Question

1) A successful firm like Microsoft has consistently generated large profits for years. Is this a violation of the Efficient Market Hypothesis (EMH)? 2) Behavioral finance posits that market prices may deviate from fundamental values because of investor psychology and that mispricing can persist if rational arbitrageurs face substantial limits to arbitrage. In our class lecture on behavioral finance, we discussed three "limits to arbitrage". Choose 2 of the 3 limits to arbitrage that we discussed and explain them. 3) Consider a $1000 par value bond with a 5% coupon rate and semiannual coupons. The bond has a maturity of 4 years. Draw a time line showing the cash flows of this bond. 4) Suppose a three-year, $100 par value bond with a 8% coupon rate and semiannual cupons is trading with a yield to maturity of 10%. a) What is the current price of this bond? Is it trading at a discount, at par, or at a premium? b) What will be the price of the bond, if yield to maturity decreases to 6%? 5) Consider a 4-year, $1000 par value bond with zero coupons. If the yield to maturity is 10%, what would be the price of this bond? If the yield to maturity increases to 12% how much does the bond's price change?

Answer 1

1]

As per the EMH, all securities are priced fairly in the market. There are no overpriced or underpriced securities, and therefore no investor can earn an excess risk-adjusted return. All information is incorporated into the prices of securities.

EMH deals with pricing of securities, and assumes that all information is reflected in the prices of securities.

Hence, if Microsoft generates large profits for years, this information is incorporated into the price of Microsoft stock.

Therefore this is not a violation of EMH.

EMH deals with pricing of securities, and not the profitability of companies.