Exam 2 review Investment
"An investor takes as large a position as possible when an equilibrium price relationship is violated. This is an example of:"
" Arbitrage activity."
"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?"
"An increase of 1% in expected return. A decrease of 1% in the risk-free rate." The same impact of increasing the sharpe ratio from .40 to .45
Define separation property?
"The property that implies port-folio choice can be separated into two independent tasks: (1) determination of the optimal risky portfolio, which is a purely technical problem, and (2) the personal choice of the best mix of the risky portfolio and the risk-free asset."
Set up expected return Asset Er SD weight X 15% 22% .5 Y 10 8 .4 Z 6 3 .1
(.15*.5)+(.1*.4)+.(06*.1)
What is an efficient frontier?
1. a modern portfolio theory tool/graph that shows investors the best possible return they can expect from their portfolio, given the level of risk that they're willing to accept. 2. Illustration: Graph shows expected return on the vertical axis and standard deviation on the horizontal axis, with a curve upon whose line optimal portfolios are constructed to balance maximum returns with any risk taken. Portfolios behind the line are inefficient and those above the line are not possible.
Suppose we have unique information suggesting that the return for security ABC will be 17% E(rm)=6% E(ri)=8% Rf=2 solve for BI
1.5
" A three-asset portfolio has the following characteristics: X Y Z Expected 15% 10 6 Return Standard Deviation 22 8 3 Weight .5 .4 .1 What is the expected return on this three-asset portfolio?"
12.1%
Solve for expected return Asset Er SD weight X 15% 22% .5 Y 10 8 .4 Z 6 3 .1
12.1%
"A bond with an annual coupon rate of 4.8% sells for $970. What is the bond's current yield?"
4.95%
" A zero-coupon bond with face value $1,000 and maturity of five years sells for $746.22" What is its yield to maturity?
6.0395%
"The yield to maturity on one-year zero-coupon bonds is 8%. The yield to maturity on two-year zero-coupon bonds is 9%.(LO 10-7) b. If you believe in the expectations hypothesis, what is your best guess as to the expected value of the short-term interest rate next year?
According to the expectations hypothesis, the forward rate equals the expected value of the short-term interest rate next year, so the best guess would be 10.01%
What is week-form?
All information contained in the history of past trading is reflected onto prices
What is semistrong-form?
All publicly available information
What is strong-form?
All relevant information, including insider information
Define Arbitrage Opportunity
Arises if an investor can construct a zero investment portfolio with a sure profit due to security mispricing -When the law of one price is violated
" Jeffrey Bruner, CFA, uses the capital asset pricing model (CAPM) to help identify mispriced securities. A consultant suggests Bruner use arbitrage pricing theory (APT) instead. In comparing CAPM and APT, the consultant made the following arguments: a. Both the CAPM and APT require a mean-variance efficient market portfolio"
Both the CAPM and APT require a mean-variance efficient market portfolio. This statement is incorrect. The CAPM required the mean-variance efficient portfolio, but APT does not.
define Passive management
Buying a well-diversified portfolio without attempting to find mispriced securities
In which one of the following cases is the bond selling at a discount?
Coupon rate is less than current yield, which is less than yield to maturity
If the market is efficient, why practice portfolio management?
Diversification Tax consideration Matching investors' risk preferences
How do you calculate Expected return?
Expected return * weight
what is the CAPM formula?
Expected return= RF + B(RM-RF)RF means risk free rate. B means beta RM means return on market
What type of risk factors is market risk, systematic risk, and non-diversifiable risk?
Factors common to the whole economy
If the efficient market hypothesis holds, it implies that prices do not fluctuate?
False
T/F The CAPM implies that investors require a higher return to hold highly volatile securities.
False
T/F: stocks with a beta of zero offer an expected rate of return of zero
False
Single-period investment horizon
False we do not know how long a period is
A random walk occurs when
Future price changes are uncorrelated with past price changes, reflects no other information and thus random
Define efficient frontier?
