FINAN 431 practice exam

Characterize each company in the previous problem as underpriced, overpriced, or prop- erly priced.

$1 Discount Store is overpriced; Everything $5 is underpriced.

Here are data on two companies. The T-bill rate is 4% and the market risk premium is 6%. Company $1 Discount Store Everything $5 Forecast return 12% 11% Standard deviation of returns 8% 10% Beta 1.5 1.0 What would be the fair return for each company, according to the capital asset pricing model (CAPM)?

$1 Discount Store: E(r) = 4% + 1.5 6% = 13% Everything $5: E(r) = 4% + 1.0 6% = 10%

Calculate breadth for the NYSE using the data in Figure 9.7 . Is the signal bullish or bearish?

15. Breadth: Advances Declines Net Advancing 2,787 270 2,517 Breadth is positive. This is a bullish signal (although no one would actually use a one-day measure as in this example).

What must be the beta of a portfolio with E ( rP) 5 20%, if r f 5 5% and E ( rM) 5 15%?

20% = 5% + B(15% - 5%) --> B = 1.5

The standard deviation of the market-index portfolio is 20%. Stock A has a beta of 1.5 and a residual standard deviation of 30%. a. What would make for a larger increase in the stock's variance: an increase of .15 in its beta or an increase of 3% (from 30% to 33%) in its residual standard deviation? b. An investor who currently holds the market-index portfolio decides to reduce the port- folio allocation to the market index to 90% and to invest 10% in stock A. Which of the changes in ( a) will have a greater impact on the portfolio's standard deviation?

5. Total variance = Systematic variance + Residual variance = β2 Var(rM) + Var(e) When β = 1.5 and σ(e) = .3, variance = 1.52 × .22 + .32 = .18. In the other scenarios: a. Both will have the same impact. Total variance will increase from .18 to .1989. b. Even though the increase in the total variability of the stock is the same in either scenario, the increase in residual risk will have less impact on portfolio volatility. This is because residual risk is diversifiable. In contrast, the increase in beta increases systematic risk, which is perfectly correlated with the market-index portfolio and therefore has a greater impact on portfolio risk.

Why are the following "effects" considered efficient market anomalies? Are there rational explanations for these effects? a. P/E effect b. Book-to-market effect c. Momentum effect d. Small-firm effect

An anomaly is considered an EMH exception because there are historical data to substantiate a claim that says anomalies have produced excess risk-adjusted abnormal returns in the past. Several anomalies regarding fundamental analysis have been uncovered. These include the P/E effect, the momentum effect, the small-firm-in-January effect, the neglected- firm effect, post-earnings-announcement price drift, and the book-to-market effect. Whether these anomalies represent market inefficiency or poorly understood risk premiums is still a matter of debate. There are rational explanations for each, but not everyone agrees on the explanation. One dominant explanation is that many of these firms are also neglected firms, due to low trading volume, thus they are not part of an efficient market or offer more risk as a result of their reduced liquidity.

Consider the statement: "If we can identify a portfolio that beats the S&P 500 Index portfolio, then we should reject the single-index CAPM." Do you agree or disagree? Explain.

An example of this scenario would be an investment in the SMB and HML. As of yet, there are no vehicles (index funds or ETFs) to directly invest in SMB and HML. While they may prove superior to the single index model, they are not yet practical, even for professional investors.

What are some possible investment implications of the behavioral critique?

An unfortunate consequence of behavioral finance (BF) is a tendency for investors to assume more than actually is claimed by the field. While BF is highly critical of EMH and claims to offer alternative theories, it does not propose to be a predictor of future returns. Investors should be wary of people purporting to offer excess returns under the façade of BH. Such claims are likely to be false.

What do we mean by fundamental risk, and why may such risk allow behavioral biases to persist for long periods of time?

Fundamental risk means that even if a security is mispriced, it still can be risky to attempt to exploit the mispricing because the correction to price could happen after the trader's investing horizon. This limits the actions of arbitrageurs who take positions in mispriced securities. Thus, the bias may persist since no one takes advantage of it.

The market price of a security is $40. Its expected rate of return is 13%. The risk-free rate is 7%, and the market risk premium is 8%. What will the market price of the security be if its beta doubles (and all other variables remain unchanged)? Assume the stock is expected to pay a constant dividend in perpetuity.

If the beta of the security doubles, then so will its risk premium. The current risk premium for the stock is: (13% - 7%) = 6%, so the new risk premium would be 12%, and the new discount rate for the security would be: 12% + 7% = 19% If the stock pays a constant dividend in perpetuity, then we know from the original data that the dividend (D) must satisfy the equation for a perpetuity: Price = Dividend/Discount rate 40 = D/0.13 D = 40 0.13 = $5.20 At the new discount rate of 19%, the stock would be worth: $5.20/0.19 = $27.37 The increase in stock risk has lowered the value of the stock by 31.58%.

