Finance portman
Black, Jensen and Scholes Findings
- a linear relationship between return and Beta - positive compensation for bearing risk - slope still too flat (estimation error?) - the intercept term is above what is predicted by the CAPM
What is the beta of the market portfolio?
0 Market 1%, B 1% correlation of something with itself
According to the CAPM, what should be the intercept in each of these regressions?
0 so alpha is 0
What is the beta of the risk-free investment?
1 no variation, 0, constant, so correlation is always 0
What does the beta of a stock measure?
Beta measures the amount of systematic risk in a stock.
Fama-McBeth results
1. The risk return relationship is linear 2. There is no compensation for residual risk 3. There exits positive compensation for market risk 4. The estimated intercept tern indicates that the results are more consistent with Black's CAPM
Semi-strong form
in which the current price reflects all publicly available information
Explain what the size effect is.
it is the empirical observation that firms with lower market capitalizations on average have higher average returns.
What is the implication of the empirical SML line being "too flat"?
mis-estimate betas
If the forecast rate of return is less than the required rate of return then the security is ____ ?
overvalued
Suppose that the analyst has estimated that a = .05% and b = .8. On the day that the market goes up 1%, what you predict the stock to do?
r = .05 +.8(1%) =.85% intercept is the risk free rate
Alpha
should be 0 if CAPM is correct it is = how much this stock has returns that are higher or lower than the CAPM
Suppose the stock of Bankruptcy Auction Services Inc., has a negative beta of -.30. How does the required return compare to the risk-free rate, according to the CAPM? Does this result make sense?
E(r) < rf because the second term (risk premium for a security) is negative
What is the expected return of a zero-beta security?
Risk-free rate of return
Do high or low beta stocks tend to outperform the predictions of the CAPM?
Seems like high B have returns that are lower than the CAPM predicts.... and lower B have returns that are too high
Standard and Poor's also publishes the S&P Equal Weight Index, which is an equally weighted version of the S&P 500. To maintain a portfolio that tracks this index, what trades would need to be made in response to daily price changes?
Sell winners and buy losers to maintain an equal investment in each
What is the capital market line (CML)?
Set of all efficient portfolios
If all investors are holding efficient portfolios, what can you conclude about Microsoft's market capitalization?
Supply = Deman so Microsoft Market Cap is double, it is much larger than Pfzier
Capital asset pricing theory asserts that portfolio returns are best explained by:
Systematic risk
Given a population of securities, there will be a simple linear relationship between the beta factors of different securities and their expected returns IF AND ONLY IF ...
The betas are computed using a minimum variance market index portfolio
If markets are efficient, what should be the correlation coefficient between stock returns for two non-overlapping time periods?
The correlation coefficient between stock returns for two non-overlapping periods should be zero. If not, returns from one period could be used to predict returns in later periods and make abnormal profits.
Beta
The degree to which that stock is influenced by the market portfolio... a measure of how the stock varies w/ market/systematic risk. B is like a correlation that also conveys magnitude by what % *only relevant measure of risk in the CAPM*
How does the disposition effect impact investors' tax obligations?
The disposition effect causes investors to sell stocks that have appreciated and hold onto stocks that have depreciated. Thus investors are paying capital gains taxes that they could defer and deferring tax deductions they could take immediately. Because of the time value of money, these investors are therefore increasing their required tax obligations.
Good News Inc. just announced an increase in its annual earnings, yet its stock price fell. Is there a rational explanation for this phenomenon?
The market may have anticipated even greater earnings. Compared to prior expectations, the announcement was a disappointment.
What are the only conditions under which the market portfolio might not be an efficient portfolio?
The market portfolio can be inefficient (so it is possible to beat the market) only if a significant number of investors either: 1. Do not have rational expectations, so that they misinterpret information and believe they are earning a positive alpha when they are actually earning a negative alpha, or 2. Care about aspects of their portfolios other than expected return and volatility, and so are willing to hold inefficient portfolios of securities.
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 premiums, not market inefficiencies.
Respond: If stock prices follow a random walk, then capital markets are little different from a casino
Though stock prices follow a random walk and intraday price changes do appear to be a random walk, over the long run there is compensation for bearing market risk and for the time value of money. Investing differs from a casino in that in the long-run, an investor is compensated for these risks, while a player at a casino faces less than fair-game odds.
