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