"Highly variable stock prices suggest that the market does not know how to price stocks." Respond.

Incorrect. In the short term, markets reflect a random pattern. Information is constantly flowing in the economy and investors each have different expectations that vary constantly. A fluctuating market accurately reflects this logic. Furthermore, while increased variability may be the result of an increase in unknown variables, this merely increases risk and the price is adjusted downward as a result.

Regret avoidance

Investors are reluctant to bear losses due to their unconventional decisions

Disposition effect

Investors are reluctant to sell stocks with "paper" losses

Conservatism bias

Investors are slow to update their beliefs when given new evidence

Representation bias

Investors disregard sample size when forming views about the future from the past

Mental accounting

Investors exhibit less risk tolerance in their retirement accounts versus their other stock accounts

Steady Growth Industries has never missed a dividend payment in its 94-year history. Does this make it more attractive to you as a possible purchase for your stock portfolio?

No, it is not more attractive as a possible purchase. Any value associated with dividend predictability is already reflected in the stock price.

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

No, this is not a violation of the EMH. Microsoft's continuing large profits do not imply that stock market investors who purchased Microsoft shares after its success already was evident would have earned a high return on their investments.

Suppose you find that prices of stocks before large dividend increases show on average consistently positive abnormal returns. Is this a violation of the EMH?

No, this is not a violation of the EMH. This empirical tendency does not provide investors with a tool that will enable them to earn abnormal returns; in other words, it does not suggest that investors are failing to use all available information. An investor could not use this phenomenon to choose undervalued stocks today. The phenomenon instead reflects the fact that dividends occur as a response to good performance. After the fact, the stocks that happen to have performed the best will pay higher dividends, but this does not imply that you can identify the best performers early enough to earn abnormal returns.

At a cocktail party, your co-worker tells you that he has beaten the market for each of the last three years. Suppose you believe him. Does this shake your belief in efficient markets?

No. The notion of random walk naturally expects there to be some people who beat the market and some people who do not. The information provided, however, fails to consider the risk of the investment. Higher risk investments should have higher returns. As presented, it is possible to believe him without violating the EMH.

Portfolio Expected Return Beta Risk-free 10% 0 Market 18 1.0 A 16 1.5

Not possible. Given these data, the SML is: E(r) = 10% + β(18% - 10%) A portfolio with beta of 1.5 should have an expected return of: E(r) = 10% + 1.5 (18% - 10%) = 22% The expected return for Portfolio A is 16% so that Portfolio A plots below the SML (i.e., has an alpha of -6%), and hence is an overpriced portfolio. This is inconsistent with the CAPM.

Portfolio Expected Return Standard Deviation Risk-free 10% 0% Market 18 24 A 20 22

Not possible. Portfolio A clearly dominates the market portfolio. It has a lower standard deviation with a higher expected return.

Portfolio Expected Return Beta A 20% 1.4 B 25 1.2

Not possible. Portfolio A has a higher beta than Portfolio B, but the expected return for Portfolio A is lower.

Portfolio Expected Return Beta Risk-free 10% 0 Market 18 1.0 A 16 .9

Not possible. The SML is the same as in Problem 18. Here, the required expected return for Portfolio A is: 10% + (0.9 8%) = 17.2% This is still higher than 16%. Portfolio A is overpriced, with alpha equal to: -1.2%

Portfolio Expected Return Standard Deviation Risk-free 10% 0% Market 18 24 A 16 12

Not possible. The reward-to-variability ratio for Portfolio A is better than that of the market, which is not possible according to the CAPM, since the CAPM predicts that the market portfolio is the most efficient portfolio. Using the numbers supplied: SA = 16-10 / 12 = 0.5 SM = 18-10/24 = 0.33 These figures imply that Portfolio A provides a better risk-reward tradeoff than the market portfolio.

If prices are as likely to increase as decrease, why do investors earn positive returns from the market on average?

Over the long haul, there is an expected upward drift in stock prices based on their fair expected rates of return. The fair expected return over any single day is very small (e.g., 12% per year is only about 0.03% per day), so that on any day the price is virtually equally likely to rise or fall. However, over longer periods, the small expected daily returns cumulate, and upward moves are indeed more likely than downward ones.

Portfolio Expected Return Standard Deviation A 30% 35% B 40 25

Possible. If the CAPM is valid, the expected rate of return compensates only for systematic (market) risk as measured by beta, rather than the standard deviation, which includes nonsystematic risk. Thus, Portfolio A's lower expected rate of return can be paired with a higher standard deviation, as long as Portfolio A's beta is lower than that of Portfolio B.

Portfolio Expected Return Standard Deviation Risk-free 10% 0% Market 18 24 A 16 22

Possible. Portfolio A's ratio of risk premium to standard deviation is less attractive than the market's. This situation is consistent with the CAPM. The market portfolio should provide the highest reward-to-variability ratio.

