Question

d. announced its annual earnings on day 0, which was higher than the analyst- casted earnings. The total abnormal return of ABC Ltd. over the 5-day window (-2, +2) urrounding the earnings announcement was positive. In the absence of any new firm-specific normation following the earnings announcement, a negative total abnormal return to ABC was observed over the period of day +3 to +60. Required: Explain whether this time pattern of abnormal return is consistent with market efficiency. If not, provide possible explanations for such a price behavior.

Answer 1

Market efficiency basically means that stock prices reflect all available information and it is generally not possible to earn abnormal return on same. Also Finance theory basically categorizes markets as following types efficient :

1. Strong Form Market Efficiency : If a market is strong form market efficient, it means that abnormal earnings cannot be earned by trading on both public and non public information as all is reflectedin the price.

2. Semi Strong form market efficiency : If a market is Semi Strong form market efficient , it means that abnormal earnings cannot be earned by fundamental analysis but can be earned by trading on Non Public information.

3. Weak Form Market Efficiency : If a market is weak form market efficient, abnormal profits can be earned by trading on technical analysis as well. Even past trends can be used to earn abnormal returns.

In the given case, Abnormal gains and losses has been earned around earning announcement. Earnings announcement should be a non public information. (As public will not have access to it before the announcement).

As abnormal gains and loses has been earned here pre / post earnings announcement, the given case is a violation of strong form market hypothesis.

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Possible explanation for such behaviour.

If a market is very much optimistic about very good financial results and earning annoucement from a company, more traders might want to hold the shares and so the price of the shares might increase. However if the earnings annoucement does not meet market expectations. This might lead to abnormal losses post earnings announcement.