Question

1. State the Efficient Market Hypothesis.
2. Current price of Apple stock is $170 per share. It pays an annual dividend of $12 per share. Equilibrium price in next year is $190. What is the equilibrium rate of return?
3. An ‘insider’ in Apple leaks out to a friend that the company will perform well, and the stock price could be $200 next year. What is the rate of return on the stock?
4. Instead of leaking out information, if it is made available to the public the optimal forecast of the price next year will be $200, what will be the current price according to the Efficient Market Hypothesis?

Answer 1

a) Efficient Market Hypothesis states that stock prices reflect all available information. It can be categorized based on the kind of information -

1) market information (weak-form)

2) public information + market information (semi-strong)

3) public information + private information (strong)

b) PV= $170 ; FV = $190 + $12 = $202

we know, PV = FV/(1+r)

   1+r = 202/170

   r = 1.1882 - 1 = 0.1882 = 18.82%

c) PV= $170 ; FV = $200 + $12 = $212

we know, PV = FV/(1+r)

   1+r = 212/170

   r = 1.247 - 1 = 0.247 = 24.7%

d) According to the Efficient Market Hypothesis,

Current Price (PV) = 200+12/(1+0.1882) = 212/1.1882 = $178.42