"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.
Suppose that after much research, you have identified the efficient portfolio. You decide to invest $10,000 in Microsoft and $5,000 in Pfizer stock. Suppose your friend, who is a wealthier but more conservative investor, has $2000 invested in Pfizer. If your friend's portfolio is also efficient, how much has she invested in Microsoft?
WEIGHTS DON'T CHANGE Recall that both invest in efficient (tangent) where the weight is the same % She has 2 x 2,000 = 4,000 in Microsoft
"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.
Asset Pricing Models are equations that give us a prediction of the relation between risk of an asset and its return. This serves what 2 important functions?
1. Benchmark rate of return for evaluating possible investments (e.g. picking a mutual fund) 2. Allows us to estimate the expected return on assets that have not yet been traded in the market using comparables (e.g. IPOs)
Identify and briefly discuss the three criticisms of beta as used in the CAPM?
1. Betas are estimated with respect to market indexes that are proxies for the true market portfolio, which is inherently unobservable 2. Empirical test of the CAPM show that average returns are not related to beta in the manner predicted by the theory. The empirical SML is flatter than the theoretical one. 3. Multi-factor models of security returns show that beta, which is a one-dimensional measure of risk, amy not capture the true risk of the stock of portfolio.
What are the 3 assumptions of the CAPM?
1. Investors can buy and sell securities at competitive market prices (without transaction costs) and can borrow and lend at the risk free rate 2. Investors hold only efficient portfolios 3. Investors have similar expectations about the future volatilities, correlations, and expected returns
2 Questions with every investment strategy
1. Is the CAPM simply wrong and therefore a useless theory? 2. Is the test we performed a bad test and the CAPM really is true?
What aspects of the CAPM do we test?
1. The relationship between Beta and expected returns is linear 2. Only Beta is necessary to explain the differences in expected returns between securites 3. The expected return of an asset with a Beta of 0 is the risk-free rate 4. The expected return of an asset with Beta of 1 is the same as the expected return on the market
The CAPM is the most widely used model for what 4 things?
1. stock returns 2. capital budgeting 3. corporate valuation 4. evaluating portfolio managers
How many regression estimates of the SCL do we have from the sample?
100 Betas for 100 stocks
To put the turnover of Figure 13.3 into perspective, let's do a back of the envelope calculation of what an investor's average turnover per stock would be were he to follow a policy of investing in the S&P 500 portfolio. Because the portfolio is value weighted, the trading would be required when Standard and Poor's changes the constituent stocks. (Let's ignore additional, but less important reasons like new share issuances and repurchases.) Assuming they change 23 stocks a year (the historical average since 1962) what would you estimate the investor's per stock share turnover to be? Assume that the average total number of shares outstanding for the stocks that are added or deleted from the index is the same as the average number of shares outstanding for S&P 500 stocks.
46/523 = 8.8%.
Consider an investment fund managing a $5 billion portfolio. Suppose that the fund manager can devise a research program that could increase the portfolio rate of return by 1/10 of 1% per year, a seemingly modest amount. This would increase the dollar return in the portfolio by how much?
5 Billion * .001 = 5 million Tremendous Impact!
How many observations are there in each of the regressions?
60 (60 months)
If the stock actually rises by 2%, what would the analyst infer about the impact of firm-specific news that day?
Abnormal returns = 2% - .85% = 1.15%
Explain why the market portfolio is efficient according to the CAPM?
All efficient portfolios summed is efficient
When the CAPM correctly prices risk, the market portfolio is an efficient portfolio. Why?
All investors will want to maximize their Sharpe ratios by picking efficient portfolios. When a riskless asset exists this means that all investors will pick the same efficient portfolio, and because the sum of all investor's portfolios is the market portfolio this efficient portfolio must be the market portfolio
Regression terms alpha beta error term
Alpha: intercept term of the regression (want 0) Beta: represents the sensitivity of the stock to market risk. When the market's return increases by 1%, the security's return increases by B% E: is the error term and represents the deviation from the best-fitting line and is 0 on average r-squared: measure of the best fit line. If 30%, then 30% of the variation in excess returns in HP can be explained by variation in Beta.
