Conceptual IFM Questions

Why do individual investors fail to diversify their portfolios adequately?

Familiarity bias: investors favor investements in companies they are familiar with Relative wealth concerns: investors care most about how their portfolio performs relative to their peers. This leads them to choose underdiversified portfolios in the hopes of at least matching the returns of their peers.

What is alternative risk preferences and how does it explain why the market portfolio might not be efficient?

Some investors focus on risk characteristics other than the volatility of their portfolio, and they may chose inefficient portfolios as a result

What is the value-effect?

Value stocks (high B2M) have consistently outperformed growth stocks (low B2M)

The opportunity set formed by two risky assets in the mean-standard deviation diagram is _____.

hyperbolic

How do we find abnormal stock return?

Actual stock return - Expected stock return

What evidence supports the strong-form EMH?

Many studies evaluating the returns of professionally managed funds have shown "expert analysts" do not achieve superior returns to the market

Almost all pairs of randomly selected stocks will have positive correlation coefficients. (T/F)

T

Shareholders can gain by making negative-NPV investments or decisions that sufficiently increase the firm's risk. Which of the following best describes the agency cost above? A. Asset substitution B. Debt overhang C. Cashing out D. Managerial entrenchment E. Asymmetric information

A

Investors tend to hold on to investments that have lost value and sell investments that have increased in value. Determine which of the following is best described by the behavior. A. Herd behavior B. Information cascade effect C. Disposition effect D. Familiarity bias E. Overconfidence bias

C

What is proxy error and how does it explain why the market portfolio might not be efficient?

Due to the lack of competitive price data, the market proxy cannot include most of the tradable assets in the economy

What is the political cycle effect?

For a given political administration, its first year and last year yield higher returns than the years in between

What is the new-issue/IPO puzzle?

Overreaction to new issues pushes up stock prices initially

What does beta measure?

Sensitivity of the asset's return to the market return

What is a bubble and how is it fueled?

The main characteristic of a bubble is that the market value of the asset significantly deviates from its intrinsic value. The bubble is fueled by more investors joining.

What is the information cascade effect?

When investors believe others have superior information so they copy trades, hoping to profit from information others have

If markets are inefficient, then _______ strategies are best

active

Does excessive trading and overconfidence impact the efficiency of the market or have an effect on market prices or returns?

no

If markets are efficient, then _______ strategies are best

passive

A semi-strong-form efficient market is also ___________ efficient

weak-form

The capital market line is the graph of the risk and return of portfolio combinations consisting of the risk-free asset and any risky portfolio. (T/F)

F - The capital market line (CML) is the graph of the risk and return of portfolio combinations consisting of the risk-free asset and the market portfolio.

If the number of assets is small, then the contribution of each individual asset's variance to the volatility of the portfolio is negligible. (T/F)

F - The number of assets is small, the contribution of one asset's variance to portfolio's risk is significant.

Which of the following effects are correct on the price of a stock option? I. The premiums would not decrease if the options were American rather than European. II. For European put, the premiums increase when the stock price increases. III. For American call, the premiums increase when the strike price increases.

I

Determine which of the following statements is TRUE with respect to Modigliani and Miller's Proposition II for perfect capital markets: A The cost of equity increases as the use of debt in the capital structure decreases. B The value of a firm is affected by its capital structure. C As the fraction of the firm financed with debt increases, both the equity cost of capital and debt cost of capital remain constant. D As the fraction of the firm financed with debt increases, the weighted average cost of capital remains constant. E The value of a firm is maximized if its capital structure is 100% debt.

E

Which of the following are inconsistent with the semi-strong form of the efficient market hypothesis but not with the weak form? I. There is a positive serial correlation in stock prices. II. It is possible to make consistent profits based on publicly available information. III. It is possible to make consistent profits based on information obtainable from a painstaking analysis of the company.

II

On average, an investor does not profit more investing in an actively managed mutual fund compared to investing in passive index funds (T/F)

T

In the FFC model what does the SMB portfolio account for?

This accounts for differences in company size based on market capitalizations. We buy small firms and finance itself by short selling big firms.

Determine which one of the following statements is TRUE with respect to a perfect capital market: A Taxes and transaction costs can exist. B A firm's choice of capital structure will have an effect on its cost of capital. C A firm's choice of capital structure will always have an effect on the firm's value. D Leverage has no effect on the risk of equity, even where there is no default risk. E The risk premium of debt is zero because the return on that debt bears no systematic risk.

E

Which of the following risks will affect the risk premium that investors will demand? I. The risk that the key employees leave the company II. The risk that oil prices increase, increasing production costs III. The risk that the design of a product is faulty and the product needs to be recalled IV. The risk that the economy slows, decreasing demand for a product

II, IV because those are systematic risks which affect risk premium. Nonsystematic risks do not affect risk premium.

Under the CAPM assumptions, which of the following statement(s) is/are true? I. A stock with a higher volatility must have a higher expected return. II. If Stock 1's systematic risk is twice Stock 2's systematic risk, then Stock 1's expected return is twice Stock 2's expected return. III. All stocks will have an alpha of zero.

III

What is non-tradable wealth and how does it explain why the market portfolio might not be efficient?

Investors are exposed to significant risks outside their portfolio. They may choose to invest less in their respective sectors to offset the inherent exposures from their human capital.

What is weak form EMH?

It is impossible to consistently attain superior profits by analyzing past returns

When we combine many stocks in a large portfolio, the firm-specific risks for each stock will average out and be diversified. (T/F)

T

Does underdiversification impact the efficiency of the market or have an effect on market prices or returns?

no

Determine which of the following statements regarding behavioral biases is FALSE: A. Uninformed investors are more likely to purchase stocks that have advertised a lot or have experienced unusually high recent trading volume or returns. B. Investors who follow the herd do not consistently outperform those who take more contrarian (i.e., anti-herd) views. C. The information cascade effect occurs when traders ignore their own information and act on information from others that they trust more. D. If fund managers are going to fail, they would much rather have done something different than their peers than to demonstrate herd behavior. E. Studies have indicated that men, on average, earn lower returns than women do.

D

Determine which of the following statements regarding the performance of fund managers is TRUE. A. Most fund managers are able to find profitable trading opportunities. B. The median mutual fund has a positive value added. C. On average, actively managed mutual funds appear to provide superior returns for their investors compared to investing in passive index funds. D. The superior past performance of mutual funds is a good predictor of their future ability to outperform the market. E. Fund size is a strong predictor of the future value added by fund managers.

E

Investors actively try to follow each other's behavior. Determine which two of the four below are explanations for this behavior: I. Disposition effect II. Familiarity bias III. Information cascade effect IV. Relative wealth concerns

III, IV

Determine which of the following statements regarding multi-factor models is NOT true. A. Trading strategies based on market capitalization, book-to-market ratios, and momentum appear to have zero alphas. B. It is much easier to identify a collection of portfolios that captures systematic risk than just a single portfolio. C. All factor portfolios in the Fama-French-Carhart factor specification are self-financing. D. The first portfolio in the Fama-French-Carhart factor specification is a self-financing portfolio that consists of a long position in the market portfolio​ that is financed by a short position in the risk-free security. E. A high-minus-low (HML) portfolio is constructed​ by taking a long position in firms with high book-to-market and taking a short position in firms with low book-to-market.

