Reading Assignment #5

The goal for a fundamental analyst seeking to generate high risk-adjusted returns is to identify ______.

firms that are better than everyone's estimates

In testing the CAPM, the time series regression to estimate the betas of securities or portfolios is referred to as the _____-_____ regression

first pass

Which statements are true under prospect theory as described by the figure? Define the reference point as where utility is zero. (Click to enlarge.)

- Investors may take large risks after they have lost money. - Given a fixed reference point, an investor will prefer a large loss to a series of small losses with the same total return. - The decision whether to accept a risk will depend on the reference point.

Which statements are true of the figure? (Click to enlarge.)

- It depicts post-earnings-announcement price drift. - When good news is made public, the stock price jumps immediately.

Which statements are true according to the basic CAPM?

- Securities only vary in their expected returns because of differences in their levels of systematic risk. - The firm-specific risk of a security does not affect its expected return. - A security's expected rate of return should rise in direct proportion to its beta.

Which statements about market efficiency are correct?

- Skilled mutual fund managers with positive abnormal returns attract new capital which makes it harder to outperform the market. - Financial market history shows that most actively managed mutual funds under-performed index funds. - Among mutual fund managers, very few show consistent stock-picking ability.

Which statements are true about testing the efficient market hypothesis?

- Strategies have been found that apparently would have provided superior risk-adjusted returns. - Apparent contradictions of the EMH may simply reflect data mining. - Analysis of whether professional managers have been able to beat the market is based on their historical performance.

Which factors are taken into account in determining the portfolio choice decision for individual investors when markets are efficient?

- Tax rates - Investor risk preferences - The beta of a security - Firm-specific risk

Which statements about anomalies are correct?

- The correct method of risk adjustment in assessing returns is usually open to debate. - Tests of risk-adjusted returns are joint tests of the efficient market hypothesis and the risk adjustment procedure. - The finding of an anomaly may simply reflect incorrect adjustment for risk.

Which are reasons that it is difficult to test the CAPM?

- There may be multiple sources of systematic risk. - It is based on an unobservable market portfolio that encompasses all assets in the economy. - Characteristics of security markets such as liquidity and transactions costs can affect expected returns.

Which of the following statements regarding high-tax-bracket investors are true?

- find it advantageous to buy tax-exempt municipal bonds - might tilt their portfolios in the direction of capital gains opposed to interest income - are attracted to investments with sensitive to tax brackets like real estate ventures

Which of the following statements are true regarding post-earnings-announcment price drift?

- negative-surprise firms continue to suffer negative abnormal returns - cumulative abnormal returns continue to rise after earnings information becomes public

Order the steps used in early testing of the CAPM.

1. collect 2. calculate 3. for each stock 4. estimate 5. test

Which are implications of the efficient market hypothesis?

Active traders will find it difficult to outperform passive strategies such as holding market indexes after adjusting for risk. Security prices properly reflect whatever information is available to investors.

Based on the figure "Alphas of value-weighted portfolios sorted on liquidity betas," which statements are true? (Click to enlarge.)

Adding liquidity effects to the two models increases our ability to explain expected asset returns. The alpha computed under the CAPM model generally rises with illiquidity.

Which statements are correct regarding momentum factors in multifactor models?

Addition of a momentum factor to the Fama-French three-factor model is common. Studies have found that what appeared to be alpha could be explained as sensitivity to a momentum factor.

the _____ can be interpreted as the risk-free equivalent excess return of the portfolio for an investor with risk aversion measured by γ.

Blank 1: Morningstar Blank 2: Risk Blank 3: Adjusted Blank 4: Rating

Placing a value on perfect timing enables us to assign value to _____-_____-_____ timers

Blank 1: less Blank 2: than Blank 3: perfect

Which are the systematic factors in the Fama-French three-factor model?

Book-to-market ratio Firm size Market index

Which of the following have been found to have statistically significant explanatory power within macro factor models?

Corporate bond risk premiums Industrial production Unanticipated inflation

The contribution of an asset class is the contribution from asset allocation given by ______ plus the contribution from security selection given by ______.

Excess weight in asset class × Benchmark return; Weight in asset class × Excess return

Which of the following risk factors can augment the market risk factor of the CAPM?

Factors that hedge future investment opportunities Factors that hedge assets not found in the market proxy Factors that hedge against price uncertainty

True or false: An event study would qualify the relationship between dividend changes and stock returns.

