Question

PBYI’s current BID-ASK is $59.00 - $60.00. PBYI is going to release their annual report tomorrow; you have special skill in valuing biotech companies, and you believe that PBYI has an expected alpha tomorrow of 2% compared to the market’s current best estimate of fair value. Should you buy PBYI? What if the expected alpha was 0.5% instead of 2%... Would this change your answer?

Answer 1

PBYI's current BID-ASK is $59.00 - $60.00

Expected alpha = 2%

In this scenario, it is favorable to buy PBYI.

Buy security @ $60.00

Its value will increase to ($60.00*1.02) = $61.02

Sell the security and you will get $60.18 ($61.02*59.00/60.00)

Net Profit is $0.18 ($60.18 - $60.00)

Expected Alpha = 0.5%

In this scenario, it is not favorable to buy PBYI.

Buy security @ $60.00

Its value will increase to ($60.00*1.005) = $60.30

Sell the security and you will get $59.29 ($60.30*59.00/60.00)

Net Loss is $0.71 ($59.29 - $60.00)