FIN Exam 1

. Assume that a risk-averse investor owning stock in Miller Corporation decides to add the stock of either Mac or Green Corporation to her portfolio. All three stocks offer the same expected return and total variability. The correlation of return between Miller and Mac is −.05 and between Miller and Green is +.05. Portfolio risk is expected to: a. Decline more when the investor buys Mac. b. Decline more when the investor buys Green. c. Increase when either Mac or Green is bought. d. Decline or increase, depending on other factors.

(a)

2. When adding real estate to an asset allocation program that currently includes only stocks, bonds, and cash, which of the properties of real estate returns affect portfolio risk? Explain. a. Standard deviation. b. Expected return. c. Correlation with returns of the other asset classes.

(a) and (c). After real estate is added to the portfolio, there are four asset classes in the portfolio: stocks, bonds, cash and real estate. Portfolio variance now includes a variance term for real estate returns and a covariance term for real estate returns with returns for each of the other three asset classes. Therefore, portfolio risk is affected by the variance (or standard deviation) of real estate returns and the correlation between real estate returns and returns for each of the other asset classes. (Note that the correlation between real estate returns and returns for cash is most likely zero.)

Which of the following factors reflect pure market risk for a given corporation? a. Increased short-term interest rates. b. Fire in the corporate warehouse. c. Increased insurance costs. d. Death of the CEO. e. Increased labor costs.

(a) and (e). Short-term rates and labor issues are factors that are common to all firms and therefore must be considered as market risk factors. The remaining three factors are unique to this corporation and are not a part of market risk.

The variable (A) in the utility formula represents the: a. Investor's return requirement. b. Investor's aversion to risk. c. Certainty equivalent rate of the portfolio. d. Preference for one unit of return per four units of risk

(b) the investor's aversion to risk.

. Which statement about portfolio diversification is correct? a. Proper diversification can reduce or eliminate systematic risk. b. Diversification reduces the portfolio's expected return because it reduces a portfolio's total risk. c. As more securities are added to a portfolio, total risk typically can be expected to fall at a decreasing rate. d. The risk-reducing benefits of diversification do not occur meaningfully until at least 30 individual securities are included in the portfolio.

(c)

Which of the following choices best completes the following statement? Explain. An investor with a higher degree of risk aversion, compared to one with a lower degree, will most prefer investment portfolios a. with higher risk premiums. b. that are riskier (with higher standard deviations). c. with lower Sharpe ratios. d. with higher Sharpe ratios.

(d) While a higher or lower Sharpe ratios are not an indication of an investor's tolerance for risk, any investor will always prefer investment portfolios with higher Sharpe ratios. The Sharpe ratio is simply a tool to absolutely measure the return premium earned per unit of risk

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 Forecasted 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, .1

What must be the beta of a portfolio with E(rP) = 18%, if rf = 6% and E(rM) = 14%?

1.5

. Portfolio theory as described by Markowitz is most concerned with: a. The elimination of systematic risk. b. The effect of diversification on portfolio risk. c. The identification of unsystematic risk. d. Active portfolio management to enhance return.

6. (b)

. Stocks A, B, and C have the same expected return and standard deviation. The following table shows the correlations between the returns on these stocks. Stock A Stock B Stock C Stock A +1.0 Stock B +0.9 +1.0 Stock C +0.1 −0.4 +1.0 Given these correlations, the portfolio constructed from these stocks having the lowest risk is a portfolio: a. Equally invested in stocks A and B. b. Equally invested in stocks A and C. c. Equally invested in stocks B and C. d. Totally invested in stock C.

6. (c)

. The measure of risk for a security held in a diversified portfolio is: a. Specific risk. b. Standard deviation of returns. c. Reinvestment risk. d. Covariance.

6. (d)

. Which of the following statements about the minimum-variance portfolio of all risky securities is valid? (Assume short sales are allowed.) Explain. a. Its variance must be lower than those of all other securities or portfolios. b. Its expected return can be lower than the risk-free rate. c. It may be the optimal risky portfolio. d. It must include all individual securities.

Answer (a) is valid because it provides the definition of the minimum variance portfolio.

Kaskin, Inc., stock has a beta of 1.2 and Quinn, Inc., stock has a beta of 0.60. Which of the following statements is most accurate? a. The expected rate of return will be higher for the stock of Kaskin, Inc., than that of Quinn, Inc. b. The stock of Kaskin, Inc., has more total risk than the stock of Quinn, Inc. c. The stock of Quinn, Inc., has more systematic risk than that of Kaskin, Inc.