False

Which statements are correct about survivorship bias in the estimation of the equity premium puzzle?

Ignoring the evidence from stock markets that did not survive for the full sample period will impart an upward bias in estimates of expected returns. The equity premium puzzle emerged from long-term averages of U.S. stock returns.

With respect to the second-pass regression estimating the SML, which of the following are the result of beta measurement error?

Intercept biased upward Slope biased downward

Which statements are true about the use of comparison universes to evaluate managers?

It can be misleading because managers' levels of risk may vary. It can be misleading when managers focus on different assets within an asset class.

Consider the following data. Portfolio P has average return of 28%, beta of 2, and standard deviation of 16%. The market has average return of 14%, beta of 1, and standard deviation of 4%. If the risk-free rate is 4%, for which measures was Portfolio P better?

Jensen's alpha Treynor measure

Which of the following are difficulties with the early testing approaches of the CAPM?

Low precision of estimates High return volatility Sampling errors of the first-pass beta estimates

An equivalent representation of Sharpe's ratio, proposed by Graham and Harvey, and later popularized by Leah Modigliani is dubbed the _____ measure

M2`

Which statements are correct about market timing?

Market timing ability can be tested by adding a squared term to the usual linear index model. Market timers shift beta based on their expectation of the performance of the market index. Market timers shift beta and mean return, moving into and out of the market.

Which behavioral finance issues have been suggested as an explanation of the equity premium puzzle?

Narrow framing and loss aversion

If P1 is the proportion of the correct forecasts of bull markets and P2 is the proportion for bear markets, then what is the correct measure of timing ability?

P1 + P2 − 1

Which assets are not included but should be when a market index proxy is used for the market portfolio in testing the CAPM?

Private business income Labor income

Evaluating the performance of a fund manager presents which difficulties?

Risk levels may change along with portfolio composition. Average portfolio return is not straightforward to measure. The proper measure of risk may not be obvious.

For an investor with preferences defined by U = E(rP) − ½ A σ2PP2, the optimal entire risky portfolio maximizes which measure?

Sharpe Ratio

The benchmark for acceptable performance is the _____ _____ of the market index because the investor can easily opt for a passive strategy by investing in an indexed equity mutual fund.

Sharpe ratio

Which of the following factors have joined momentum as additions to the Fama-French three-factor model?

Stock Issues: Growth in share outstanding Volatility

Limitations on insider trading should lead to which form of market efficiency not holding?

Strong-form

Which statements are true about the empirics of consumption-based asset pricing models?

Studies suggest that the explanatory power of the Fama-French factors for average returns may reflect differences in consumption risk. The use of consumption-tracking portfolios improves the quality of estimation. The use of consumption data directly is limited by the lack of variation over time.

A test of the hypothesis that the multifactor CAPM and APT are elegant theories of how exposure to multiple systematic risk factors should influence expected returns requires which of the following stages?

Test of the explanatory power and risk premiums of the hedge portfolios. Specification of risk factors. Identification of portfolios that hedge these fundamental risk factors.

Which of the following is not a fundamental concerns about the validity of CAPM tests?

The two-stage procedure employed by researchers is not straightforward, making this approach invalid.

What is true of estimating the betas of security characteristic lines?

They are the result of the first-pass regression.

What is the appropriate performance metric when evaluating potential components of the full risky portfolio?

Treynor measure

A financial analyst is hoping to determine which market has the stronger rally by comparing advances and declines. The US market in the farming sector has 21 advances and 6 declines, while the Canadian market has 9 advances to 7 declines. Which market is the analyst more likely to identify as being stronger?

US market

Which statements are part of Roll's critique of empirical tests of the CAPM?

Whether a proxy for the market portfolio such as the S&P 500 is mean-variance efficient does not prove the efficiency of the true market portfolio. The use of different proxies for the market portfolio can lead to different conclusions about the CAPM. The CAPM is not testable unless the true market portfolio is observable, and it is not.

