After the public announcement of the merger of two firms an investor makes abnormal returns by going long on the target firm and short on the acquiring firm. This most likely violates which form of market efficiency? A. Semi-strong form only B. Weak and semi-strong forms C. Semi-strong and strong form Answer is B but i was expecting C. Explanation is that it is a violation of the semi-strong form of market efficiency. Note that the semi-strong form of market efficiency encompasses the weak form. Therefore, both weak and semi-strong forms of market efficiency are violated. I get that the semi-strong form is violated. I don’t understand the second part. I would appreciate if someone can clear this to me. This is Q88 in the morning CFAI mock. Thanks.
You can refer the below. link…
http://www.analystforum.com/forums/cfa-forums/cfa-level-i-forum/91321776
I don’t get it. What happens to the stock price of the target firm and the acquiring firm? They both go up?
Thanks Nitish. Correct answer was indeed C. They updated this in the errata.
Hei.so - Price of the target firm will go up in value as they will be brought by the acquiring firm. The acquiring firm price will go down.
The errata says correct answer is A…
Its C for sure. They didn’t phrase it properlay.
So, their correction to the original mistake also wrong?
There is something I’ve been meaning to ask about this… semi-strong form says that you cannot earn abnormal profits by acting on public information because it will be reflected in the price. But in order to be reflected in the price, someone (or plural) has to have had acted on it (supposing no insider trading) causing the price to go up and hence reflecting the public information right? In that scenario, the person(s) would have earned abnormal profit. How does this compare against the semi-strong form theory?
I think that if this violates weak form, this also violates semi-strong and strong form so we should choose C.
That’s a very good question. Highlighted in bold in not necessarily correct though. Public information becomes available to everyone at the same time so no one has an advantage.
eg. Consider a company X trading at $95 per share. Suppose that this company publicaly announces a project that is expected to increase its income by $5 per share. Everyone in the market is aware of this information now(asssuming semi-strong).
An abnormal profit could be earned if you could manage to buy the stock at under $100 and sell it later. Now since everyone is aware that the value of the stock should be $100 due to the project no one would sell it below that.
Key point is that no trading was needed to be done for the share price to increase. Market price is determined by the price someone is willing to buy sell. Hope this helps.
I think I sort of get it, but just to add one last point for me to clear any doubts… Say no purchases were made after the announcement was made and before the price increased to $100, so there were no buyers who (could have) acted on the information to buy low and sell high to earn abnoral profits… But due to the information, the holders/sellers increase their asking price to reflect the information (which is what I think you mean), would this be considered earning abnormal profit by acting on the information?
Although I don’t think it would be that complicated or convulated for the exam…
Another thing, is the minimum level of efficient market the weak market? Or is there any possibility to violate that?
True that the holder benefit by asking for a high price. However, the point to take away and what they are trying to convery here is that in the semi-strong no one can make abnormal profit by having a strategy to act on newly released public information. The holders who benefit by the announcement haven’t really “acted” on the information to earn the $5 increase in that sense to consider the profit abnormal.
In terms of market efficeincy the order is weak
I think the missing word is consistently. No one can make abnormal profits consistently.
Understooded. =)