You have estimated the historical relationship between stock ITTs return and market return using a single-index model with daily return data:

r = 0.1% + 1.5rM

On the announcement date (t=0) of ITTs earnings, its return was 5.5% while the market return was 2%. Your assistant has worked out the remaining abnormal returns (AR) for ITT surrounding the announcement date (t=0).

Required:

1. (1) Calculate the abnormal return for ITT on t=0. Does the market perceive the earnings announcement as good news? [4 marks]

2. (2) Calculate cumulative abnormal return CAR from t=1 to t=5. Does CAR[1, 5] violate the semi-strong form of market efficiency? Explain. [4 marks]

3. (3) Does CAR[-3, -1] violate the semi-strong form of market efficiency? Explain. [3 marks]

4. (4) If you believe the above pattern of abnormal returns is caused by market inefficiency, how would you design a trading strategy to exploit the inefficiency? [3 marks]

5. (5) Discuss how Prospect Theory may help explain why momentum strategy works?

t = -3 -2 -1 0 2 3 4 5 1 1.2% AR = 2.2% 1.8% 2.5% ? 2.1% 2.2% 3.5% 2.8% t = -3 -2 -1 0 2 3 4 5 1 1.2% AR = 2.2% 1.8% 2.5% ? 2.1% 2.2% 3.5% 2.8%