Beta is a measure of systematic risk. Since only systematic risk is rewarded, it is safe to conclude that the expected return will be higher for Kaskin's stock than for Quinn's stock.

. True or false: Assume that expected returns and standard deviations for all securities (including the risk-free rate for borrowing and lending) are known. In this case, all investors will have the same optimal risky portfolio.

False. If the borrowing and lending rates are not identical, then, depending on the tastes of the individuals (that is, the shape of their indifference curves), borrowers and lenders could have different optimal risky portfolios.

True or false: The standard deviation of the portfolio is always equal to the weighted average of the standard deviations of the assets in the portfolio.

False. The portfolio standard deviation equals the weighted average of the component-asset standard deviations only in the special case that all assets are perfectly positively correlated. Otherwise, as the formula for portfolio standard deviation shows, the portfolio standard deviation is less than the weighted average of the component-asset standard deviations. The portfolio variance is a weighted sum of the elements in the covariance matrix, with the products of the portfolio proportions as weights

Although we stated that real assets constitute the true productive capacity of an economy, it is hard to conceive of a modern economy without well-developed financial markets and security types. How would the productive capacity of the U.S. economy be affected if there were no markets in which to trade financial assets?

Financial assets make it easy for large firms to raise the capital needed to finance their investments in real assets. If Ford, for example, could not issue stocks or bonds to the general public, it would have a far more difficult time raising capital. Contraction of the supply of financial assets would make financing more difficult, thereby increasing the cost of capital. A higher cost of capital results in less investment and lower real growth.

Which indifference curve represents the greatest level of utility that can be achieved by the investor?

Indifference curve 2 because it is tangent to the CAL.

. Investment Management Inc. (IMI) uses the capital market line to make asset allocation recommendations. IMI derives the following forecasts: ∙ Expected return on the market portfolio: 12% ∙ Standard deviation on the market portfolio: 20% ∙ Risk-free rate: 5% Samuel Johnson seeks IMI's advice for a portfolio asset allocation. Johnson informs IMI that he wants the standard deviation of the portfolio to equal half of the standard deviation for the market portfolio. Using the capital market line, what expected return can IMI provide subject to Johnson's risk constraint?

Johnson requests the portfolio standard deviation to equal one half the market portfolio standard deviation. The market portfolio , which implies . The intercept of the CML equals and the slope of the CML equals the Sharpe ratio for the market portfolio (35%). Therefore using the CML:

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

Market efficiency implies investors cannot earn excess risk-adjusted profits. If the stock price run-up occurs when only insiders know of the coming dividend increase, then it is a violation of strong-form efficiency. If the public also knows of the increase, then this violates semistrong-form efficiency.

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

No, markets can be efficient even if some investors earn returns above the market average. Consider the Lucky Event issue: Ignoring transaction costs, about 50% of professional investors, by definition, will "beat" the market in any given year. The probability of beating it three years in a row, though small, is not insignificant. Beating the market in the past does not predict future success as three years of returns make up too small a sample on which to base correlation let alone causation.

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

No. The value of dividend predictability would be already reflected in the stock price.

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

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

Which point designates the optimal portfolio of risky assets?

Point E at the right end of the CAL represents the optimal portfolio of risky assets.

The semistrong form of the efficient market hypothesis asserts that stock prices: a. Fully reflect all historical price information. b. Fully reflect all publicly available information. c. Fully reflect all relevant information, including insider information. d. May be predictable.

Semi-strong form efficiency implies that market prices reflect all publicly available information concerning past trading history as well as fundamental aspects of the firm.

You estimate that a passive portfolio, for example, one invested in a risky portfolio that mimics the S&P 500 stock index, yields an expected rate of return of 13% with a standard deviation of 25%. You manage an active portfolio with expected return 18% and standard deviation 28%. The risk-free rate is 8%. 27. Draw the CML and your funds' CAL on an expected return-standard deviation diagram. a. What is the slope of the CML? b. Characterize in one short paragraph the advantage of your fund over the passive fund.

Slope of the CML= .13-.08//.25=.20 b. My fund allows an investor to achieve a higher mean for any given standard deviation than would a passive strategy, i.e., a higher expected return for any given level of risk.

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

The correlation coefficient between stock returns for two non-overlapping periods should be zero. If not, one could use returns from one period to predict returns in later periods and make abnormal profits

Examine the accompanying figure, which presents cumulative abnormal returns both before and after dates on which insiders buy or sell shares in their firms. How do you interpret this figure? What are we to make of the pattern of CARs before and after the event date?

