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IAI Actuarial Core Principles · Economic Modelling · Rational expectations theory and the efficient markets hypothesis

In an event study of quarterly earnings announcements for a sample of listed Indian companies, cumulative abnormal returns (CAR) rise sharply on the announcement day and then continue to drift upward for the following 40 trading days. Which conclusion is most consistent with this evidence?

Prices appear to under-react to public information, which is evidence against semi-strong efficiency. If the market were semi-strong efficient, the adjustment would be complete on announcement day and the cumulative abnormal return would then be flat. A continuing drift indicates slow incorporation of public news.

  1. ASemi-strong efficiency is supported, as prices adjust fully on the announcement day
  2. BPrices appear to under-react to public information, which is evidence against semi-strong efficiencyCorrect
  3. CStrong-form efficiency is rejected because insiders earned abnormal profits
  4. DWeak-form efficiency is supported because returns are positively autocorrelated
  5. The market model used to compute abnormal returns must be incorrect, so no conclusion is possible in principle

Explanation

Under semi-strong efficiency, public news is reflected in prices immediately, so CAR should stay flat after announcement day. Continued drift means public information is incorporated slowly, an anomaly known as post-earnings-announcement drift. Positive autocorrelation would also be against weak form, not support it.

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