Perfect market timing is equivalent to holding ______.

a free call option on the market index

A financial analyst observes the price of Red Line Company shares seems to be consistently $1.00 to $2.00 higher than its intrinsic value. This distortion is more likely to cause ______.

a misallocation of capital market resources to Red Line and away from its competition

Macro factor models suggest a negative or "wrong" sign on the market proxy variable, which suggests ______ market-risk premium.

a negative

The return on a stock beyond what would be predicted by market movements alone is referred to as the _____ return

abnormal

What appears as ______ in a single-factor CAPM can be ______ in a multifactor CAPM.

alpha; an extra-market source of risk

Patterns of returns that seem to contradict the efficient market hypothesis are referred to as _____

anomalies

In testing the CAPM, the use of an inappropriate proxy for the true market portfolio is referred to as _____ error

benchmark

Which of the following coefficients are the betas (also called loadings) of the stock on the three factors?

bi hi si

The performance attribution procedure explains the difference in returns between a managed portfolio and a selected benchmark portfolio which is called the

bogey

Use of the confidence index is based on the assumption that the ______ provides information about future equity returns.

bond market

Young customers face meaningful ______ _____ that are important when placed in the context of life cycle and are often overlooked.

borrowing constraints

The measure of the extent to which movement in a market index is reflected widely in the price movements of all the stocks in the market, typically measured as the spread between the number of stocks that advance and decline in price, is the market's _____

breadth

The collection of money managers of similar investment style used for assessing relative performance of a portfolio manager is the

comparison universe

The ratio of the yield of top-rated corporate bonds to the yield on intermediate-grade bonds is the _____ ratio

confidence

The notion that investors are too slow to update their beliefs in response to new evidence is referred to as

conservatism

If the value of labor income is not perfectly ______ with the market-index portfolio, then the possibility of _____ returns to labor will represent a source of _____ not fully captured by the index.

correlated; negative; risk

As mutual funds are barred from short positions, the regression coefficients of a style analysis are constrained to be ________.

either zero or positive

The finding that the historical risk premium implies implausibly high levels of risk aversion is referred to as the

equity premium puzzle

A technique of empirical financial research that enables a researcher to assess the impact of something on a firm's stock price is referred to as a(n) _____ study

event

In the constant-growth DDM, the _____ capital gains rate on the stock will _____ the ______ ____ of dividends.

expected; equal; growth rate

variable in the case of each factor listed in Table 13.4 is a characteristic of each stock, not its slope against the return on the factor.

explanatory

The finding that growth stocks underperform value stocks surrounding earnings announcements is considered support of the behavioral theory of ______.

extrapolation error

Jon Grimm is a (non-contrarian) technician who has observed an increase in the put/call ratio. Grimm is likely to view this change as a hedge against stock market volatility and to expect markets to ______.

fall

True or false: If prices are distorted, then capital markets will give important signals as to where the economy may best allocate resources.

false

If an investor's decision of whether to purchase shares in a mutual fund were to differ based on the fund's returns being compared to the higher returns of the S&P 500 or the lower returns of Treasuries, it would be an example of ______.

framing

The idea that investors evaluate every risk they face in isolation is referred to as narrow

framing

When decisions are affected by how choices are described, for example, whether uncertainty is posed as potential gains from a low baseline level, or as losses from a higher baseline value, it is an example of

framing

Research to predict stock values that focuses on such determinants as earnings and dividends prospects, expectations for future interest rates, and risk evaluation of the firm is referred to as _____ analysis

fundamental

The risk that even if an asset is mispriced, the mispricing can widen before price eventually converges to intrinsic value, is the limitation on arbitrage referred to as _____ risk

fundamental

The statement by John Maynard Keynes who knew from personal experience that "markets can remain irrational longer than you can remain solvent" is a description of ______.

fundamental risk

the _____ _____is the constant annual return over the 20 years that would provide the same total cumulative return over the entire investment period.

geometric average

A bulk of the evidence suggests that any supposedly superior investment strategy should be taken with many _____ of _____ , meaning that the market is competitive enough that only differentially superior information or insight will earn money and easy pickings have already been picked.

grains salt

The equity premium puzzle describes the phenomenon that historical excess returns on risk assets are too ______ to be consistent with investors' attitudes towards risk.

high

Portfolios of low price-earnings (P/E) ratio stocks have ______ returns than high P/E portfolios _____ if they are adjusted for portfolio beta.

higher, even

When evaluating the performance of equity mutual funds, using a single factor model with the S&P 500 index may not be adequate because many funds _______.

invest in small stocks

When we evaluate the performance of a fund manager, the historical average return would be invalid as a performance measure because ______.