After reading about three successful investors in The Wall Street Journal you decide that active investing will also provide you with superior trading results. What sort of behavioral tendency are you exhibiting?

Representativeness bias. The sample size is not considered when making future decisions.

In forming a portfolio of two risky assets, what must be true of the correlation coefficient between their returns if there are to be gains from diversification? Explain.

So long as the correlation coefficient is below 1.0, the portfolio will benefit from diversification because returns on component securities will not move in perfect lockstep. The portfolio standard deviation will be less than a weighted average of the standard deviations of the component securities.

Which one of the following would be a bullish signal to a technical analyst using moving average rules? a. A stock price crosses above its 52-week moving average. b. A stock price crosses below its 52-week moving average. c. The stock's moving average is increasing. d. The stock's moving average is decreasing.

Statement b, that a price has moved above its 52 week moving average, is considered a bullish sign.

Which version of the efficient market hypothesis (weak, semistrong, or strong-form) focuses on the most inclusive set of information?

Strong-form efficiency includes all information: historical, public, and private.

If markets are efficient, what should be the correlation coefficient between stock returns for two nonoverlapping time periods?

The correlation coefficient should be zero. If it were not zero, then one could use returns from one period to predict returns in later periods and therefore earn abnormal profits.

When adding a risky asset to a portfolio of many risky assets, which property of the asset is more important, its standard deviation or its covariance with the other assets? Explain.

The covariance with the other assets is more important. Diversification is accomplished via correlation with other assets. Covariance helps determine that number.

An investor ponders various allocations to the optimal risky portfolio and risk-free T-bills to construct his complete portfolio. How would the Sharpe ratio of the complete portfolio be affected by this choice?

The expected return of the portfolio will be impacted if the asset allocation is changed. Since the expected return of the portfolio is the first item in the numerator of the Sharpe ratio, the ratio will be changed.

"If all securities are fairly priced, all must offer equal expected rates of return." Comment.

The phrase would be correct if it were modified to say "expected risk adjusted returns." Securities all have the same risk adjusted expected return if priced fairly; however, actual results can and do vary. Unknown events cause certain securities to outperform others. This is not known in advance, so expectations are set by known information.

What are the strong points of the behavioral critique of the efficient market hypothesis? What are some problems with the critique?

The premise of behavioral finance is that conventional financial theory ignores how real people make decisions and that people make a difference. Behavioral finance may cite examples of market inefficiencies, but they give no insight into how to exploit such phenomenon. The strength of their argument relies upon observed market inefficiencies and unexplained market behavior. There are many anomalies, yet many can be reverse engineered or explained. Also, while anomalies exist, they rarely meet the test of statistical significance.

Suppose investors believe that the standard deviation of the market-index portfolio has increased by 50%. What does the CAPM imply about the effect of this change on the required rate of return on Google's investment projects?

The required rate of return on a stock is related to the required rate of return on the stock market via beta. Assuming the beta of Google remains constant, the increase in the risk of the market will increase the required rate of return on the market, and thus increase the required rate of return on Google.

Use the data from The Wall Street Journal in Figure 9.7to verify the trin ratio for the NYSE. Is the trin ratio bullish or bearish?

Trin = "Volume Declining/Number Declining " /"Value Advancing/Number Advancing" = "231,468,687/270" /"4,681,742,414/2,787" = 0.5103 This trin ratio, which is below 1.0, would be taken as a bullish signal.

If the trading volume in advancing shares on day 1 in the previous problem was 1.1 billion shares, while the volume in declining issues was .9 billion shares, what was the trin statistic for that day? Was trin bullish or bearish?

Trin = "Volume Declining/Number Declining " /"Value Advancing/Number Advancing" = "900,000,000/704" /"1,100,000,000/906" = 1.0529 This is a slightly bearish indicator, with average volume in advancing issues a bit greater than average volume in declining issues.

"If the business cycle is predictable, and a stock has a positive beta, the stock's returns also must be predictable." Respond.

While positive beta stocks respond well to favorable new information about the economy's progress through the business cycle, the stock's returns should be predictable and should not show abnormal returns around already anticipated events. If a recovery, for example, is already anticipated, the actual recovery is not news. The stock price should already reflect the coming recovery. The level of the stock price will be unpredictable only when responding to new information.

A portfolio's expected return is 12%, its standard deviation is 20%, and the risk-free rate is 4%. Which of the following would make for the greatest increase in the portfolio's Sharpe ratio? a. An increase of 1% in expected return. b. A decrease of 1% in the risk-free rate. c. A decrease of 1% in its standard deviation.

a and b will have the same impact of increasing the Sharpe ratio from .40 to .45.