A

Firms can do several things to mitigate the agency costs of debt. Determine which of the following statements is FALSE. A. Agency costs are largest for short-term debt. B. Short-term debt may increase the firm's risk of financial distress and its associated costs. C. Debt covenants may limit the firm's ability to pay large dividends or restrict the types of investments that the firm can make. D. Debt covenants may limit the amount of new debt the firm can take on. E. Debt covenants have the potential to get in the way of positive NPV opportunities and can have costs of their own.

A

A publicly traded company announced​ unexpected bad news in its quarterly earnings. At the announcement date​, the company's stock price did not move. After the announcement​ date, stock price adjustments occurred. Which of the following supports the phenomenon above? A. Semi-strong form of the efficient markets hypothesis B. Strong form of the efficient markets hypothesis C. New-issue puzzle D. Earnings announcement puzzle E. Momentum effect

D

Which of the following statements is/are true regarding debt financing? I. Collateralized Debt Obligations (CDOs) can have a higher average rating than the individual assets backing them. II. Due to double-barreled protection, municipal bonds tend to be safer investments compared to sovereign bonds. III. A dollar-denominated bond and an euro-denominated bond that have the same maturity and default risk must have the same yield to maturity.

I

Which of the following statements regarding SEC filings is/are true? I. The SEC requires companies to prepare a registration statement that provides its financial and other information to investors prior to an IPO. II. The red herring circulates to investors before the stock is offered. III. The red herring contains all the details of the IPO, including the number of shares offered and the offer price.

I, II

Which of the following statements regarding the performance of fund managers is/are true? I. The average mutual fund managers are able to find profitable trading opportunities in financial markets. II. The mutual fund industry as a whole has positive value added. III. The superior past performance of mutual funds is not a good predictor of their future ability to outperform the market.

I, II, III

Which of the following statements regarding the multi-factor model MAY NOT be true? I. Factor portfolios are efficient portfolios. II. Each factor portfolio can be interpreted as either a risk factor itself or a portfolio of stocks correlated with an observable risk factor. III. Each factor beta is the expected percentage change in the excess return of a security for a 1% change in the excess return of the factor portfolio, holding the other factors constant. IV. The risk premium of a security can be expressed as the sum of the risk premium of each factor in the multifactor model.

I, II, IV

Some strategies have generated higher returns historically than the CAPM predicts. Which of the following statements regarding style-based effects is/are TRUE? I. Stocks with large market capitalization tend to be above the security market line. II. Stocks with high book-to-market ratio tend to be above the security market line. III. When the market portfolio is not efficient, past returns can be used to predict alphas.

II and III

Which of the following behaviors may cause the market portfolio to be inefficient? I. Investors invest in stocks of companies that are in the same industry or are geographically close. II. Investors tend to hold on to investments that have lost value and sell investments that have increased in value. III. Investors tend to buy stocks that have recently been in the news.

II, III

Which of the following is evidence for the semi-strong form of the efficient market hypothesis? I. In a scatter plot for prices changes of four stocks, the autocorrelation coefficients of the time series of percentage changes are close to 0. II. There was a one-time increase in stock price at the time of the takeover announcement but no significant abnormal returns afterwards. III. Professional managers cannot beat the market.

II, III

Rank these from highest to lowest volatility I. International stocks II. Small-cap stocks III. Large-cap stocks IV. Treasury bills V. AAA-rated corporate bonds

II, III, I, V, IV

Investors actively try to follow each other's behavior and imitate each other's actions. Determine which of the following are explanations for this behavior: I. Investors desire intense risk-taking experiences. II. Investors believe others have superior information that they can take advantage of. III. Investors want to avoid the risk of underperforming their peers. IV. Professional fund managers may face reputational risk if their actions are far different from those of their peers.

II, III, IV

Which of the following statements about market anomalies is/are true? I. For IPOs, the high returns observed in the first few days after a new issue are often followed by relatively poor performance in the years ahead, suggesting that investors underreact to the initial news. II. Investors typically overreact to earning announcements, causing a subsequent price adjustment. III. The momentum effect is inconsistent with weak-form market efficiency.

III

Which of the following statements regarding the valuation in a traditional IPO process is/are true? I. The only way to set the initial price range for the offer price is by estimating the present value of future cash flows. II. Once an initial price range is set, the underwriters try to determine what the market thinks of the valuation by using a greenshoe provision. III. The underwriters undergo a process called book building where they adjust the share price to customer demand so that the IPO is most likely to succeed.

III

Why do individual investors tend to trade very actively?

Overconfidence bias: investors often overestimate their knowledge or expertise and believe they can do a better job in picking winners and losers when, in fact, they cannot. This overconfidence leads to frequent trading. Sensation seeking: the individual's desire for intense risk-taking experiences

What did Poterba and Summers find that supports the weak form of EMH?

Poterba and Summers found that variance of multi-period change is approximately proportional to number of periods

The lower the correlation coefficients among pairs of stocks in a portfolio, the lower the variability of the portfolio. (T/F)

T

The risk premium for diversifiable risk is zero. (T/F)

T

The risk premium of a security is determined by its systematic risk. (T/F)

T

When can the market portfolio be inefficient?

The market portfolio can be inefficient only if a significant number of investors: 1. Do not have rational expectations 2. Care about aspects of their portfolio other than expected return and volatility

What is strong-form EMH?

There are only lucky and unlucky investors. No one (not even company insiders) can consistently attain superior profits. Passive strategy is best.

What is the reversal effect?

There is a negative serial correlation in stock prices as investors overreact to new information

What is the momentum effect?

There is a positive serial correlation in stock prices as investors underreact to new information

What did Brealey, Meyers, and Allen find that supports the weak form of EMH?

They created a scatter plot for price changes of four stocks (return of stock on day t is plotted on the x-axis and the return on day t+1 on the y-axis) and found that there were 1. no distanct pattern in the points, with the concentration of points around the origin. There was no bias toward any quadrants. 2. autocorrelation coefficients were close to 0.

What is the neglected firm effect?

Lesser-known firms yield abnormally high returns

What is the Time-of-day effect?

Returns are more volatile close to the opening and closing hours for the market. Also, the trading volumes are higher during these times

What is the Monday effect?

Returns have been lower on Monday (and higher on Friday) than on other days of the week

A very large, equally-weighted portfolio with independent and identical risks will have no risk. (T/F)

T

Another name of firm-specific risk is idiosyncratic risk. (T/F)

T

Investors are not compensated for holding diversifiable risk. (T/F)

T

It is possible for the covariance of returns between two stocks to be negative. (T/F)

T

Determine which of the following statements regarding public debt is FALSE: A. Corporate bonds always pay coupons semiannually. B. Bearer bonds are like currency. C. Almost all bonds that are issued today are registered bonds. D. Debentures and notes are unsecured debt. E. For asset-backed bonds and mortgage bonds, specific assets are pledged as collateral that bondholders have a direct claim to in the event of bankruptcy.