it does not adjust for risk

When we compare a fund with its benchmark index, the interpretation becomes more intuitive if we use M2 rather than the Sharpe ratio because ______.

it shows the difference in return when portfolio variance is the same as market variance

Suppose you invested $2,000 in a mutual fund two years ago, added $1,000 a year later, and redeemed all your shares today. If the fund returns for the first and the second year were 10% and 8% respectively, the dollar-weighted average return on your investment is ______.

less than the time-weighted average return

Broad market indexes demonstrate a strong or stronger momentum at _____ horizons, multiyear periods.

long

the _____-_____ forward-looking view generates much higher values for systematic (consumption-based) risk and makes historical equity premium easier to justify

long run

If two firms have the same expected earnings, the riskier stock will sell at a _____ price and _____ P/E ratio and because of its _____ risk, the _____ P/E stock also will have _____ expected returns.

lower lower higher lower higher

The difficulty in assessing small but meaningful managerial outperformance is referred to as the _____ issue in evaluating market efficiency.

magnitude

_____ _____involves shifting funds between a market-index portfolio and a safe asset, depending on whether the index is expected to outperform the safe asset.

market timibg

The ICAPM and CCAPM begin with the idea that instead of measuring systematic risk based on the covariance of returns with the _____ return, we are better off using the covariance of returns with "aggregate" or economywide _____

market' consumption

When individuals segregate assets into independent accounts, typically to be used for different purposes, rather than viewing them as part of a unified portfolio, they are engaging in _____ _____

mental accounting

Augmenting the original Fama-French model with a _____ factor led to a common four-factor model used to evaluate abnormal performance of a stock portfolio.

momentum

The tendency of poorly-performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods is referred to as the _____ effect

momentum

When evaluating the performance of equity mutual funds, the conventional benchmark today is a four-factor model that includes the market, size, book-to-market, and _____ factors

momentum

Suppose a market exists in which investors suffer from conservatism. The most likely divergence from traditional capital market theory would be ______.

momentum in stock prices

Studies suggest that overconfidence leads investors to trade ______ and to receive ______ returns as a result.

more lower

An active strategy interferes with portfolio evaluation by making the portfolio apparently ______ volatile and ______ the estimate of the Sharpe ratio.

more; lowering

The average price over a given interval, where that interval is updated as time passes, is the _____ average

moving

Because small firms tend to be neglected by large institutional traders, their higher returns may be a form of compensation for risk associated with limited information which is referred to as the _____ -firm effect.

neglected

A rationale for the neglected-firm effect shows that _____ firms might be expected to earn higher _____ returns as compensation for risk associated with limited information

neglected equillibrium

In an efficient capital market, only ______ or ______ information will make stock prices move.

new, unexpected

Technicians typically believe that prices ______ intrinsic value.

only gradually close in on

The tendency of people to overestimate the precision of their beliefs and forecasts and to overestimate their abilities is referred to as

overconfidence

Suppose we are attributing performance of a managed portfolio to asset allocation, sector selection, and security selection. If the portfolio outperforms the bogey by sector selection, it ______.

overweights well-performing sectors and underweights poorly performing sectors

An investment strategy that does not attempt to identify mispriced securities or otherwise "beat" the market is referred to as

passive

the _____ skew of the timer's distribution is a manifestation of the fact that the extreme values are all positive.

positive

Investor utility depends on changes in wealth rather than levels of wealth in _____ theory

prospect

The _____/_____ ratio refers to the ratio of outstanding put options to outstanding call options and typically hovers around _____%

put/call 65

The tendency for individuals to make decisions that are more conventional because they will feel less bad if such decisions turn out badly than they would if an unconventional decision turned out badly is referred to as _____ _____

regret avoidance

A technical analyst who calculates the ratio of an individual security's price to a price index for the security's sector to identify trading opportunities is using a ______ strategy.

relative strength

The extent to which a security has outperformed or underperformed either the market as a whole or its particular industry is defined as its _____ _____

relative strength

Most bubbles become obvious in ____ , but at the time, price run-ups seem to have a defensible rationale.

retrospect

The moving average share price of Potts Electric has shifted from being higher than the share price to being lower. A technical analyst would most likely view this as a sign of ______ stock prices.

rising

The active strategy with shifting means appears _____ than it really is and ____ the estimate of the Sharpe measure downward.