The negative abnormal returns (downward drift in CAR) just prior to stock purchases suggest that insiders deferred their purchases until after bad news was released to the public. This is evidence of valuable inside information. The positive abnormal returns after purchase suggest insider purchases in anticipation of good news. The analysis is symmetric for insider sales.

Shares of small firms with thinly traded stocks tend to show positive CAPM alphas. Is this a violation of the efficient market hypothesis?

Thinly traded stocks will not have a considerable amount of market research performed on the companies they represent. This neglected-firm effect implies a greater degree of uncertainty with respect to smaller companies. Thus positive CAPM alphas among thinly traded stocks do not necessarily violate the efficient market hypothesis since these higher alphas are actually risk premia, not market inefficiencies.

The average rate of return on investments in large stocks has outpaced that on investments in Treasury bills by about 8% since 1926. Why, then, does anyone invest in Treasury bills?

Treasury bills serve a purpose for investors who prefer a low-risk investment. The lower average rate of return compared to stocks is the price investors pay for predictability of investment performance and portfolio value.

Financial engineering has been disparaged as nothing more than paper shuffling. Critics argue that resources used for rearranging wealth (i.e., bundling and unbundling financial assets) might be better spent on creating wealth (i.e., creating real assets). Evaluate this criticism. Are any benefits realized by creating an array of derivative securities from various primary Securities?

Ultimately, it is true that real assets determine the material well being of an economy. Nevertheless, individuals can benefit when financial engineering creates new products that allow them to manage their portfolios of financial assets more efficiently. Because bundling and unbundling creates financial products with new properties and sensitivities to various sources of risk, it allows investors to hedge particular sources of risk more efficiently.

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

Volatile stock prices could reflect volatile underlying economic conditions as large amounts of information being incorporated into the price will cause variability in stock price. The Efficient Market Hypothesis suggests that investors cannot earn excess risk-adjusted rewards. The variability of the stock price is thus reflected in the expected returns as returns and risk are positively correlated.

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

While positive beta stocks respond well to favorable new information about the economy's progress through the business cycle, they should not show abnormal returns around already anticipated events. If a recovery, for example, is already anticipated, the actual recovery is not news. The stock price should already reflect the coming recovery.

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

a. Acute market inefficiencies are temporary in nature and are more easily exploited than chronic inefficiencies. A temporary drop in a stock price due to a large sale would be more easily exploited than the chronic inefficiencies mentioned in the other responses.

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

a. Consistent. Based on pure luck, half of all managers should beat the market in any year. b. Inconsistent. This would be the basis of an "easy money" rule: simply invest with last year's best managers. c. Consistent. In contrast to predictable returns, predictable volatility does not convey a means to earn abnormal returns. d. Inconsistent. The abnormal performance ought to occur in January when earnings are announced. e. Inconsistent. Reversals offer a means to earn easy money: just buy last week's losers.

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

a. Multiple studies suggest that "value" stocks (measured often by low P/E multiples) earn higher returns over time than "growth" stocks (high P/E multiples). This could suggest a strategy for earning higher returns over time. However, another rational argument may be that traditional forms of CAPM (such as Sharpe's model) do not fully account for all risk factors which affect a firm's price level. A firm viewed as riskier may have a lower price and thus P/E multiple. b. The book-to-market effect suggests that an investor can earn excess returns by investing in companies with high book value (the value of a firm's assets minus its liabilities divided by the number of shares outstanding) to market value. A study by Fama and French[1] suggests that book-to-market value reflects a risk factor that is not accounted for by traditional one variable CAPM. For example, companies experiencing financial distress see the ratio of book to market value increase. Thus a more complex CAPM which includes book-to-market value as an explanatory variable should be used to test market anomalies. c. Stock price momentum can be positively correlated with past performance (short to intermediate horizon) or negatively correlated (long horizon). Historical data seem to imply statistical significance to these patterns. Explanations for this include a bandwagon effect or the behavioralists' (see Chapter 12) explanation that there is a tendency for investors to underreact to new information, thus producing a positive serial correlation. However, statistical significance does not imply economic significance. Several studies which included transaction costs in the momentum models discovered that momentum traders tended to not outperform the Efficient Market Hypothesis strategy of buy and hold. d. The small-firm effect states that smaller firms produce better returns than larger firms. Since 1926 returns from small firms outpace large firm stock returns by about 1% per year. Do small cap investors earn excess risk-adjusted returns? [1] Fama, Eugene and Kenneth French, "Common Risk Factors in the Returns on Stocks and Bonds," Journal of Finance 33:1, pp. 3-56.