A

What is an efficient market?

A market in which security prices adjust rapidly to reflect any new information, i.e., security prices reflect all past and present information

What does it mean for investors to have rational expectations?

All investors correctly interpret and use their own information, along with information from market prices and the trades of others

Determine which of the following behaviors is idiosyncratic and does not cause the market portfolio to be inefficient. A. Investors buy stocks that have recently been in the news. B. Investors seek sensation and desire intense risk-taking experiences. C. Stock returns tend to be higher on a sunny day at the stock exchange. D. Investors actively try to follow each other's behavior. E. Investors tend to hold on to investments that have lost value and sell investments that have increased in value.

B

Determine which of the following risks is mostly likely a systematic risk. A. The risk that your main production plant is shut down due to a winter storm. B. The risk that the economy underperforms, reducing demand for your company's product. C. The risk that your key employees will be hired by competitors. D. The risk that a drug trial fails. E. The risk of an airliner crash.

B

What happens to a stock's price when a stock recommendation is given without news?

The stock price seems to overreact. The stock price surges the following day, then it falls compared to the market.

What is the disposition effect?

The tendency to hold onto investments that have lost value and sell investments that have increased in value

What is the Siamese twins anomaly?

Two stocks with claims to a common cash flow should be exposed to identical risks but perform differently

Determine which of the following statements regarding the small-minus-big (SMB) portfolio is TRUE: A. This portfolio is created by taking a long position in stocks with low market capitalization and a short position in stocks with high market capitalization. B. This portfolio is created by taking a short position in stocks with low market capitalization and a long position in stocks with high market capitalization. C. This portfolio is created by taking a long position in high book‐to‐market stocks and a short position in low book‐to‐market stocks. D. This portfolio is created by taking a short position in high book‐to‐market stocks and a long position in low book‐to‐market stocks. E. This portfolio is not self-financing.

A

What happens to a stock's price when a takeover offer is announced?

After the initial jump in the stock price at the time of the announcement, target stocks do not appear to generate abnormal subsequent returns on average.

Determine which of the following factor portfolios is NOT used in the Fama-French-Carhart (FFC) factor specification. A. High-minus-low portfolio B. Inflation risk portfolio C. Market portfolio D. Prior one-year momentum portfolio E. Small-minus-big portfolio

B

Determine which one of the following statements regarding multi-factor models is NOT true. A. A collection of well-diversified portfolios, from which an efficient portfolio can be constructed, can be used to measure risk. B. These models are also referred to as the Arbitrage Pricing Theory. C. Taxes and transaction costs are incorporated when estimating the expected rate of return for a multi-factor model. D. The market portfolio of securities is not necessarily efficient. E. Small-Minus-Big (SMB) and High-Minus-Low (HML) portfolios are part of the Fama-French-Carhart multi-factor model.

C

Which of the following statements about the Fama-French-Carhart factor specification is FALSE? A. Trading strategies based on market capitalization, book-to-market ratios, and momentum appear to have positive alphas. B. A trading strategy that each year buys a portfolio of small stocks and finances this position by short selling a portfolio of big stocks has produced positive risk-adjusted returns historically. C. A trading strategy that each year buys a portfolio of low book-to-market stocks and finances this position by short selling a portfolio of high book-to-market stocks has produced positive risk-adjusted returns historically. D. A momentum strategy is constructed by longing the top 30% of stocks and shorting the bottom 30% and then holding the portfolio for a year. E. All factor portfolios in the FFC model are self-financing.

C

Determine which of the following statements regarding multi-factor models is NOT true. A. If we use multiple portfolios as factors, then together these factors may capture all systematic risk, with each factor capturing different components of the systematic risk. B. The model is also referred to as the Arbitrage Pricing Theory (APT). C. A self-financing portfolio is any portfolio with portfolio weights that sum to zero. D. A self-financing portfolio is constructed​ by going long some stocks, and going short other stocks with equal book value. E. Multifactor models rely on the weaker condition that we can construct an efficient portfolio from a collection of well-diversified portfolios or factors.

D

Determine which of the following statements regarding the high-minus-low (HML) portfolio is TRUE: A. This portfolio is created by taking a long position in stocks with low market capitalization and a short position in stocks with high market capitalization. B. This portfolio is created by taking a short position in stocks with low market capitalization and a long position in stocks with high market capitalization. C. This portfolio is created by taking a long position in low book‐to‐market stocks and a short position in high book‐to‐market stocks. D. This portfolio is created by taking a short position in low book‐to‐market stocks and a long position in high book‐to‐market stocks. E. This portfolio is not self-financing.

D

A portfolio is efficient if there is no other portfolio in the opportunity set that offers a lower volatility for a given level of expected return. (T/F)

F - A portfolio is efficient if there is no other portfolio in the opportunity set that offers a higher expected return for a given level of volatility.

A portfolio on the capital market line with returns greater than the returns on the market portfolio represents a lending portfolio. (T/F)

F - A portfolio on the CML with returns greater than the returns on the market portfolio represents a borrowing portfolio.

Relative to portfolios on the capital market line, any portfolio that plots below the capital market line is considered efficient. (T/F)

F - Any point above the CML is not achievable, and any point below the CML is dominated by and inferior to any point on the CML.

Diversification reduces a portfolio's total risk by averaging out systematic fluctuations. (T/F)

F - Diversification reduces a portfolio's total risk by averaging out nonsystematic risks

With a large number of assets, all risk can be eliminated. (T/F)

F - Even with a very large portfolio, we cannot eliminate all risk. After the number of assets in a portfolio reaches a certain number, the volatility becomes constant. The remaining risk is systematic risk that cannot be avoided through diversification.

If the investment's returns are independent and identically distributed, the compound annual return is a better measure of the investment's expected return next year.

F - If the investment's returns are independent and identically distributed, the average annual return is a better measure of the investment's expected return next year. In general, the arithmetic average return should be used when trying to estimate an investment's expected return over a future horizon based on its past performance. If past returns are independent draws from the same distribution, then the arithmetic average return provides an unbiased estimate of the true expected return.

Stocks in the same industry tend to have less highly correlated returns than stocks in different industries. (T/F)

F - Stocks in the same industry tend to have more highly correlated returns than stocks in different industries.

Another name of undiversifable risk is unique risk. (T/F)

F - Systematic risk is also called common, market, or nondiversifiable risk. Nonsystematic risk is also called firm-specific, independent, idiosyncratic, unique, or diversifiable risk.

Between the average annual return and the compound annual return, the average annual return is most often used to compare historical performance of mutual funds. (T/F)

F - The compound annual return is most often used to compare historical performance of mutual funds. In general, the compound annual return is a better description of the historical performance of an investment. It is the return that is most often used to compare the performance of mutual funds.

The decrease in volatility when going from one to two stocks is much lower than the decrease from going from 100 to 101 stocks. (T/F)

F - The diversification effect is most significant initially. The decrease in volatility when going from 1 to 2 stocks is much larger than the decrease when going from 100 to 101 stocks. You can see this on the diagram above as well.