riskier; biases

In testing the CAPM, a cross-sectional regression of portfolio returns on betas, where the estimated slope is the measurement of the reward for bearing systematic risk during the period, is referred to as the _____-_____ regression

second pass

The _____ and _____ _____requires insiders to register their trading activity, making the trades public.

securities and exchange commision

The problem that any investment scheme that could outperform the market would probably be kept secret is referred to as the _____ _____ issue in evaluating market efficiency.

selection bias

matching

sharpe average excess return treynor beta jensen CAPM information alpha

A broad market index demonstrates only weak serial correlations on _____ horizons, for example a month or so.

short

A portfolio that has a higher Treynor measure than the market will have a T-line with a larger ______ than the ______ Market Line

slope; Security

When the estimated SML is "too flat", the γ1 coefficient is too _____

small

The finding of differences in the returns of the highest and lowest deciles of firms by size is referred to as the _____ - _____ (or size) effect.

small firm

If all investors attempted to follow a passive investment strategy, ______.

stock prices would fail to reflect new information

An innovation in testing the CAPM was to use ______ returns in place of ______ returns.

stratified portfolio; single security

The systematic measurement of the exposures of managed portfolios by the regression of fund returns on indexes representing a range of asset classes is referred to as

style analysis

Bias in the average returns of a sample induced by excluding past returns that left the sample because they happened to be unsuccessful is referred to as _____ bias

survivorship

Research to identify mispriced securities that focuses on recurrent and predictable stock price patterns and on proxies for buy or sell pressure in the market is _____ analysis

technical

The search for recurrent and predictable patterns in stock prices is referred to as _____ analysis

technical

The only manipulation-proof performance measure is ______.

the Morningstar risk-adjusted return

If investors could generate abnormal returns consistently by using _______ of a stock, it would be evidence against the weak form of the efficient market hypothesis.

the relative strength - charts of past prices - the relative strength

When we attribute the performance of a managed portfolio, the contribution of asset allocation to superior performance equals the sum over all markets of the excess weight in each market times ________.

the return of the market index

Since each return has an equal weight in the geometric average, it is also called the _____-_____ average return

time weighted

The value of an imperfect timer is the value of the perfect-timing call option ______ the measure of timing ability.

times

Early tests of the CAPM found that the intercept of the SML was ______ and its slope was ______.

too high too flat

Which technical measure incorporates volume in its assessment?

trin

The semistrong-form efficient market hypothesis states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price.

true

True or false: A concern of the multifactor CAPM and APT theories is that they provide little guidance concerning which sources of risk out to result in risk premiums

true

True or false: Even moderate levels of statistical noise make performance evaluation extremely difficult in practice.

true

True or false: Style analysis has become a very popular in the investment management industry and has spawned quite a few variations on Sharpe's methodology.

true

True or false: The momentum effect is observed where good or bad recent stock performance of particular stocks continue over time.

true

True or false: Efficient allocation depends on the quality of financial professionals and the ability of financial markets to identify and direct capital to the best stewards.

truw

Individuals who make poor decisions are more likely to regret them if the decision was more _____

unconventional

A behavioral explanation for why "value firms" outperform "glamour" firms is that analysts tend to ______ the value of firms with ______ recent performance.

underestimate; bad overestimate; good

An explanation of the equity premium puzzle offered by Fama and French is that recent realized excess rates of return were ______.

unexpectedly high

the _____-form hypothesis asserts that stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices, trading volume, or short interest.

weak

In testing the CAPM with a sample of 100 securities, there will be ______ second-pass regression(s) and ______ estimated market risk premium(s).

1; 1

Which is a typical sample for testing the CAPM?

5 years of monthly data

Which measures of liquidity have been used in empirical analyses?

The price impact per dollar of transactions The component of price impact that is due to information issues Evidence of price reversals following large trades

The total abnormal return for a time period of interest is referred to as the _____ abnormal return

cumulative

If an investor creates an account to fund the purchase of a speedboat and purchases an asset much riskier than the rest of his portfolio for it, the investor is exhibiting ______.

mental accounting

The dollar-weighted average return on an investment is ______.

the discount rate that makes the net present value of the investment equal to zero

If you were a perfect market timer, ______.

your return would be truly risk-free

If there are only three factors, the intercept of a regression of that three-factor asset pricing model should be equal to _____

zero