My failed attempt at writing a research paper

It's a terribly flawed model....after a massive attempt to answer a simple classwork question. The result ended up building a model that is biased and perhaps because of suiting the model to answer an ambiguous model, I have not defined clearly what my aims are. Conversely, after properly defining my aims, I find that I am not really answering the question because it can be interpreted in many ways.

And whatever it is, I have wasted 4 hours. Many people will not attempt to think creatively because they are not willing to end up looking stupid. I just did. If you think it's excessive, you definitely belong to the type.



Q1. A successful firm like Microsoft has consistently generated large profits for years. Is this a violation of the Efficient Market Hypothesis?

Efficient Market Hypothesis (EMH) states that prices reflect all available information, that the market responds only to new information and it is not possible to forecast price changes.

Under a direct perspective, the generation of large profits is not a violation of the EMH. The company is able to generate great profits for years due largely to superlative business performance such as a favourable macroeconomic environment, innovations leading to new technology widely subscribed by consumers, patents and monopoly power as for the case of Microsoft.

To see whether the generation of large profits for years violates EMH, we need to test that, under the information set that of companies that consistently generate large profits for years explains higher share price, there is no arbitrage opportunity, that is, prices fully reflect the known value of firms generating large profit for years.

Formally, Ri – E[RiI] = 0 for EMH.

Following, ‘I’ can be defined as information that the discounted cashflow valuation[1] of firms provides an accurate valuation of the firm’s market price. Alternatively, ‘I’ can be defined as the knowledge that firms with higher profit margins yield a higher return on average when compared to firms with lower profit margins for a given length of time (or a number of years)[2].

After defining, we test for the validity of ‘I’ by running a regression reflective of the hypothesis of the information set. Then we proceed to calculate the abnormal returns (AR) of a firm in the given information set.

I shall elaborate on the testing using alternative information set. First, we rank a basket of companies with high profit margin to low profit margin. We shall take the top 25% as the representative companies with high profit margin yielding an average return of rHt on share price at time t. The bottom 25% will be the representative companies with low profit margin yielding an average return of rLt on share price at time t. In the basket, we shall need companies that consistently generate low profit margins or high profit margins in consecutive quarters.

Next, we run the following regression: ri = α + β(rH – rL)

Thereafter, we begin to test for cumulative abnormal profits of Microsoft shares in the above model. Parameters are estimated for α and β, and we test for the hypothesis... ...



Disclaimer: This essay is in true reflection of my ideas and do not seek to ridicule, or in any other way, understate your effort in enriching the knowledge of your students. If in any case you think the thesis of the essay is deficient, then obviously, I do not understand the question, or you need to rephrase the questions (or a third explanation is a fundamental explanatory error on my part that is not related to the thesis of the essay). However, I do agree that I attempted to refine the question. This is in most truly the product of my curiosity.
[1] DCF is based on predicted price, hence analogous to semi-strong form efficiency
[2] Similarly, this is analogous to weak form efficiency since past prices are used predict the model.