Graph representing a set of portfolios that maximizes expected return at each level of portfolio volatility
framing
How the risk is described, e.g., risky losses vs. risky gains, can affect investor decisions
"Stocks offer an expected rate of return of 10% with a standard deviation of 20%, and gold offers an expected return of 5% with a standard deviation of 25%. (LO 6-3) " How would you answer (a) if the correlation coefficient between gold and stocks were 1? Draw a graph illustrating why one would or would not hold gold."
If gold had a perfectly positive correlation with stocks, gold would not be a part of efficient portfolios. The set of risk/return combinations of stocks and gold would plot as a straight line with a negative slope.
Persistent positive performance implies
If you can out preform the market consistent
Portfolio AARR SD Beta R 11% 10% .5 SP500 14% 12% 1 When plotting portfolio R on the preceding table relative to the SML, portfolio R lies:
Insufficient data given
Portfolio AARR SD Beta R 11% 10% .5 SP500 14% 12% 1 When plotting portfolio R relative to the capital market line, Portfolio R lies:
Insufficient data given we need to know the risk free rate
Regret Avoidance Bias
Investors blame themselves more when an unconventional or risky bet turns out badly
Portfolio Expected Return Standard Deviation Risk free 10% 0 Market 18% 24 A 16% 22 Is CAPM possible?
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 Is CAPM possible?
Not possible, Portfolio A has a higher beta than Portfolio B, but the expected return for portfolio A is lower
Define security characteristic line (SCL)
Plot of a security's predicted excess return given the excess return of the market
According to the theory of arbitrage
Positive alpha investment opportunities will quickly disappear
Define excess return?
Rate of return in excess of the risk-free rate.
Define mutual fund theory
States that all investors desire the same portfolio of risky assets and can be satisfied by a single mutual fund composed of that portfolio
EMH prediction
Stock prices should follow a random walk Short-term price changes are random and unpredictable Expected return should still be positive in the long run The price of a portfolio of non-dividend paying stocks should have a positive trend in the long run but be random around the trend
Which version of the efficient market hypothesis focuses on the most inclusive set of information?
Strong-form efficiency includes all information; historical, public, and private
Briefly explain the concept of the efficient market hypothesis (EMH) and each of its three forms— strong—and briefly discuss the degree to which existing empirical evidence supports each of the three forms of the EMH"
That current market prices reflect all information that can be relevant to the valuation of the firm
Define alpha inference from SCL
The abnormal return on a security in excess of what would be predicted by CAPM
What is efficient diversification?
construct portfolios that provide the lowest possible risk for any given level of expected return.
Risk Premium of Market Portfolio
depends on the average risk aversion of all market participation
What is unique risk, firm specific risk, nonsystematic risk and diversifiable risk?
factors that eliminated by diversification
If the efficient market hypothesis holds, It implies that future events can be forecast with perfect accuracy
false
Information is costless and available to all investors
false
what is homogeneous expectations?
people do not come to the same conclusion after reading the same information
What is index model?
statistical models designed to estimate these two components of risk for a particular security or portfolio.
Weak-form EMH
the assertion that stock prices already reflect all information contained in the history of past trading
Semistrong-form EMH
the assertion that stock prices already reflect all publicly available information
Strong-form EMH
the assertion that stock prices reflect all relevant information, including inside information
" In contrast to the capital asset pricing model, arbitrage pricing theory:"
" Does not require the restrictive assumptions concerning the market portfolio."
"Which of the following observations would provide evidence against the semi-strong form of the efficient market theory? Explain."
"Low P/E stocks tend to have positive abnormal returns", the P/E ratio is public information so this observation would provide evidence against the semi-strong form of the efficient market theory
What must be the beta of a portfolio with E(rP) = 20%, if rf = 5% and E(rM) = 15%?
1.5
Suppose the risk-free rate is 5 percent, the average investor has a risk-aversion coefficient of A=2, and the standard deviation of the market portfolio is 20%. According to equation 7.1 we can estimate the equilibrium value of the market risk premium as 2X .20^2=___. So the expected return on the market must be ____.