Both the expected return and the volatility of a portfolio can be less than the corresponding weighted average expected return and volatility. (T/F)

F - The expected return of a portfolio is equal to the weighted average expected return. The volatility of a portfolio is less than or equal to the weighted average volatility. This is because we can eliminate some volatility by diversifying.

The reduction in risk becomes greater as the correlation increases. (T/F)

F - The reduction in risk becomes greater as the correlation decreases. The graph below illustrates this point:

When we combine many stocks in a large portfolio, all risks will be diversified away. (T/F)

F - When we combine many stocks in a large portfolio, only nonsystematic risks can be diversified. The volatility of the portfolio will therefore decline until only the systematic risk (also known as common, undiversifiable, or market risk) remains.

With respect to capital market theory, an investor's optimal portfolio is the combination of a risk-free asset and a risky asset with the highest expected return. (T/F)

F - With respect to capital market theory, an investor's optimal portfolio is the combination of a risk-free asset and a risky asset with the highest Sharpe ratio.

What is the Super Bowl effect?

Historical data shows in the year after the Super Bowl, the stock market is more likely to do better if an NFC team won and worse if an AFC team won

What is the stock split effect?

Returns are higher before and after the company announces the stock split

What is the January effect?

Returns have been higher in January (and lower in December) than in other months

Relative to portfolios on the capital market line, any portfolio that plots above the capital market line is considered unachievable. (T/F)

T

The diversification benefit is least valuable when adding a second stock to a one-stock portfolio when the correlation coefficient is 1. (T/F)

T

The efficient portfolios created by a risk-free asset and a risky asset in the mean-standard deviation diagram lies on a straight line. (T/F)

T

With a large number of assets, the average covariance between all pairs of assets accounts for most of the portfolio's risk. (T/F)

T

The median mutual fund actually ______ value

destroys

Stocks that are ultimately acquired tend to appreciate and have ________ alphas, while stocks that are not acquired tend to depress and have ________ alphas

positive and negative

A strong-form efficient market is also _________ and _________ efficient

semi-strong and weak-form

What are the components for the Fama-French-Carhart (FFC) model?

- self-financing market portfolio - small-minus-big (SMB) portfolio - high-minus-low (HML) portfolio -momentum

Explain investor attention, mood, and experience

1. Individual investors tend to be influenced by attention-grabbing news or events. They buy stocks that have recently been in the news. 2. Positive effects on mood tend to result in higher stock returns 3. Investors appear to put inordinate weight on their experience compared to empirical evidence. People who grew up during a time of high stock returns are more likely to invet in stocks.

What evidence supports the semi-strong form of EMH?

3 months prior to a takeover announcement, the stock price gradually increased. At the time of announcement the stock price instantaneously jumped. After the announcement, the abnormal returns dropped to zero.

A stock exchange is located in a city and the city experiences weather changes. Determine which of the following is TRUE. A. It would affect investors' moods, and investors would depart from the CAPM in systematic ways. B. It would affect investors' moods, and investors would depart from the CAPM in random, idiosyncratic ways. C. It would not affect investors' moods, and investors would not depart from the CAPM in systematic ways. D. It would not affect investors' moods, and investors would not depart from the CAPM in random, idiosyncratic ways. E. It would not affect investors' moods, but investors would depart from the CAPM in systematic ways.

A

Assume the Capital Asset Pricing Model applies. Determine which of the following statements is TRUE. A. To determine the appropriate risk premium for any investment, the market risk premium must be rescaled by the amount of market risk present in the security's returns. B. There is no clear relationship between a stock's beta and its expected return. C. There is a linear relationship between a stock's total risk and its expected return. D. The beta of a security with respect to the market portfolio must be either zero or positive. E. The beta of a portfolio is the arithmetic average beta of the securities in the portfolio.

A

Determine which of following is an example of a behavioral bias that might cause the market portfolio not to be efficient. A. Investors are attracted to large growth stocks that receive greater news coverage. B. Investors are attracted to investments with skewed distributions that have a small probability of an extremely high payoff. C. The true market portfolio may be efficient, but the proxy an investor uses to mimic the market portfolio may be inaccurate. D. Investors are exposed to significant non-tradeable risks outside their portfolio, such as human capital. E. Investors systematically ignore positive-NPV investment opportunities.

A

Determine which of the following statements about investor behavior and capital market efficiency is FALSE. A. According to the Capital Asset Pricing Model, when both are holding the market portfolio, a less informed investor with a less than average trading skill will underperform compared to an average investor. B. Relative wealth concerns can lead investors to choose undiversified portfolios. C. Investors may choose sub-optimal portfolios due to familiarity bias. D. People who grew up and lived during a time of high stock returns are more likely to invest in stocks than people who experienced times when stocks performed poorly. E. An informational cascade effect may lead investors to depart from the CAPM in systematic ways, thus imparting systematic uncertainty into prices.

A

Determine which of the following statements about the Capital Asset Pricing Model is TRUE. A. If an investment has a negative beta, then its expected return would be less than the risk-free rate. B. The expected return on an investment with a beta of 2 is two times as high as the expected return on the market portfolio. C. A security with a beta of 0 will offer zero expected return. D. If a stock lies below the security market line, it is undervalued. E. None of (A), (B), (C), and (D) are correct.

A

Determine which of the following statements regarding a multi-factor model is always TRUE: A. Securities are traded in a competitive market. B. Factor portfolios are efficient portfolios. C. Each factor portfolio can be interpreted as either a risk factor itself or a portfolio of stocks correlated with an observable risk factor. D. Each factor beta is the expected percentage change in the excess return of a security. E. The risk premium of a security can be expressed as the sum of the risk premium of each factor in the multi-factor model.

A

Determine which of the following statements regarding the CAPM is TRUE. A. Individuals who depart from the CAPM in random, idiosyncratic ways will hold the market portfolio in aggregate. B. If individuals depart from the CAPM in systematic ways, then despite the fact that each individual doesn't hold the market, when we combine their portfolios together these departures will tend to cancel out. C. According to the CAPM, whether or not an investor should hold the market portfolio depends on the quality of an investor's information or trading skill. D. According to the CAPM, investors should trade frequently. E. None of (A), (B), (C), and (D) are true.

A

Determine which of the following statements regarding the disposition effect impacting investor tax obligations is TRUE. A. The disposition effect causes investor tax obligations to increase. B. The disposition effect causes investor tax obligations to decrease. C. The disposition has no effect on investor tax obligations. D. The disposition effect increases tax obligations for losing stocks only. E. The disposition effect decreases tax obligations for winning stocks only.

