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You can discuss the exam questions, but only with other students in the class, and without taking notes during the discussion. You must prepare your own answers and hand in your own write-up of the answers. You are not to show your answers to other students.
Do not turn in this exam question unless you accept the following honor code pledge.
I pledge on my honor that in preparing the answers to this question, I have not consulted anyone other than students in the current class, I have not taken notes during my discussions, and I have not consulted written material prepared by other students in the class or the answers to related questions prepared by students in previous years.
Focus on the question and be precise. Irrelevant material in your answer will draw a penalty.
Explain your answers, but in a total of less than one single-spaced or two double-spaced typewritten pages (one inch left and right margins, 10 point minimum font).
2.a. (25%) “At each time t we get a drawing from the joint distribution of prices assessed by the market in setting prices at the beginning of time t-1. Thus, with long time series on prices, it is easy to test whether the market uses all information about next period’s prices in setting this period’s prices. No model of market equilibrium is required.” Do you agree?
2b. (25%) “Stock returns are predictable. For example, many papers produce statistically reliable evidence that the return (RMt) for year t on the value-weight portfolio of NYSE stocks is predicted by the portfolio’s dividend yield for year t-1 (Dt-1/Pt-1, the ratio of the dividends earned on the portfolio during year t-1 to the price of the portfolio at the end of year t-1). Specifically, in the regression,
RMt = a + bDt-1/Pt-1 + et,
the regression slope b is positive and more than two standard errors from zero. This is evidence that the market is inefficient.” If one accepts the statistical evidence that b is reliably positive, when is the claim about market inefficiency true and when is it false?
2.c. (25%) “The FFJR stock split study finds that firms that split their shares experience different post-split returns depending on whether they increase or decrease dividends (relative to the market) in the year after the split. This in itself is not evidence of market efficiency, since it is normal that firms that continue to do well after the split have higher returns than firms that do relatively poorly.” Do you agree? If so, is there any evidence on market efficiency in the stock split study? Do you disagree? If so, explain?
2.d. (25%) “Firm A’s managers are lazy and a bit crooked. They forego investment projects that would add value to the firm, and they give high-paying jobs to their incompetent children and friends. In contrast, the managers of firm B always act to maximize the value of the firm. It is clear, then, that even though we all agree that the common stocks of the two firms have the same risk, the stock of firm B has a higher expected return.” Do you agree? Explain briefly.
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