13%
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)?
13% and 10%
Northeast airlines has a market beta of 1.2 and a T-bond beta of .7. Suppose the risk premium of the market index is 6%, while that of the T-bond portfolio is 3%. Then the overall risk premium on Northeast stock is the sum of the risk premiums required as compensation for such source of systematic risk,
13.3%
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%?
15%, its expected return is exactly the same as market return when beta is 1
Suppose the return on the market is expected to be 14%, a stock has a beta of 1.2, and the T-bill rate is 6%. The SML would predict an expected return on the stock of?
15.6%
Within the context of CAPM, assume: Expected market return = 15% Risk-free rate = 8% Beta of security ABC = 1.25 What is the expected return of security ABC?
16.75
" A zero-coupon bond with face value $1,000 and maturity of five years sells for $746.22" What happens to its yield to maturity if its prices falls immediately to 730?
6.4965%
"Why do bond prices go down when interest rates go up? Don't bond investors like to receive high interest rates?"
A bond's coupon interest payments and princpal repayment are not affected by changes in market rates. Consequently, if market rates increase bonds investors in the secondary markets are not willing to pay much for a claim on a given bond's fixed interest and principal payments as they would if market rates were lower. This relationship is apparent from the inverse relationship between interest rates and present value. An increase in the discount rate decreases the present value of the future cash flows.
Briefly explain the concept of the efficient market hypothesis (EMH) and each of its three forms— semistrong, —and briefly discuss the degree to which existing empirical evidence supports each of the three forms of the EMH"
A firm's stock prices reflects all publicly available information about a firm's prospects. Example of publicly available information are company annual reports and investments advisory data.
What is CAPM?
A model that relates the required rate of return on a security to its systematic risk as measured by beta
Define Zero investment portfolio
A portfolio with zero net investment, established by shorting one security or a portfolio and use the proceeds to buy another at the same time
A zero-investment, well-diversified portfolio with a positive alpha could arise if
A risk-free arbitrage opportunity exists
The security market line depicts:
A security's expected return as a function of its systematic risk
Define alpha
A stock's expected excess return beyond that consistent with its beta and the market's excess return.
Define arbitrage pricing theory?
A theory of risk-return relationships derived from no-arbitrage considerations in large capital markets.
"The yield to maturity on one-year zero-coupon bonds is 8%. The yield to maturity on two-year zero-coupon bonds is 9%.(LO 10-7) If you believe in the liquidity preference theory, is your best guess as to next year's short-term interest rate higher or lower than in (b)?
According to the liquidity preference hypothesis, the forward rate equals the expected short-term interest rate next year, so the best guess would be lower than 10.01%
"Stocks offer an expected rate of return of 10% with a standard deviation of 20%, and gold offers an expected return of 5% with a standard deviation of 25%. (LO 6-3)a. In light of the apparent inferiority of gold to stocks with respect to both mean return and volatility, would anyone hold gold? If so, demonstrate graphically why one would do so."
Although it appears that gold is dominated by stocks, gold can still be an attractive diversification asset. If the correlation between gold and stocks is sufficiently low, gold will be held as a component in the optimal portfolio
Define firm-specific risk or residual risk?
Component of return variance that is independent of the market factor.
What is arbitrage?
Creation of riskless profits made possible by relative mispricing among securities
Market anomaly refers to _______.
D. price behavior that differs from the behavior predicted by the efficient market hypothesis
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 Characterize each company in the previous problem as underprice, overpriced, or properly priced?
Discount store is overpriced and everything $5 is underpriced
"Karen Kay, a portfolio manager at Collins Asset Management, is using the capital asset pricing model for making recommendations to her clients. Her research department has developed the information shown in the following exhibit" FR SD Beta Stock x 14% 36% .8 Stock y 17 25 1.5 Market 14 15 1.0 index Risk-Free Rate 5 Calculate the equilibrium expected return according to the CAPM and the alpha for each stock
E(rx)=12.2% Ax1.8% E(ry)=18.5% aY=-1.5%
Mean reversion
Empirical Rule, it appears that betas exhibits a statistical property
Which of the following would most appear to contradict the proposition that the stock market is weakly efficient?
