Optimal Strategy for Microsquish and AWOL Stocks | CFA® Level 1 Exam Answer

Optimal Strategy for Microsquish and AWOL Stocks

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Question

You believe the stock of Microsquish reflects a 90% chance of a dismissal of its contractual liability suit. If the suit is dismissed, you expect the stock of

Microsquish and its partner, AWOL, to rise. If the suit is not dismissed, both will fall in price. However, you think that AWOL's stock only reflects a 60% chance of dismissal of this suit. What strategy would be optimal?

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A. B. C. D.

D

This is an example of the investment consequences of inconsistent probabilities. If the true probability of a lawsuit dismissal is only 60%, then AWOL's stock is fairly valued, and Microsquish is overvalued. If the true probability is 90%, then Microsquish is fairly valued, and AWOL is undervalued. Your can thus construct a profitable risk-free strategy. You should buy AWOL, because at worst, the stock will be fairly valued. At best, it is undervalued. You could also simultaneously short

Microsquish, because at best, it is fairly valued; there is a chance that it is overvalued. Note that this example ignores all other factors other than the lawsuit.

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