What is an efficient portfolio?
An efficient portfolio is any portfolio that only contains systematic risk; it contains no diversifiable risk
Why does the CAPM imply that investors should trade very rarely?
Because they should hold the market portfolio which is a value-weighted portfolio and thus requires no retrading when prices change to maintain the value weights.
Suppose Best Buy stock is trading for $30 per share for a total market cap of $9 billion, and Walt Disney has 1.65 billion shares outstanding. If you hold the market portfolio, and as part of it hold 100 shares of Best Buy, how many shares of Walt Disney do you hold?
Best Buy has 9/30 = .3 billion shares outstanding Therefore, you hold 100 x (1.65/0.3) = 550 shares of Disney
Suppose Kraft Food's stock has a beta of 0.50, whereas Boeing's beta is 1.25. If the risk-free rate is 4%, and the expected return of the market portfolio is 10%, what is the expected return of an equally weighted portfolio of Kraft Foods and Boeing stocks according to the CAPM?
Bp = 1/2(.5) + 1/2(1.25) = 0.875 E(rp) = rf + .875(10-4) = 9.25
You know that firm XYZ is very poorly run. On a scale of 1 (worst) to 10 (best), you would give it a score of 3. The market consensus evaluation is that the management score is only 2. Should you buy or sell the stock?
Buy. In your view, the firm is not as bad as everyone else believes it to be. Therefore, you view the firm as undervalued by the market. You are less pessimistic about the firm's prospects than the beliefs built into the stock price.
Explain what the following sentence means: The market portfolio is a fence that protects the sheep from the wolves, but nothing can protect the sheep from themselves.
By investing in the market portfolio, investors can protect themselves from being exploited by investors with better information than they have themselves. By choosing not to invest in the market portfolio, investors expose themselves to being exploited. If they do this because of overconfidence, they will lose money.
Suppose the risk-free interest rate is 3%, and the market risk premium is 5%. What range for Cisco's equity cost of capital is consistent with the 95% confidence interval for its beta? Recall: B=1.57 w/ [1.3 to 1.8] CI
E(r) = 3% + 1.57(5%) = 10.85% if B = 1.3 E(r) = 3% + 1.3(5%) = 9.5% if B = 1.8 E(r) = 3% + 1.8(5%) = 12% So 95% CI for E(r) is 9.5% to 12% and of that you would want to chose the most conservative
Market Efficiency
Equilibrium prices and returns are "correct" because they "fully reflect" all information available It is very difficult to make abnormal returns
"If all securities are fairly prices, all must offer equal expected rates of return." Comment
Expected rates of return differ because of differential risk premiums across all securities.
What is the Alpha for a security?
Forecast rate of return - CAPM Expected rate of return = .25%
Positive alpha... Negative alpha...
If positive, then the stock has performed better than predicted by the CAPM If negative, the stock's historical return is below the SML
Joint Hypothesis Problem
If we find abnormal profits from a trading strategy, rejecting market efficiency means we accept the asset pricing model... Therefore, we always have to ask ourselves if we find excess returns: 1. Is it our real profit (and evidence of inefficiency) 2. Is our model of expected returns wrong
Respond: A good part of a company's future prospects are predictable. Given this fact, stock prices can't possibly follow a random walk.
In an efficient market, any predictable future prospects of a company have already been priced into the current value of the stock. Thus, a stock share price can still follow a random walk.
You know that there are informed traders in the stock market, but you are uninformed. Describe an investment strategy that guarantees that you will not lose money to the informed traders and explain why it works.
Invest in the market portfolio. Because the average investor must hold the market, by investing in the market you guarantee the average investor return. If the informed traders make higher returns than the average investor, somebody must make lower returns, so by holding the market you can guarantee that it is not you.
Suppose you find that prices of stocks before large dividend increase 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.
Suppose the market portfolio has an expected return of 10% and a volatility of 20%, while Microsoft's stock has a volatility of 30%... What would have to be true for Microsoft's equity cost of capital to be equal to 10%?