Every January, the stock market earns abnormal return
EMH Rational competition
Everyone likes free lunch As long as the prices do not reflect all available information and arbitrage opportunities exist, competition among investors will make the prices reflect all information
How do you solve for the Sharpe ratio?
Expected return/Standard deviation or Risk free rate/Standard deviation
"The SML leads all investors to invest in the same portfolio of risky assets"
False
The basic conclusion of the expectations hypothesis is that the long-term spot rate is equal to the anticipated short-term rate.
False
The expectations hypothesis predicts a flat yield curve if anticipated future short-term rates exceed current short-term rates.
False
The liquidity preference theory states that a rising yield curve necessarily implies that the market anticipates increase in interest rates?
False
You can construct a portfolio with beta of .75 by investing .75 of the investment budget in T-bills and the remainder in the market portfolio.
False
Investors are rational mean-variance optimizers
False people do not do rational things
All risky assets can be traded
False- not all human capital can be bought
FR SD Beta Stock x 14% 36% .8 Stock y 17 25 1.5 Market 14 15 1.0 index Risk-Free Rate 5 "Identify and justify which stock would be more appropriate for an investor who wants to: ii Hold this stock as a single-stock portfolio
For an investor who wants to hold this stock as a single-stock portfolio, Kay should recommend stock Y, because it has higher forecasted return and lower standard deviation than stock x. stock x (.14-.05)/.36 Stock y (.17-.05)/.25 Market index (.14-.05)/.15
"The semistrong form of the efficient market hypothesis asserts that stock prices:"
Fully reflects all public information
Stock offer an expected rate of return of 10% with a standard deviation of 20% and gold offers an expected return of 5% with a standard deviation of 25%. How would you answer A if the correlation coefficient between gold and stocks were 1?
If gold is perfectly positive correlation with stocks, gold would not be part of the portfolios. The risk/return of stocks and gold would be drawn as a straight line with a downward slope.
Which of the fallowing sources of market inefficiency would be most easily exploited?
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.
"The yield curve is upward-sloping. Can you conclude that investors expect short-term interest rates to rise? Why or why not?"
If the yield curve is upward sloping, we cannot conclude that investors expect short-term interest rates to rise because the rising slope could be due to either expectations of future increase in rates or the demand of investors for a risk premium on long-term bonds. In fact the yield curve can be upward sloping even in the absence of expectations of future increases in rates.
"A bond has a current yield of 9% and a yield to maturity of 10%. Is the bond selling above or below par value? Explain."
If the yield to maturity is greater than current yield, the bond is selling below its par value.
Define expected return-beta relationship?
Implication of the CAPM that security risk premiums should be proportional to beta
" Dollar-cost averaging means that you buy equal dollar amounts of a stock every period, for example, $500 per month. The strategy is based on the idea that when the stock price is low, your fixed monthly purchase will buy more shares, and when the price is high, fewer shares. Averaging over time, you will end up buying more shares when the stock is cheaper and fewer when it is relatively expensive. Therefore, by design, you will exhibit good market timing. Evaluate this strategy"
Implicit in the dollar-cost average strategy is the notion that stock prices fluctuate around a normal level. Otherwise, there is no meaning to statements such as "when the price is high. How do we know, for example, whether a price of $25 today will be viewed as high or low compared to the stock price is six months from now.
what are assumptions for CAPM?
Investors are price takers Information is costless and available to all investors All risky assets can be traded No taxes No transaction costs Unlimited borrowing and lending at the risk-free rate
conservatism
Investors are slow to update their beliefs and under react to new information
mental accounting
Investors may segregate accounts in their mind and take risks with their gains that they would not take with their principal
Overconfidence
Investors overestimate their abilities and the precision of their forecasts
What beta does cyclical or aggressive stock have?