A

Research proves that the capital asset pricing model does not depend on homogeneous expectations of investors. However, it does require rational expectations and everyone to hold the market portfolio in aggregate. Determine the bias or effect that will NOT cause inefficiency in the market portfolio. A. Overconfidence bias B. Disposition effect C. Information cascade effect D. Herd behavior E. Size effect

A

Which of the following outlines the correct sequence of a traditional IPO process? A. Formation of underwriters and syndicates, SEC filings, Valuation B. Formation of underwriters and syndicates, Valuation, SEC filings C. SEC filings, Formation of underwriters and syndicates, Valuation D. SEC filings, Valuation, Formation of underwriters and syndicates E. Valuation, SEC filings, Formation of underwriters and syndicates

A

Determine which of the following is NOT an example of a systematic bias that will lead to market inefficiency. A. Disposition effect B. Overconfidence bias C. Investor's mood D. Herd behavior E. None of the above

B

Determine which of the following scenarios does NOT cause the market portfolio to be inefficient. A. A significant number of investors do not have rational expectations. B. Sensation-seeking investors hold inefficient portfolios. C. Investors keep the losers and sell the winners in their portfolio. D. Investors do not seek to maximize the Sharpe ratio of their portfolio. E. All of the above would cause the market portfolio to become inefficient.

B

Determine which of the following statements about perfect capital markets is FALSE. A Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. B The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt. C A firm's financing decisions do not change the cash flows generated by its investments. D A firm's financing decisions do not reveal new information about the investments. E The total value of a firm's securities is equal to the market value of the total cash flows generated by its assets.

B

Determine which of the following statements is TRUE. A. Beta measures market risk whereas volatility measures firm-specific risk. B. In a well-diversified portfolio, market risk accounts for a considerably greater proportion of total risk than firm-specific risk. C. A portfolio's beta is the arithmetic average of all the betas for the individual stocks in the portfolio. D. A stock's beta is the ratio of the covariance between the stock returns and the market returns to the standard deviation of market returns. E. The average beta of a stock in the market is greater than 1.

B

Determine which of the following statements regarding international bonds is FALSE: A Domestic bonds are bonds issued by a local entity and traded in a local market, but purchased by foreigners, and are denominated in the local currency. B Foreign bonds are bonds issued by a foreign company in a local market and are intended for local investors, and are denominated in the foreign currency. C Foreign bonds in the United States are known as Yankee bonds. D Eurobonds are international bonds that are not denominated in the local currency of the country in which they are issued. E Global bonds combine the features of domestic, foreign, and Eurobonds, and are offered for sale in several different markets simultaneously.

B

Which of the following statements about Arbitrage Pricing Theory (APT) is FALSE? A. The CAPM yields an equation equivalent to the one-factor APT with the factor being the stock market index. B. The factors in the APT must be based on market capitalization, book-to-market ratios, and momentum. C. A portfolio with no exposure to any APT risk factors should earn the risk-free rate on average. D. The APT can be used to estimate the cost of equity capital for a firm. E. None of (A), (B), (C), or (D)

B

Which of the following would not support the weak form of the efficient market hypothesis? A. Stock prices behave more like a random walk. B. Stock returns exhibit positive serial correlation. C. Prior to the takeover announcement, there was a gradual increase in the target's stock price. At the time of the announcement, there was a one-time instantaneous price increase. After the announcement, there was no significant further price drift. D. The top performing fund managers in one year only have a 50% chance to beat their reference index the following year. E. (A), (B), (C), and (D) support the weak form of the efficient market hypothesis.

B

A binomial tree is used to model stock prices. As the number of periods in the tree increases, which distribution of stock price will the binomial tree approximate? A Uniform B Normal C Lognormal D Exponential E None of (A), (B), (C), and (D) are correct.

C

Determine which of the following is NOT consistent with the semi-strong form efficient markets hypothesis. A. In a market that is semi-strong form inefficient, it is possible that a data scientist is consistently able to use a machine learning algorithm to analyze corporate financial statements to successfully pick stocks that are underpriced. B. In a market that is semi-strong form inefficient, it is possible that an investor is able to reliably make abnormal profits by reading the financial press each morning and buying the stocks that have positive news. C. In a market that is semi-strong form efficient, it is impossible that a corporate executive is able to consistently beat the market by selling shares of the company's stock prior to the announcement of negative news. D. In a market that is semi-strong form efficient, it is possible to exploit insider information to earn an abnormal risk-adjusted expected return. E. If a market is not semi-strong form efficient, then it also cannot be strong form efficient.

C

Determine which of the following statements about weighted average cost of capital (WACC) is TRUE. A. The WACC provides a good evaluation measure for a specific capital budgeting project that is safer than other projects of the firm. B. One purpose of the WACC is to adjust the cost of equity by the appropriate tax rate. C. The WACC provides correct discount rate only for projects with business risks that are similar to those of the average existing assets of the firm. D. Only before-tax costs should be considered. E. If a company issues additional debts, the increased leverage causes the WACC to rise.

C

Determine which of the following statements is FALSE. A Static hedging strategies are also known as hedge-and-forget strategies. B A static hedge for a variable annuity guarantee may be created by using exotic options. C Static strategies generally focus on the value of the assets over time. D A dynamic hedge focuses on the value of the assets over time rather​ than the cash flows that they generate. E A dynamic strategy is a hedging strategy that involves frequent buying and selling of securities in the hedge portfolio.

C

Determine which of the following statements is TRUE. A The variance of equity returns for an equally-weighted portfolio is proportional to the number of stocks held. B Beta is the correlation between the returns on an asset and the returns on the market portfolio. C The variability of an investment portfolio that is balanced evenly between two stocks is no more than the average variability of the two individual stocks. D Full diversification of an investment portfolio eliminates market risk. E The total risk of an individual stock held in isolation determines its contribution to the risk of a well-diversified portfolio.

C

Determine which of the following statements regarding multi-factor models of risk is TRUE. A. As a practical matter, it is extremely difficult to identify a collection of well-diversified portfolios. B. Well-diversified portfolios are efficient portfolios. C. The Capital Asset Pricing Model may be seen as a special case of the multi-factor model. D. All multi-factor models use the market portfolio as one of the factor portfolios. E. The disadvantage of multi-factor models over single-factor models is that it is easier to identify a single efficient portfolio than a collection of well-diversified portfolios.

C

Determine which of the following statements regarding private debt is FALSE: A. Private debt is cheaper to issue than public debt. B. The private debt market is larger than the public debt market. C. The private debt market is more liquid than the public debt market. D. A private placement is a bond issue that is sold privately to a small group of investors. E. A revolving line of credit is a credit commitment for a specific time period up to some limit.

C

It has been suggested that companies often overstate earnings in bad years and understate them in good years because they want investors to believe that the cash flows are less variable than they actually are. Which of the following, if true, would cast the most doubt on the sensibility of this strategy? A. Investors are risk-averse. B. Earnings follow a random walk. C. The strong efficient market hypothesis holds. D. Investors rely on historically observed betas. E. Corporate tax rates increase with earnings.