Microsoft stock would need to have a Beta of 1
Suppose that in place of the S&P 500, you want to use a broader market portfolio of all U.S. stocks and bonds as the market proxy. Could you use the same estimate for the market risk premium when applying the CAPM? if not, how would you estimate the correct risk premium to use?
No, expected return of this portfolio would be lower due to bonds. Compute the historical excess return of this new index.
From the start of 1999 to the start of 2009, the S&P 500 had a negative return. Does this mean the market risk premium we should have used in the CAPM was negative?
No, expected returns of this portfolio would be lower due to bonds. Compute the historical excess returns of this new index.
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.
Suppose the market portfolio has an expected return of 10% and a volatility of 20%, while Microsoft's stock has a volatility of 30%...Given its higher volatility, should we expect Microsoft to have an equity cost of capital that is higher than 10%?
No, volatility includes diversifiable risk, so it cannot be used to assess the equity cost of capital
A successful firm like Microsoft has consistently generated large profits for years. Is this a violation of the EMH?
No. Microsoft's continuing profitability does not imply that stock market investors who purchased Microsoft shares after its success was already evident would have earned an exceptionally high return on their investments. It simply means that Microsoft has made risky investments over the years that have paid off in the form of increased cash flows and profitability. Microsoft shareholders have benefited from the risk-expected return tradeoff, which is consistent with the EMH.
Standard and Poor's also publishes the S&P Equal Weight Index, which is an equally weighted version of the S&P 500. Is this index suitable as a market proxy?
No. The market portfolio should represent the aggregate portfolio of all investors. However, in aggregate, investors must hold more of the larger market cap stocks; the aggregate portfolio is value weighted, not equally weighted.
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 return 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. Remember that economies tend to grow over time and stock prices tend to follow economic growth, so it is only natural that there is an upward drift in equity prices.
Respond: If markets are efficient, you might as well select your portfolio by throwing darts at the stock listings in the Wall Street Journal
While the random nature of dart board selection seems to follow naturally from efficient markets, the role of rational portfolio management still exists. It exists to ensure a well-diversified portfolio, to assess the risk-tolerance of the investor, and to take into account tax code issues.
Suppose that we see negative abnormal returns (declining CARs) after announcement date. Is this a violation of efficient markets?
Yes! If it doesn't go flat then there is something inefficient - ish
Assume that all investors have the same information and care only about expected return and volatility. If new information arrives about one stock, can this information affect the price and return of other stocks? If so, explain why.
Yes. When the new information arrives, it will change the attractiveness of this stock. If other stock prices do not change, then investors would want to increase their weight in this stock, implying they would not be holding the market portfolio.
Explain how to construct a positive-alpha trading strategy if stocks that have had relatively high returns in the past tend to have positive alphas, and stocks that have had relatively low returns in the past tend to have negative alphas.
You buy stocks that have done well in the past and sell stocks that have done poorly.
Assume the economy consisted of three types of people. 50% are fad followers, 45% are passive investors (they have read this book and so hold the market portfolio), and 5% are informed traders. The portfolio consisting of all the informed traders has a beta of 1.5 and an expected return of 15%. The market expected return is 11%. The risk-free rate is 5%. a) What alpha do the informed traders make? b) What is the alpha of the passive investors? c) What is the expected return of the fad followers? d) What alpha do the fad followers make?
a) 1% b) 0 c. 10.6% d. -0.1%
Suppose that all investors have the disposition effect. A new stock has just been issued at a price of $50, so all investors in this stock purchased the stock today. A year from now the stock will be taken over, for a price of $60 or $40 depending on the news that comes out over the year. The stock will pay no dividends. Investors will sell the stock whenever the price goes up by more than 10%. a. Suppose good news comes out in 6 months (implying the takeover offer will be $60). What equilibrium price will the stock trade for after the news comes out, that is, the price that equates supply and demand? b. Assume that you are the only investor who does not suffer from the disposition effect and your trades are small enough to not affect prices. Without knowing what will actually transpire, what trading strategy would you instruct your broker to follow?
a. $55. b. Buy if the price goes up by 10% or more.
Which of the following hypothetical phenomena would be either consistent with or a violation of the efficient market hypothesis? Explain. 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 predictable 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.