What is the expected rate of return for a stock that has a beta of 1 if the expected return on the market is 15%? a. 15%. b. More than 15%. c. Cannot be determined without the risk-free rate.

a. 15%. Its expected return is exactly the same as the market return when beta is 1.0.

Which of the following phenomena would be either consistent with or a violation of the efficient market hypothesis? Explain briefly. a. Nearly half of all professionally managed mutual funds are able to outperform the S&P 500 in a typical year. b. Money managers that outperform the market (on a risk-adjusted basis) in one year are likely to outperform in the following year. c. Stock prices tend to be predictably more volatile in January than in other months. d. Stock prices of companies that announce increased earnings in January tend to outperform the market in February. e. Stocks that perform well in one week perform poorly in the following week.

a. Consistent. Half of all managers should outperform the market based on pure luck in any year. b. Violation. This would be the basis for an "easy money" rule: Simply invest with last year's best managers. c. Consistent. Predictable volatility does not convey a means to earn abnormal returns. d. Violation. The abnormal performance ought to occur in January, when the increased earnings are announced. e. Violation. Reversals offer a means to earn easy money: Simply buy last week's losers.

Are the following true or false? Explain. a. Stocks with a beta of zero offer an expected rate of return of zero. b. The CAPM implies that investors require a higher return to hold highly volatile securities. c. You can construct a portfolio with beta of .75 by investing .75 of the investment bud- get in T-bills and the remainder in the market portfolio.

a. False. According to CAPM, when beta is zero, the "excess" return should be zero. b. False. CAPM implies that the investor will only require risk premium for systematic risk. Investors are not rewarded for bearing higher risk if the volatility results from the firm-specific risk, and thus, can be diversified. c. False. We can construct a portfolio with the beta of .75 by investing .75 of the investment budget in the market portfolio and the remainder in T-bills.

After Polly Shrum sells a stock, she avoids following it in the media. She is afraid that it may subsequently increase in price. What behavioral characteristic does Shrum have as the basis for her decision making? a. Fear of regret b. Representativeness c. Mental accounting

a. Fear of regret.

Jill Davis tells her broker that she does not want to sell her stocks that are below the price she paid for them. She believes that if she just holds on to them a little longer, they will recover, at which time she will sell them. What behavioral characteristic does Davis have as the basis for her decision making? a. Loss aversion b. Conservatism c. Representativeness

a. Loss aversion.

All of the following actions are consistent with feelings of regret except: a. Selling losers quickly. b. Hiring a full-service broker. c. Holding on to losers too long.

a. Selling losers quickly.

Which of the following statements are true if the efficient market hypothesis holds? a. It implies that future events can be forecast with perfect accuracy. b. It implies that prices reflect all available information. c. It implies that security prices change for no discernible reason. d. It implies that prices do not fluctuate.

b. This is the definition of an efficient market.

Which of the following sources of market inefficiency would be most easily exploited? a. A stock price drops suddenly due to a large block sale by an institution. b. A stock is overpriced because traders are restricted from short sales. c. Stocks are overvalued because investors are exuberant over increased productivity in the economy.

c. If the stocks are overvalued, without regulative restrictions or other constraints on the trading, some investors observing this trend would be able to form a trading strategy to profit from the mispricing, thereby exploiting the inefficiency and forcing the price to the correct level.

Which of the following observations would provide evidence against the semistrong form of the efficient market theory? Explain. a. Mutual fund managers do not on average make superior returns. b. You cannot make superior profits by buying (or selling) stocks after the announcement of an abnormal rise in dividends. c. Low P/E stocks tend to have positive abnormal returns. d. In any year approximately 50% of pension funds outperform the market.

c. The P/E ratio is public information so this observation would provide evidence against the semi-strong form of the efficient market theory.

Suppose that, after conducting an analysis of past stock prices, you come up with the following observations. Which would appear to contradict the weak form of the efficient market hypothesis? Explain. a. The average rate of return is significantly greater than zero. b. The correlation between the return during a given week and the return during the following week is zero. c. One could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall. d. One could have made higher-than-average capital gains by holding stocks with low dividend yields.

c. This is a filter rule, a classic technical trading rule, which would appear to contradict the weak form of the efficient market hypothesis.

Which of the following most appears to contradict the proposition that the stock market is weakly efficient? Explain. a. Over 25% of mutual funds outperform the market on average. b. Insiders earn abnormal trading profits. c. Every January, the stock market earns abnormal returns.

c. This is a predictable pattern of returns, which should not occur if the stock market is weakly efficient.

In an efficient market, professional portfolio management can offer all of the following benefits except which of the following? (LO 8-4) a. Low-cost diversification. b. A targeted risk level. c. Low-cost record keeping. d. A superior risk-return trade-off.

d. It is not possible to offer a higher risk-return trade off if markets are efficient.