C

Philip Hand is a financial analyst researching two equity markets: Finland and Norway. Hand interviews several portfolio managers from Finland regarding efficiency and the speed with which information is reflected in stock prices. Hand also interviews a Norwegian investor who sits on three boards of publicly held companies in his country. Hand arrives at the following conclusions: Finland: The use of technical trading strategies based on historical prices by portfolio managers consistently results in outperformance. Norway: The use of private information by board members consistently results in outperformance. Which statement is most likely accurate regarding Hand's conclusions? A. The market in Finland may be weak form efficient. B. The market in Finland may be semi-strong form efficient. C. The market in Norway may be semi-strong form efficient. D. The market in Norway may be strong form efficient. E. Neither market is efficient.

C

Some strategies have generated higher returns historically than the CAPM predicts. Determine which of the following statements is FALSE. A. The small stocks tend to be above the security market line. B. Value stocks tend to have positive alphas, and growth stocks tend to have low or negative alphas. C. When the market portfolio is not efficient, theory predicts that stocks with high market capitalizations or low book-to-market ratios will have positive alphas. D. As long as beta is not a perfect measure of risk, we should expect to observe the size effect. E. The size effect is potential evidence against the efficiency of the market portfolio.

C

Tong is a financial analyst using fundamental analysis to identify undervalued fixed income and equity securities. Tong uses data on inflation, dividend yields, duration, and beta to develop trading strategies. Tong is able to consistently outperform his equity benchmark but consistently matches the performance of his fixed income benchmark over a ten-year period. Tong is most likely to agree with which observation? A. The equity market is inefficient. B. The equity market is strong form efficient. C. The fixed income market is semi-strong form efficient. D. The fixed income market is strong form efficient. E. Both the equity and fixed income markets are semi-strong form efficient.

C

Which of the following statements regarding reasons to early exercise an American option is TRUE? A For an American call, the advantage of early exercising is receiving the strike price sooner rather than later. B For an American call, the advantage of early exercising is receiving the implicit insurance protection against the possibility that the stock price will move below the strike price. C For an American put, the advantage of early exercising is receiving the strike price sooner rather than later. D For an American put, the advantage of early exercising is receiving the implicit insurance protection against the possibility that the stock price will move above the strike price. E The correct answer is not given by (A), (B), (C), or (D).

C

Assume a perfect capital market. Determine which of the following statements regarding Modigliani-Miller I is FALSE. A In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security holders is equal to the total cash flow generated by the firm's assets. B By the Law of One Price, the firm's securities and its assets must have the same total market value. C As long as the firm's choice of securities does not change the cash flows generated by its assets, this decision will not change the total value of the firm or the amount of capital it can raise. D Using leverage may result in net gain or loss. E The value of the firm is determined by the present value of the cash flows from its current and future investments.

D

Determine which of the following statements about efficient portfolios is FALSE. A. A portfolio is efficient if and only if the expected return of every available security equals its required return. B. The efficient portfolio has the highest Sharpe ratio of any portfolio in the economy. C. An efficient portfolio contains only systematic risk. D. The volatility of an efficient portfolio can be reduced without lowering its expected return. E. We can determine the appropriate risk premium for an investment from its beta with the efficient portfolio.

D

Determine which of the following statements about equity financing is FALSE. A Convertible notes allow angel investors to convert into equity at a discount when the company finances with equity for the first time. B Venture capital firms are run by their general partners. C General partners in venture capital firms are also called venture capitalists. D The annual management fee that venture capital firms typically charge is known as carried interest. E A leveraged buyout is a transaction in which private equity firms initiate their investment by finding a publicly traded firm and purchasing the outstanding equity, thereby taking the company private. In most cases, the private equity firms use debt as well as equity to finance the purchase.

D

Determine which of the following statements about issuing equity and adverse selection is FALSE. A. The stock price declines on the announcement of an equity issue. B. Managers issuing equity have an incentive to delay the issue until any news that might positively affect the stock price becomes public. C. The stock price tends to rise prior to the announcement of an equity issue. D. Firms tend to issue equity immediately before earnings announcements. E. Managers who perceive the firm's equity is underpriced will have a preference to fund investment using retained earnings, or debt, rather than equity.

D

Determine which of the following statements about the effect of increasing the amount of leverage in a firm's capital structure in the presence of taxes is FALSE. A With no debt, both the pre-tax WACC and the effective after-tax WACC are equal to the unlevered equity cost of capital. B As leverage increases, the firm's equity cost of capital rises. C As leverage increases, the firm's pre-tax WACC remains unchanged. D As leverage increases, the firm's effective after-tax WACC remains unchanged. E As the debt and equity costs of capital both rise when leverage is high, the effective after-tax WACC declines.

D

Determine which of the following statements is TRUE. A The opportunity set formed by two risky assets in the mean-standard deviation diagram is parabolic. B A portfolio is efficient if there is no other portfolio in the opportunity set that offers a lower volatility for a given level of expected return. C The reduction in risk becomes greater as the correlation increases. D The efficient portfolios created by a risk-free asset and a risky asset in the mean-standard deviation diagram lies on a straight line. E In a market with risk-free assets and risky assets, risk-averse investors would invest more in the risky asset with a lower volatility when compared to risk-seeking investors in their portfolio of risky assets.

D

Determine which of the following statements is TRUE. A The value of a European call can never exceed the strike price. B The value of a European put can never exceed the stock price. C The value of a European call on a stock with dividends (with time-to-maturity T2T2) is always at least as great as the value of an otherwise equivalent European call (with time-to-maturity T1T1), where T1≤T2T1≤T2. D The value of a European call on a nondividend-paying stock (with time-to-maturity T2T2) is always at least as great as the value of an otherwise equivalent European call (with time-to-maturity T1T1), where T1≤T2T1≤T2. E The value of a European put option (with time-to-maturity T2T2) is always at least as great as the value of an otherwise equivalent European put option (with time-to-maturity T1T1), where T1≤T2T1≤T2.

D

Determine which of the following statements regarding equity financing for private companies is TRUE. A Angel financing often occurs at such an early stage in the business that it is difficult to assess a value for the firm. Angel investors often circumvent this problem by holding equity. B A venture capital firm is a general partnership that specializes in raising money to invest in the private equity of young firms. C A venture capital firm is run by the limited partners. D Private equity firms often initiate their investment by finding a publicly traded firm and purchasing the outstanding equity, thereby taking the company private in a transaction called a leveraged buyout. E Corporate investors will only invest ​in companies for the financial return that they will earn on their investments.

D

Determine which of the following statements regarding sovereign debt is TRUE. A. Sovereign debt is issued by state and local governments. B. Treasury securities that do not pay any coupons and have an original maturity of 26 weeks are called STRIPS. C. Treasury securities that pay semiannual coupons and have an original maturity of 7 years are called Treasury bonds. D. Treasury securities that pay semiannual coupons and have an original maturity of 15 years are called Treasury bonds. E. The dollar coupon of TIPS is fixed.

D

Determine which of the following statements regarding the efficient market hypothesis is FALSE: A. If markets are efficient, the difference between the required return and expected return of a company's security is zero. B. Semi-strong-form inefficient markets are not necessarily weak-form inefficient. C. Technical analysts who attempt to profit by looking at patterns of prices and trading volume assume that markets are weak-form inefficient. D. Fundamental analysts who attempt to profit by using publicly available information to estimate a security's intrinsic value to determine if the security is mispriced assume that markets are semi-strong-form efficient. E. A company whose share price reacts gradually to the public release of its annual report most likely indicates that the market where the company trades is semi-strong-form inefficient.