Assume that the CAPM is a good description of stock price returns. The market expected return is 7% with 10% volatility and the risk-free rate is 3%. New news arrives that does not change any of these numbers but it does change the expected return of the following stocks: a. At current market prices, which stocks represent buying opportunities? b. On which stocks should you put a sell order in?
a. Green Leaf, HanBel b. Rebecca Automobile and possibly NatSam (although its alpha is close enough to zero that we might regard it as insignificant).
Your brother Joe is a surgeon who suffers badly from the overconfidence bias. He loves to trade stocks and believes his predictions with 100% confidence. In fact, he is uninformed like most investors. Rumors are that Vital Signs (a startup that makes warning labels in the medical industry) will receive a takeover offer at $20 per share. Absent the takeover offer, the stock will trade at $15 per share. The uncertainty will be resolved in the next few hours. Your brother believes that the takeover will occur with certainty and has instructed his broker to buy the stock at any price less than $20. In fact, the true probability of a takeover is 50%, but a few people are informed and know whether the takeover will actually occur. They also have submitted orders. Nobody else is trading in the stock. a. Describe what will happen to the market price once these orders are submitted if in fact the takeover will occur in a few hours. What will your brother's profits be: positive, negative or zero? b. What range of possible prices could result once these orders are submitted if the takeover does not occur? What will your brother's profits be: positive, negative or zero? c. What are your brother's expected profits?
a. In this case the informed traders and your brother will both submit buy orders for any price less than 20, so the only market clearing price is $20, and nobody trades. Zero profits. b. In this case the informed traders will submit sell orders for any price above $15 and your brother will submit his buy order for any price below $20. Trade will occur at some price in between and your brother will make negative profits. c. Negative
Suppose the CAPM equilibrium holds perfectly. Then the risk-free interest rate increases, and nothing else changes. a. Is the market portfolio still efficient? b. If your answer to part (a) is yes, explain why. If not, describe which stocks would be buying opportunities and which stocks would be selling opportunities.
a. No b. Stocks with betas (calculated using the market portfolio prior to the interest rate change) greater than one will have positive alphas and so would be buying opportunities. Similarly stocks with betas less than one will be selling opportunities.
Assume that a company announces an unexpectedly large cash dividend to its shareholders. In an efficient market without information leakage, one might expect:
a. The full price adjustment should occur just as the news about the dividend becomes publicly available.
Suppose that as the economy moves through a business cycle, risk premiums also change. For example, in a recession, when people are concerned about their jobs, risk tolerance might be lower and risk premiums might be higher. In a booming economy, tolerance for risk might be higher and premiums lower. A) Would a predictably shifting risk premium such as described here be a violation of the efficient market hypothesis? B) How might a cycle of increasing and decreasing risk premiums create an appearance that stock prices "overreact," first falling excessively and then seeming to recover
a. The market risk premium moves countercyclical to the economy, peaking in recessions. A violation of the efficient market hypothesis would imply that investors could take advantage of this predictability and earn excess risk adjusted returns. However, several studies, including Siegel, show that successfully timing the changes have eluded professional investors thus far. Moreover a changing risk premium implies changing required rates of return for stocks rather than an inefficiency with the market. b. As the market risk premium increases during a recession, stocks prices tend to fall. As the economy recovers, the market risk premium falls, and stock prices tend to rise. These changes could give investors the impression that markets overreact, especially if the underlying changes in the market risk premium are small but cumulative. For example, the October Crash of 1987 is commonly viewed as an example of market overreaction. However, in the weeks running up to mid-October, several underlying changes to the market risk premium occurred (in addition to changes in the yields on long-term Treasury Bonds). Congress threatened investors with a "merger tax" that would have truncated the booming merger industry and loosened the discipline that the threat of mergers provides to a firm's management. In addition, the Secretary of Treasury threatened further depreciation in the value of the dollar, frightening foreign investors. These events may have increased the market risk premium and lowered stock prices in a seeming overreaction.