It has a beta of greater then 1
Stock offer an expected rate of return of 10% with a standard deviation of 20% and gold offers an expected return of 5% with a standard deviation of 25%. Could the expected returns, standard deviations, and correlation is part b represent an equilibrium for the security bonds?
It is not possible to be the equilibrium, gold prices will rise and fall.
I an efficient market, professional portfolio management can offer all of the following benefits except which of the following?
It is not possible to offer a higher risk-return trade-off if markets are efficient
What beta does defensive stock have?
Less then 1
Consider a five-year bond with a 10% coupon selling at a yield to maturity of 8%. If interest rates remain constant, one year from now the price of this bond will be:
Lower
What is Fama and French five-factor model?
MKT, SMB, HML RMW: Robust minus Weak (profitability factor) The return of a portfolio of stocks with high profitability minus the return of a portfolio of stocks with low profitability CMA: Conservative minus Aggressive (investment/asset growth factor) The return of a portfolio of stocks with low asset growth (i.e., low investment) minus the return of a portfolio of stocks with high asset growth
What is Fama and French three-factor model?
MKT: Market risk premium (market factor) SMB: Small minus Big (size factor) The return of a portfolio of small stocks minus the return of a portfolio of large stocks HML: High minus Low (book-to-market factor) The return of a portfolio of stocks with high book-to-market ratios minus the return of a portfolio of stocks with low book-to-market ratios
Define index model
Model that return stock returns to returns on both a broad market index and firm-specific factors
What is multifactor models?
Models of security market positing that returns respond to several systematic factors.
Portfolio Expected Return Beta Risk free 10% 0 Market 18% 1.0 A 16% 1.5 Is CAPM possible?
Not possible. Given these data, the SML is E(r) 10%+B(18%-10%). A portfolio with beta of 1.5 should have an expected 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
Portfolio Expected Return Beta Risk free 10% 0 Market 18% 1.0 A 16% .9 Is CAPM possible?
Not possible. The SML is the same as in problem 18. Here, the required expected return for Portfolio A is: 10%+(.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 Is CAPM possible?
Not possible. The reward-to-variability ratio for portfolio A is better then 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.
Portfolio ER Beta X 16% 1 Y 12% .25 in this situation you could conclude that portfolios X and Y:
Offer an arbitrage opportunity
" 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
One could have made superior returns by buying stocks after a 10% rise in price and selling after a 10% fall.
Unlimited borrowing and lending at the risk-free rate
Only the government can do that
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 price based on their fair expected rate of return. The fair expected return over any single day is very small, so that on any day the price is virtually equally likely to rise or fall.
"Briefly explain the roles or responsibilities of portfolio managers in an efficient market environment."
Portfolio managers have several roles and responsibilities even in perfectly efficient markets. the most important responsibility is to identify the risk/return objectives for a portfolio given the investor's constraints. In an efficient market, portfolio managers are responsible for tailoring the portfolio to meet the investor's needs, rather than to beat the market, which requires identifying examining the investor's constraints, including liquidity, time horizon, laws and regulations, taxes, and unique preferences and circumstances such as age and employment.
Portfolio Expected Return Standard Deviation A 30% 35% B 40% 25% Is CAPM possible?
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 Is CAPM possible?
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
Version of EMH
Prices of securities should fully reflect all available information
EMH (efficient market hypothesis)
Prices of securities should fully reflect all available information No abnormal return could be earned If not, arbitrage opportunities could exist The existence of arbitrage opportunities will drive the prices to fully reflect all available information
Define information ratio
Ratio of alpha to the standard deviation of the residual
What is empirical anomalies?
Return patterns that are not supposed to occur if the EMH holds, yet we observe them in reality
What is the regression equation?
Ri(t)=ai+BiRm(t)+ ei(t)
Define investment opportunity set?
Set of available portfolio risk-return combinations
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, the portfolio will benefit from diversification because returns on component securities will not be less than a weighted average of the standard deviations of the component securities.
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 and deviation will be less than a weighted average of the standard deviation of the component securities.
What is the mutual fund theorem?