D

Determine which of the following statements regarding the present value of financial distress costs is FALSE. A. The probability of financial distress increases with the amount of a firm's liabilities relative to its assets. B. The probability of financial distress increases with the volatility of a firm's cash flows and asset values. C. Firms whose value comes largely from human capital are likely to incur high costs when they risk financial distress. D. Firms whose ​main assets are physical capital are likely to incur high costs when they risk financial distress. E. The beta of distress costs will have an opposite sign to that of the firm.

D

Determine which of the following statements regarding trading on news or recommendations is FALSE. A. After the initial jump in the stock price at the time of the takeover announcement, target stocks do not appear to earn abnormal subsequent returns on average. B. Stocks that are ultimately acquired tend to appreciate and have positive alphas, while those that are not acquired have negative alphas. C. When stock recommendations coincide with a news story about the company, the initial stock price reaction appears correct and future alphas are not significantly different from zero. D. When stock recommendations do not coincide with a news story about the company, the initial stock price reaction appears to underreact, generating a positive future alpha. E. None of (A), (B), (C), or (D) are false.

D

Identify which of the following events has NOT been shown to affect market performance, according to Corporate Finance by Berk and DeMarzo. A. Weather B. Sports C. Financial news D. Celebrity news E. Investor experience

D

Professor Merton wishes to use the Black-Scholes formula to price a derivative, but would like to relax a few of its restrictions. Determine which of the following statements is most likely FALSE. A He could adjust the risk-free rate to a predetermined rate. B He could adjust the volatility according the economic environment. C He could adjust the present value of the dividends to reflect decreasing future cash flows. D He could adjust the stock price in a discrete manner to account for any earning announcements. E He could adjust the volatility and interest rate to vary over time in a known way. Solution

D

Which of the following best describes the credibility principle? A. A seller with private information is likely to sell you worse-than-average goods. B. Managers will prefer to use retained earnings first, and will issue new equity only as a last resort. C. Wasteful spending is more likely to happen when firms have high levels of cash flow in excess of what is needed. D. Claims in one's self-interest are credible only if they are supported by actions that would be too costly to take if the claims were untrue. E. When a seller has private information about the value of a good, buyers will discount the price they are willing to pay due to adverse selection.

D

Which of the following statements regarding the information cascade effect is TRUE? A. The information cascade effect is a result of relative wealth concerns. B. The information cascade effect leads to the pecking order of financing. C. The information cascade effect does not affect the efficiency of the market portfolio. D. The information cascade effect occurs when traders ignore their own information to attempt to profit from the information of others. E. The information cascade effect occurs when investors overweigh their own experience over considering all historical evidence.

D

Determine which of the following is NOT a reason why the market portfolio might not be efficient. A. We cannot include most of the traded investment wealth in the economy in the market proxy because competitive price data is not available. B. Some investors may be subject to systematic behavioral biases. C. Some investors may be attracted to investments with skewed distributions that have a small probability of an extremely high payoff. D. Some investors are exposed to other significant risks outside their portfolio that are not tradable, the most important of which is due to their human capital. E. Some investors fail to diversify their portfolios adequately.

E

Determine which of the following is the most likely NOT a typical feature of convertible preferred stock. A. Anti-dilution protection B. Board membership C. Participation rights D. Liquidation preference E. Guarantee on initial investment

E

Determine which of the following statements about a firm's capital structure in a perfect capital market is FALSE. A. When a firm changes its capital structure without changing its investments, its unlevered beta will remain unchanged. B. When a firm changes its capital structure without changing its investments, its equity beta will change. C. The firm's equity beta increases with leverage. D. Cash or risk-free securities reduce the required risk premium of the firm's assets. E. When we are trying to assess a firm's enterprise value, it is natural to measure leverage in terms of the firm's net debt, which is its debt plus its holdings of excess cash or short-term investments.

E

Determine which of the following statements regarding individual investors is TRUE. A. Individual investors tend to diversify their portfolios adequately. B. Individual investors tend to trade less frequently than they should. C. Individual investors tend to hold on to stocks that have risen in value and sell stocks that have lost value. D. Individual investors are less likely to buy stocks that have recently been in the news. E. Individual investors who grew up and lived during a time of low stock returns are less likely to invest in stocks.

E

Determine which of the following statements regarding investor behavior and capital market efficiency is FALSE: A. If an investor can use past returns to construct a trading strategy that makes consistent profit, it is evidence that market portfolio is not efficient. B. Investors might expect stocks to have non-zero alphas if the market proxy portfolio is not highly correlated with the true market portfolio, even if the true market portfolio is efficient. C. If some investors are subject to systematic behavioral biases while others select efficient portfolios, then the market portfolio will not be efficient. D. An employee who cares about the risk due to human capital will likely underweight the amount of money he invests in his own company's stock relative to an investor who does not work for his company. E. The disposition effect reduces investor's tax obligations.

E

Determine which of the following statements regarding the average behavior of individual investors is FALSE. A. Investors fail to diversify their portfolios adequately. B. Investors favor investments in companies they are familiar with. C. Investors care most about the performance of their portfolio relative to that of their peers. D. Investors tend to trade very actively. E. Investors tend to hang on to winners and sell losers.

E

Determine which of the following statements regarding venture capital financing terms is TRUE. A. When a company founder decides to sell equity to outside investors for the first time, it is common practice for private companies to issue common stock to raise capital. B. The preferred stock issued by young companies typically pay regular cash dividends to the owner. C. If the company runs into financial difficulties, the common stockholders have a senior claim on the assets of the firm relative to any preferred stockholder. D. It is uncommon for investors in later rounds to demand seniority over investors in earlier rounds. E. If things are not going well and the firm raises new funding at a lower price than in a prior round, it is referred to as a "down round."

E

Leverage has agency benefits and can improve incentives for managers to run a firm more efficiently and effectively. The agency benefits of leverage are least likely due to: A. Increased ownership concentration B. Reduced wasteful investment C. Reduced managerial entrenchment D. Increased commitment E. Increased empire building

E

Which of the following anomalies is an example of overreaction to information? I. New-issue puzzle II. Earnings announcement puzzle III. Super Bowl effect IV. Monday effect

I

Which of the following observations is/are TRUE with respect to the weak form of the efficient market hypothesis? I. Stock prices behave as though successive values differ by a random number. II. In a scatterplot with the return of day tt on the xx-axis and the return of day t+1t+1 on the yy-axis, the points are concentrated in the first quadrant. III. The variance of returns do not vary with the interval over which the returns are measured.

I

Consider the following four investment strategies: I. An investment in stocks that have recently had a stock split. II. An investment in stocks of small firms that are often neglected by analysts. III. An investment in stocks of takeover targets following a takeover annoucement. IV. An investment in stocks that have recently had unexpectedly bad earnings. Determine which two of the four aforementioned strategies have historically resulted in superior differential returns.

