1. Bayes’ rule Consider a manager of an event-driven hedge fund. This type of hedge fund...
1. Bayes’ rule
Consider a manager of an event-driven hedge fund. This type of hedge fund strategy is focused on investing in financial instruments of companies undergoing some event, for example, bankruptcy. Suppose that the goal of the manager is to identify companies that may become acquisition targets for other companies. The manager is aware of some empirical evidence that companies with a very high value of a particular indicator-the ratio of stock prices to free cash flow per share (PFCF)- are likely to become acquisition targets and wants to test this hypothesis. The hedge fund manager gathers the following data about the companies of interest:
• The probability that a company becomes an acquisition target during the course of the year is 40%.
• 75% of the companies that become acquisition targets had values of PFCF more than three times the industry average.
• Only 35% of the companies that were not targeted for acquisition had PFCF higher than three times the industry average.
Suppose that a given company has a PFCF higher than three times the industry average.
What is the chance that this company becomes target for acquisition during the course of the year?
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1. Bayes’ rule
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2. options for a:lower or higher
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