Stated that all investors desire the same portfolio of risky assets and can be satisfied by a single mutual fund composed of that portfolio
Assume both portfolios A and B are well diversified, that E(rA) = 14% and E(rB) = 14.8%. If the economy has only one factor, and βA = 1 while βB = 1.1,What must be the risk-free rate?
Substituting the portfolio returns and betas in the mean-beta relationship, we obtain two equations in the in knowns, the risk-free rate (rF) and the factor return (F): 14.0%= rF+1*(F-rF) 14.8=rF+1.1*(F-rF) rF=6%
Contrast the concepts of systematic risk and firm-specific risk, and give and example of each type of risk.
Systematic risk refers to fluctuations in asset prices caused by macroeconomic factors that are common to all risky assets; hence systematic risk is often referred to as market risk. Example: business cycle, inflation, monetary policy and, technology changes Specific risk refers to fluctuations in assets prices caused by factors that are independent of the market, such as industry characteristics or firms characteristics. Example: Litigation, patents, management and financial leverage.
" Jeffrey Bruner, CFA, uses the capital asset pricing model (CAPM) to help identify mispriced securities. A consultant suggests Bruner use arbitrage pricing theory (APT) instead. In comparing CAPM and APT, the consultant made the following arguments: "The CAPM assumes that one specific factor explains security returns but APT does not. State whether each of the consultant's arguments is correct or incorrect. Indicate, for each incorrect argument, why the argument is incorrect"
The CAPM assumes that one specific factor explains security returns but APT does not. this statement is correct
Cite one advantage and one disadvantage of investing in callable bonds rather than noncallable bonds
The advantage of a callable bond is the higher coupon when the bond is issued. If the bond is never called, then an investor will earn a higher realized compound yield on a callable bond issue at par than on a non-callable bond issued at par on the same date. The disadvantage of the callable bond is the risk of call. If rates fall and the bonds is called, then investor receive the call price and will have to reinvest the proceeds at interest rates that are lower than the yield to maturity at which the bond was originally issued. In this event, the firm's savings in interest payments are the investor's loss.
Define optimal risky portfolio?
The best combination of risky assets to be mixed with safe assets when forming the complete portfolio
Two bonds have identical times to maturity and coupon rates. One is callable at 105, the other at 110. Which should have the higher yield to maturity? Why?
The bond callable at 105 should sell at a lower price because the call provision is more valuable to the firm. therefore, its yield to maturity should be higher.
" Consider a bond with a 10% coupon and with yield to maturity = 8%. If the bond's yield to maturity remains constant, then in one year will the bond price be higher, lower, or unchanged? Why?"
The bond price will be lower. As time passes, the bond price, which is now above par value, will approach par
Explain the likely impact on the bond's expected life of adding a call feature to a proposed bond issue
The call option reduces the expected life of the bond. If interest rates fall substantial so that the likelihood of a call increase, investors will treat the bond as if it will "mature' and be paid off at the call date, not at the stated maturity date. On the other hand if rates rise, the bond must be paid off at the maturity date, not later. This asymmetry means that the expected life of the bond will be less than the stated maturity.
if markets are efficient, what should be correlation coefficient between stock returns for two nonoverlapping time periods?
The correlation coefficient should be 0. If it were not 0, then one could use returns from one period to predict returns in later periods and therefore earn abnormal profits.
" Is the coupon rate of the bond in the previous problem more or less than 9%?"
The coupon rate is less than 9%
"When adding a risky asset to a portfolio of many risky assets, which property of the asset has a greater influence on risk: 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.
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. To have a diversified portfolio you need correlation with other assets. covariance tells you how many are needed.
"Treasury bonds paying an 8% coupon rate with semiannual payments currently sell at par value. What coupon rate would they have to pay in order to sell at par if they paid their coupons annually?"
The effective annual yield on the semiannual coupon bonds is 1.04^2-1=8.16% If the annual coupon bonds are to sell at par they must offer the same yield, it requires an annual coupon of 8.16
Kaskin, Inc., stock has a beta of 1.2 and Quinn, Inc., stock has a beta of .6. Which of the following statements is most accurate?
