Question

1)You have a friend who claims that because Microsoft has a higher standard deviation than Exxon, it must have a higher cost of equity as well. Briefly explain why this is an incorrect statement.

2)You are currently looking for a new stock in which to invest. Through a friend of a friend, you hear that Evaporite Systems Inc. has just successfully completed testing on a new system to eliminate wastewater which will make all other systems obsolete, and have partnered with a major petroleum development company to bring it to market.   In the space below, describe under which form(s) of market efficiency it would be worth your time and effort to invest in this company, and under what form(s) of efficiency it would not be feasible. Why is this the case?

Answer 1

1. This is an incorrect statement because cost of equity is not dependent on standard deviation but on Beta. Standard Deviation is a measure of total risk which Beta is a measure of only market risk. Hence, a Company can have a higher Standard Deviation but still may have lower cost of equity.

2. It would be worth my time and effort to invest in this Company only if the market is semi-strong form efficient. In case, the market is strong form efficient, it will not be worth to invest.

In case of semi-strong efficiency, only publically available information is priced in the market price and hence a profit can be made based on private information. However, in case of strong form efficiency, even the private information is priced in and hence no profit can be made even with insider information which is not available in public.