Suppose housing prices across the world double. a. Is society any richer for the change? b. Are homeowners wealthier? c. Can you reconcile your answers to (a) and (b)? Is anyone worse off as a result of the change?

a. No. The increase in price did not add to the productive capacity of the economy. b. Yes, the value of the equity held in these assets has increased. c. Future homeowners as a whole are worse off, since mortgage liabilities have also increased. In addition, this housing price bubble will eventually burst and society as a whole (and most likely taxpayers) will endure the damage.

. Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either $70,000 or $200,000 with equal probabilities of .5. The alternative risk-free investment in T-bills pays 6% per year. a. If you require a risk premium of 8%, how much will you be willing to pay for the portfolio? b. Suppose that the portfolio can be purchased for the amount you found in (a). What will be the expected rate of return on the portfolio? c. Now suppose that you require a risk premium of 12%. What is the price that you will be willing to pay? d. Comparing your answers to (a) and (c), what do you conclude about the relationship between the required risk premium on a portfolio and the price at which the portfolio will sell?

a. The expected cash flow is: (0.5 × $70,000) + (0.5 × 200,000) = $135,000 With a risk premium of 8% over the risk-free rate of 6%, the required rate of return is 14%. Therefore, the present value of the portfolio is: $135,000/1.14 = $118,421 b. If the portfolio is purchased for $118,421, and provides an expected cash inflow of $135,000, then the expected rate of return [E(r)] is as follows: $118,421 × [1 + E(r)] = $135,000 Therefore, E(r) = 14%. The portfolio price is set to equate the expected rate of return with the required rate of return. c. If the risk premium over T-bills is now 12%, then the required return is: 6% + 12% = 18% The present value of the portfolio is now: $135,000/1.18 = $114,407 d. For a given expected cash flow, portfolios that command greater risk premia must sell at lower prices. The extra discount from expected value is a penalty for risk.

. Assume that a company announces an unexpectedly large cash dividend to its shareholders. In an efficient market without information leakage, one might expect: a. An abnormal price change at the announcement. b. An abnormal price increase before the announcement. c. An abnormal price decrease after the announcement. d. No abnormal price change before or after the announcement.

a. The full price adjustment should occur just as the news about the dividend becomes publicly available.

. A "random walk" occurs when: a. Stock price changes are random but predictable. b. Stock prices respond slowly to both new and old information. c. Future price changes are uncorrelated with past price changes. d. Past information is useful in predicting future prices.

c. A random walk implies that stock price changes are unpredictable, using past price changes or any other data.

. According to the efficient market hypothesis: a. High-beta stocks are consistently overpriced. b. Low-beta stocks are consistently overpriced. c. Positive alphas on stocks will quickly disappear. d. Negative alpha stocks consistently yield low returns for arbitrageurs.

c. In an efficient market, no securities are consistently overpriced or underpriced. While some securities will turn out after any investment period to have provided positive alphas (i.e., risk-adjusted abnormal returns) and some negative alphas, these past returns are not predictive of future returns.

Which one of the following portfolios cannot lie on the efficient frontier as described by Markowitz? Portfolio Expected Return (%) Standard Deviation (%) a. W 15 36 b. X 12 15 c. Z 5 7 d. Y 9 21

d) Portfolio Y cannot be efficient because it is dominated by another portfolio. For example, Portfolio X has both higher expected return and lower standard deviation.

Which one of the following would provide evidence against the semistrong form of the efficient market theory? a. About 50% of pension funds outperform the market in any year. b. All investors have learned to exploit management signals about the future performance of the firm. c. Trend analysis is worthless in determining stock prices. d. Low P/E stocks tend to have positive abnormal returns over the long run.

d. If low P/E stocks tend to have positive abnormal returns, this would represent an unexploited profit opportunity that would provide evidence that investors are not using all available information to make profitable investments.

. Which of the following would be a viable way to earn abnormally high trading profits if markets are semistrong-form efficient? a. Buy shares in companies with low P/E ratios. b. Buy shares in companies with recent above-average price changes. c. Buy shares in companies with recent below-average price changes. d. Buy shares in companies for which you have advance knowledge of an improvement in the management team.

d. In a semistrong-form efficient market, it is not possible to earn abnormally high profits by trading on publicly available information. Information about P/E ratios and recent price changes is publicly known. On the other hand, an investor who has advance knowledge of management improvements could earn abnormally high trading profits (unless the market is also strong-form efficient).