The equilibrium expected rate of return is higher for Kaskin than for Quinn
According to CAPM, the expected rate of return of a portfolio with a beta of 1 and an alpha of 0 is:
The expected return on the market, rm
"The yield to maturity on one-year zero-coupon bonds is 8%. The yield to maturity on two-year zero-coupon bonds is 9%.(LO 10-7)a. What is the forward rate of interest for the second year?"
The forward rate (f2) is the rate that makes the return from rolling over one-year bonds the same as the return from investing in the two-year maturity bond and holding to maturity. 10.01%
"You are a portfolio manager meeting a client. During the conversation that follows your formal review of her account, your client asks the following question:(LO 8-2)My grandson, who is studying investments, tells me that one of the best ways to make money in the stock market is to buy the stocks of small-capitalization firms as well as stocks with high ratios of book value to market value. What is he talking about? a. Identify the apparent market anomalies that would justify the proposed strategy."
The grandson is recommending taking advantage of the small firm anomaly and the January anomaly. In fact this seems to be one anomaly: the small-firm-in-January anomaly
" Assume that a company announces an unexpectedly large cash dividend to its shareholders. In an efficient market without information leakage, one might expect"
The information should be adsorbed instantly, An abnormal price change at the announcement
"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 adjusted return" securities all have the same risk adjusted expected return if priced fairly; however, actual results can and do very. Unknown events cause certain securities to outperform others. This is not known in advance, so expectations are set by known information
Define active portfolio
The portfolio formed by optimally combining analyzed stocks
What is systematic risk?
The portion of risk common to the entire economy, also known as market risk or non-diversifiable risk.
"The following figure shows plots of monthly rates of return and the stock market for two stocks. (LO 6-5)a. Which stock is riskier to an investor currently holding a diversified portfolio of com-mon stock?"
The risk of the diversified portfolio consist primarily of systematic risk. Beta measures systematic risk, which is the slope of the security characteristic line (SCL). Two figures depict the stocks SCL's. Stock B's SCL is steeper, hence Stock B's systematic risk is greater.
The following figure shows plots of monthly rate of return and the stock market for two stocks. Which stocks is riskier to an investor currently holding diversified portfolio of common stock?
The risk of the diversified portfolio consist primarily of systematic risk. Beta measures systematic risk, which is the slope of the security characteristic line. The two figures depict the stocks' SCLs. Stock B's SCL is steeper, and hence Stock B's systematic risk is greater. The slope of the SCL, and hence the systematic risk, of stock A is lower. Thus, for this investor the risker.
What three thing can sum up the expected rate of return on a security?
The risk-free rate of return, the security's sensitivity to the market index times the risk premium of the T-bond portfolio, The security's sensitivity to interest rate risk times the risk premium of the T-bond portfolio
What is Beta?
The sensitivity of a security's return to the return on the market index.
firm-specific risk or residual risk contribute to?
The total volatility of return
The following figure shows plots of monthly rate of return and the stock market for two stocks. Which stock is risker to an undiversified investor who puts all of his funds in only one stock of these stocks?
The undiversifibed investor is exposed primarily to firm-specific risk. Stock A has higher specific risk because the deviations of the observations from the SCL are larger for stock A then for stock B. Deviations are measured by the vertical distance of each observation from the SCL. that means stock a is more risker.
" Briefly explain the concept of the efficient market hypothesis (EMH) and each of its three forms—weak, and briefly discuss the degree to which existing empirical evidence supports each of the three forms of the EMH"
The weak form of the EMH assert that stock prices reflect all the information that can be derived by examining market trading data such as the history of past prices to profit from the information A strong body of evidence in the major U.S. securities markets. Test results suggest that technical trading rules do not produce adjusting for transaction costs and taxes.
"Stocks offer an expected rate of return of 10% with a standard deviation of 20%, and gold offers an expected return of 5% with a standard deviation of 25%. (LO 6-3) " Could the expected returns, standard deviations, and correlation in part (b) represent an equilibrium for the security market?"
