Question

35 30 25 Cumulative percent change in stock price of takeover target 15 10 5 + 5 + 10 0 15 -45 -40 -35 -30 -25 -20 -15 -10 -5 0 Days relative to takeover announcement (Day 0)

Suppose in Figure 5.3 that the stock prices of target firms in acquisitions responded to acquisition announcements over a three-day period rather than almost instantly. a. Would you describe such an acquisition market as efficient? Why or why not? b. Can you think of any trading strategy to take advantage of the delayed price response? c. If you and many others pursued this trading strategy, what would happen to the price response to acquisition announcements? d. Some argue that market inefficiencies contain the seeds of their own destruction. In what ways does your answer to this problem illustrate the logic of this statement, if at all? e. Immediately after some merger announcements, the stock price of the target firm jumps to a level higher than the bid price. Is this proof of market inefficiency? What might explain this price pattern?

Answer 1

a)

The acquisition market will be considered to be market inefficiency, the efficient market hypothesis is not enthusiastically hailed by professional portfolio managers. It implies that a great deal of the activity of portfolio managers – the search for undervalued securities - is at best wasted effort and quite probably harmful to clients because it costs money and leads to imperfectly diversified portfolio. So the market will be inefficient.

b)

Trading strategy which will help in delaying the response is to hold the merger.

c)

With this the prices of the stocks are likely to decline.

d)

Fama and French argue that the three-factor model, in which risk is determined by the sensitivity of a stock to (1) the market portfolio, (2) a portfolio that reflects the relative returns of small versus large firms, and (3) a portfolio that reflects the relative returns of firms with high versus low ratios of book value to mar­ket value, does a much better job than one-factor

CAPM in explaining security returns. While size or book-to-market ratios per se are obviously not risk factors, they perhaps might act as proxies for more fundamental determinants of risk. Fama and French argue that these patterns of re­turns may therefore be consistent with an efficient market in which expected returns are consistent with risk.