I and II

Evidence shows that individual investors fail to diversify their portfolios adequately. Which of the following is an explanation for this behavior? I. Familiarity bias II. Overconfidence bias III. Relative wealth concerns

I and III

Which of the following are evidence against the efficient market hypothesis? I. Lesser-known firms yield abnormally high returns. II. New issues have high returns on the first day but underperform over the 3-5 year period after issue. III. There was a one-time increase in the stock price at the time of takeover announcement but no significant abnormal returns afterwards.

I, II

Which of the following statements about calendar/time anomalies is/are true? I. Stock returns have been observed to be lower in December than in other months. II. Stock returns have been observed to be higher on Friday than on other days. III. Stock returns have been observed to be more volatile during the middle of the trading day than toward either the beginning or the end of the trading day.

I, II

You trade in a market by randomly choosing five stocks to buy and five stocks to sell every day. The market has the following traits: I. Small transaction costs II. Highly skilled traders are better informed than you Determine which of the traits above would cause your portfolio to underperform the market portfolio over the long run.

I, II

Which of the following may prevent investors from profiting from market anomalies? I. Market anomalies may be artifacts of data mining. II. Investor may not have access to a computing algorithm to engage in high-frequency trading. III. Market anomalies found in past data may not persist into the future.

I, II, III

Which of the following statements about debt funding is/are true? I. A mortgage is an example of secured debt. II. A mortgage-backed security is an example of secured debt. III. A collateralized mortgage obligation is an example of secured debt.

I, II, III

Which of the following statements is/are NOT true? I. Two stocks with a correlation of zero will not offer any diversification when combined in a portfolio. II. The tangent portfolio must have the highest expected return of any possible combination of risky assets. III. The risk of a portfolio consisting of multiple assets cannot be lower than that of the least risky of the individual assets.

I, II, III

Which of the following anomalies is an example of underreaction to an event or information? I. New-issue puzzle II. Earnings announcement puzzle III. Momentum effect IV. Reversal effect

II and III

Which of the following describes the conditions under which the market portfolio might not be an efficient portfolio? I. A significant number of investors do not have homogeneous expectations. II. A significant number of investors do not have rational expectations. III. A significant number of investors care about aspects of their portfolios other than expected return and volatility.

II and III

You are given the following scenarios regarding investor behavior: I. A significant number of uninformed investors hold an inefficient portfolio because they are overconfident in their ability to manage a portfolio. II. Investors hold inefficient portfolios because they care about other factors other than expected return and volatility. III. Investors do not have rational expectations, thus misinterpret information to believe they are earning a positive alpha when they are actually holding a negative alpha. Determine which of the scenarios above would cause the market portfolio to become inefficient.

II and III

Evidence shows that individual investors tend to trade very actively. Which of the following is an explanation for this behavior? I. Relative wealth concerns II. Overconfidence bias III. Sensation seeking

II, III

Which of the following are evidence against the efficient market hypothesis? I. Stock prices appeared to follow a random walk. II. Stock of firms with unexpected good earnings outperformed stocks of firms with unexpected bad earnings over a six-month period following announcement. III. Returns are higher before and after the company announces the stock split.

II, III

What are behavioral biases and how does it explain why the market portfolio might not be efficient?

Investors may be subject to systematic behavioral biases and therefore hold inefficient portfolios

What is the earnings announcement puzzle?

Investors underreact to the earnings announcement

What is sem-strong-form EMH?

It is impossible to consistently attain superior profits by analyzing public information because the information is already fully built into the security price

What did Kendall find that supports the weak form of EMH?

Kendall found that prices followed a random walk model, i.e., past stock prices have no bearing on future prices.

What is size effect?

Small-cap companies have outperformed Large-cap companies on a risk-adjusted basis

What does it mean for beta = 1?

The asset has the same systematic risk as the market. The asset will tend to go up and down the same percentage as the market.

What happens to a stock's price when a stock recommendation is given at the same time that news about the stock is released?

The initial stock price reaction appears correct. The stock price increases in the beginning, then it flattens out.

In the FFC model what does the HML portfolio account for?

This accounts for differences in returns on value stocks and growth stocks. We buy high book-to-market stocks and finance itself by selling low book-to-market stocks.

In the FFC model what does the self-financing market portfolio account for?

This accounts for equity risk. We take a long position in the market portfolio and finance itself with a short position in the risk-free asset.

In the FFC model what does momentum account for?

This accounts for the tendency of an asset return to be positively correlated with the asset return from the previous year. We buy the top 30% stocks and finance itself by short selling the bottom 30% stocks.

What is herd behavior?

When investors actively try to follow each other's behavior

Why does the mutual fund industry still have positive value added?

because skilled managers manage more money and add value to the whole industry

What behaviors lead investors to depart from the CAPM in systematic ways and subsequently impact the efficiency of the market?

holding on to losers and the disposition effect, investor attention, mood, and experience, and herd behavior

Determine which of the following statements regarding multi-factor models of risk is NOT true. A. Any efficient portfolio will be well-diversified. B. We can construct an efficient portfolio from other well-diversified portfolios. C. Factor portfolios are portfolios that we can combine to form an efficient portfolio. D. When we use a well-diversified portfolio, it alone may not capture all systematic risk. E. At least one of the factor portfolios used in the multifactor model must be efficient.

E

For a two-stock portfolio, which of the following situations would have the lowest risk? A. The two stocks are perfectly positively correlated. B. The two stocks have a modest positive correlation. C. There is no correlation between the two stocks. D. The two stocks have a modest negative correlation. E. The two stocks are perfectly negatively correlated.

E

Suppose you create a portfolio by purchasing 100 shares of stock in a technology company. Determine which of the following would least likely reduce the volatility of your portfolio. A. Buy 100 shares of stock in a financial company. B. Buy 100 shares of stock in a consumer discretionary company. C. Buy 100 shares of stock in a similar company overseas. D. Buy 100 shares of stock in a real estate company. E. Buy 100 more shares of stock in the same technology company.

E

The Fama-French-Carhart (FFC) factor specification is the most commonly used multi-factor model. Determine which of the following portfolios is NOT self-financing. A. A portfolio consists of a long position in the market portfolio and a short position in the risk-free asset. B. High-minus-low portfolio C. Small-minus-big portfolio D. Prior one-year momentum portfolio E. All of the portfolios above are self-financing.

E

In a market with risk-free assets and risky assets, risk-averse investors would invest more in the risky asset with a lower volatility when compared to risk-seeking investors in their portfolio of risky assets. (T/F)

Thus, in a market with risk-free assets and risky assets, both risk-averse and risk-seeking investors would choose the same risky portfolio of risky assets. The only decision that the investor would have to make is how to allocate investments between the risk-free asset and the risky portfolio.

What are cyclical industries?

Types of industries which are more sensitive to economic shocks (tend to have higher betas).

What are non-cyclical industries?

Types of industries which are more stable and highly regulated, and thus are less sensitive to fluctuations in the overall market (tend to have lower betas).