This cannot be an equilibrium; the price of gold must fall and its expected return must rise.
Forecasting Errors
Too much weight is placed on recent experiences
"The SML provides a benchmark for evaluating expected investment performance."
True
Properly valued assets plot exactly on the SML
True
The SML is a graphic representation of the relationship between expected return and beta"
True
The liquidity hypothesis indicates that, all other things being equal, longer maturity bonds will have higher yield.
True
" Under the expectations hypothesis, if the yield curve is upward-sloping, the market must expect an increase in short-term interest rates. True/false/uncertain? Why?"
True, under the expectations hypothesis, there are no risk premium built into bond prices. The only reason for long-term yields to exceed short-term yields is an expectation of higher short-term rates in the future.
"Under the liquidity preference theory, if inflation is expected to be falling over the next few years, long-term interest rates will be higher than short-term rates. True/false/uncertain? Why?"
Uncertain. Lower inflation usually leads to lower nominal interest rates. Nevertheless, if the liquidity premium is sufficiently great, long-term yields can exceed short-term yields despite expectations of falling short rates.
"Briefly explain whether investors should expect a higher return from holding portfolio Avers us portfolio B under capital asset pricing theory (CAPM). Assume that both portfolios are fully diversified." Systematic Risk
Under the CAPM, the only risk that investors are compensated for bearing is the risk that cannot be diversified away. Because systematic risk is equal to 1,0 for each of the two portfolios, an investor would expect the same rate of return from each portfolio.
Briefly discuss the implications of the efficient market hypothesis for investment policy as it applies to:(LO 8-4 Fundamental analysis?
Uses earnings and dividends prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. The EMH predicts the most ____ is doomed to failure. According to semistrong-form efficiency, no investor can earn excess returns from trading rules based on publicly available information.
What is fundamental analysis?
Using economic and accounting information to predict stock prices
What is technical analysis?
Using prices and volume information to predict future prices (the chartists)
prospect theory
Utility depends on changes instead of levels of current wealth Disposition effect -The tendency of investors to hold losers too long and sell winners too quick
A bond with a call feature?
Will usually have a higher yield to maturity than similar noncallable bonds
Stock offer an expected rate of return of 10% with a standard deviation of 20% and gold offers an expected return of 5% with a standard deviation of 25%. In light of the apparent inferiority of gold to stocks with respect to both mean return and volatility, would anyone hold gold? If so demonstrate graphically why one would do so?
Yes, it is a way to diversify ones portfolio. If the correlation between gold and stocks is sufficiently low, gold will be held as a component in the optimal portfolio.
risk premium on individual security
a function of its return covariance with the market returns
CAPM (Capital Asset Pricing Model)
an equilibrium asset pricing model showing that the expected return for a particular asset depends on the pure time value of money plus a reward for bearing systematic risk
A portfolio's expected return is 12%, it standard deviation is 20%, and the risk-free rate is 4%. Which of the following would make for the greater increase in the portfolio's Sharp ratio?
an increase of the expected return and a decrease in the risk free rate.
If the efficient market hypothesis holds, It implies that security prices change for no discernible reason
false
define active management?
focus on security analysis and timing, is costly
What combonation of factors will help product stock price
fundamental analysis and weak-form
Security Market Line (SML)
graphical representation of the expected return-beta relationship of the CAPM
Sample size neglect (representativeness)
investors are too quick to infer a pattern or trend from a small sample
"Briefly discuss the implications of the efficient market hypothesis for investment policy as it applies to:(LO 8-4 Technical analysis in the form of charting.
involves the search for recurrent and predictable patterns in stock prices in order to enhance return. The EMH implies that ___ is without value. If past prices contain no useful information for predicting future prices, there is no point in following any technical trading rule.
security characteristic line
plot of a security's predicted excess return from the excess return of the market
If the efficient market hypothesis holds, it implies that prices reflect all available information
true
What are the three forms of version of EMH?
weak, semi-strong, strong