You are trading in a market in which you know there are a few highly skilled traders who are better informed than you are. There are no transaction costs. Each day you randomly choose five stocks to buy and five stocks to sell (by, perhaps, throwing darts at a dartboard). a. Over the long run will your strategy outperform, underperform, or have the same return as a buy and hold strategy of investing in the market portfolio? b. Would your answer to part (a) change if all traders in the market were equally well informed and were equally skilled?
a. You will underperform for two reasons: (1) transaction costs and (2) you will lose every time you trade with an informed investor. Of course in this problem only (2) will cause underperformance. b. This time the only source of losses are transaction costs. In this case, your trades should break even so you should earn the same return.
Davita Spencer is a manager at Half Dome Asset Management. She can generate an alpha of 2% a year up to $100 million. After that her skills are spread too thin, so she cannot add value, and her alpha is zero. Half Dome charges a fee of 1% per year on the total amount of money under management (at the beginning of each year). Assume that there are always investors looking for positive alpha and no investor would invest in a fund with a negative alpha. In equilibrium, that is, when no investor either takes out money or wishes to invest new money, a. What alpha do investors in Davita's fund expect to receive? b. How much money will Davita have under management? c. How much money will Half Dome generate in fee income?
a. Zero b. $200 million c. $2 million
Consider the price paths of the following two stocks over six time periods: Neither stock pays dividends. Assume you are an investor with the disposition effect and you bought at time 1 and right now it is time 3. Assume throughout this question that you do no trading (other than what is specified) in these stocks. a. Which stock(s) would you be inclined to sell? Which would you be inclined to hold onto? b. How would your answer change if right now is time 6? c. What if you bought at time 3 instead of 1 and today is time 6? d. What if you bought at time 3 instead of 1 and today is time 5?
a. sell 1, hold 2 b. sell both c. sell both d. sell 2, hold 1
The semistrong form of the efficient market hypothesis asserts that stock prices:
b. Semistrong form efficiency implies that market prices reflect all publicly available information concerning past trading history as well as fundamental aspects of the firm.
Which of the following are true if the EMH holds? a. it implies that future events can be forecast with perfect accuracy b. it implies that prices reflect all available information c. it implies that security prices change for no discernable reason d. it implies that prices do not fluctuate
b. This is the definition of an efficient market.
A "random walk" occurs when:
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:
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.
Suppose that, after conducting an analysis of past stock prices, you come up with the following observations. Which would appear to contradict the weak form of the efficient market hypothesis? Explain. a. the average rate of return is significantly greater than zero b. the correlation between the return during a given week and the return during the following week is zero c. one could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall. d. One could have made higher-than-average capital gains by holding stocks with low dividend yeilds
c. This is a classic filter rule that should not produce superior returns in an efficient market.
Which of the following (hypothetical) observations would most contradict the proposition that the stock market is weakly efficient? a. over 25% of mutual funds outperform the market on average b. insiders earn abnormal trading profits c. every January, the stock market earns abnormal returns
c. This is a predictable pattern in returns that should not occur if the weak-form EMH is valid.
Cumulative Abnormal Returns (CARs)
capture the total firm-specific movement for the entire period when the market might responding to new information
Which of the following would provide evidence against the semistrong form of the efficient market theory?
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
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).
Weak forn
in which the current price reflects all information in the historic series of prices
Strong form
in which the current price reflects all information, including proprietary and insider information
Suppose the risk-free return is 4% and the market portfolio has an expected return of 10% and a volatility of 16%. 3M stock has a 22% volatility and a correlation with the market of 0.50. What is 3M's beta with the market? What capital market line portfolio has equivalent market risk, and what is its expected return?
rf = 4% E(rm) = 10% SDmp = 16% B = cov(rm,r3m) / var(rm) B = .22(.5) / .16 = .69 * when market is up 1% 3M is up /69% E(r3m) = 4% + 69%(10-4) = 8.1%
Value stocks have higher Sharpe ratios so...
the market is not efficient
Roll critique
the real test is if the efficient portfolio is actually efficient
If the forecast rate of return is greater than the required rate of return then the security is ___?
undervalued
3 forms of market efficiency
weak, semi-strong, strong
What is the implication of an estimate of y2?
y2 is gamma 2... is the total variance and it should be 0 .310/.026 > 2 SO it's STATISTICALLY SIGNIFICANT... so returns are related to Total risk, which is NOT consistent with the CAPM