Go to Connect and link to Chapter 7 materials, where you will find a spreadsheet with monthly returns for GM, Ford, Toyota, the S&P 500, and Treasury bills. a. Estimate the index model for each firm over the full five-year period. Compare the betas of each firm. b. Now estimate the betas for each firm using only the first two years of the sample and then using only the last two years. How stable are the beta estimates obtained from these shorter sub periods?
> Even if prices follow a random walk, they still may not be information ally efficient. Explain why this may be true, and why it matters for the efficient allocation of capital.
> In contrast to the capital asset pricing model, arbitrage pricing theory: a. Requires that markets be in equilibrium. b. Uses risk premiums based on micro variables. c. Specifies the number and identifies specific factors that determine expected retur
> What is meant by data mining, and why must technical analysts be careful not to engage in it?
> a. Investors are slow to update their beliefs when given new evidence. i. Disposition effect b. Investors are reluctant to bear losses due to their unconventional decisions. ii. Representativeness bias c. Investors exhibit less risk tolerance in their re
> “Constantly fluctuating stock prices suggest that the market does not know how to price stocks.” Respond.
> Which version of the efficient market hypothesis (weak, semistrong, or strong-form) focuses on the most inclusive set of information?
> In an efficient market, professional portfolio management can offer all of the following benefits except which of the following? a. Low-cost diversification. b. A targeted risk level. c. Low-cost record keeping. d. A superior risk-return trade-off.
> Which of the following statements are true if the efficient market hypothesis 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 price
> 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?
> A successful firm like Microsoft has consistently generated large profits for years. Is this a violation of the EMH?
> If prices are as likely to increase as decrease, why do investors earn positive returns from the market on average?
> 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 aversion and therefore risk premiums might be higher. In a booming economy, tolerance for
> An investor takes as large a position as possible when an equilibrium price relationship is violated. This is an example of: a. A dominance argument. b. The mean-variance efficient frontier. c. Arbitrage activity. d. The capital asset pricing model.
> Examine the accompanying figure, which presents cumulative abnormal returns (CARs) 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 af
> Shares of small firms with thinly traded stocks tend to show positive CAPM alphas. Is this a violation of the efficient market hypothesis?
> Good News, Inc., just announced an increase in its annual earnings, yet its stock price fell. Is there a rational explanation for this phenomenon?
> 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?
> We know that the market should respond positively to good news and that good-news events such as the coming end of a recession can be predicted with at least some accuracy. Why, then, can we not predict that the market will go up as the economy recovers?
> “If all securities are fairly priced, all must offer equal expected rates of return.” Comment.
> 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 i
> Why are the following effects” considered efficient market anomalies? Are there rational explanations for these effects? a. P/E effect. b. Book-to-market effect. c. Momentum effect. d. Small-firm effect.
> Which of the following 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. Mone
> “If the business cycle is predictable, and a stock has a positive beta, the stock’s returns also must be predictable.” Respond.
> A zero-investment, well-diversified portfolio with a positive alpha could arise if: a. The expected return of the portfolio equals zero. b. The capital market line is tangent to the opportunity set. c. The law of one price remains inviolate. d. A risk
> Suppose you find that before large dividend increases, stocks show on average consistently positive abnormal returns. Is this a violation of the EMH?
> 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?
> Which of the following observations would provide evidence against the semistrong form of the efficient market theory? Explain. a. Mutual fund managers do not on average make superior returns. b. You cannot make superior profits by buying (or selling)
> 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 gre
> Which of the following would most appear to contradict the proposition that the stock market is weakly efficient? Explain. a. Over 25% of mutual funds outperform the market on average. b. Insiders earn abnormal trading profits. c. Every January, the s
> Which of the following sources of market inefficiency would be most easily exploited? a. A stock price drops suddenly due to a large block sale by an institution. b. A stock is overpriced because traders are restricted from short sales. c. Stocks are
> If markets are efficient, what should be the correlation coefficient between stock returns for two no overlapping time periods?
> What must be the beta of a portfolio with E(rP) = 20%, if rf = 5% and E(rM) = 15%?
> In a single-factor market, the SML relationship of both the CAPM and the APT states that the risk premium on any security is proportional to beta, or, equivalently, that the security’s expected return must be a linear function of beta.
> Kidskin, Inc., stock has a beta of 1.2 and Quinn, Inc., stock has a beta of 0.6. Which of the following statements is most accurate? a. The equilibrium expected rate of return is higher for Kaskin than for Quinn. b. The stock of Kaskin has higher volati
> According to the theory of arbitrage: a. High-beta stocks are consistently overpriced. b. Low-beta stocks are consistently overpriced. c. Positive-alpha investment opportunities will quickly disappear. d. Rational investors will pursue arbitrage cons
> 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%? a. 15%. b. More than 15%. c. Cannot be determined without the risk-free rate.
> Characterize each company in the previous problem as underpriced, overpriced, or properly priced.
> Here are data on two companies. The T-bill rate is 4% and the market risk premium is 6% What should be the expected rate of return for each company, according to the capital asset pricing model (CAPM)?
> Suppose the market can be described by the following three sources of systematic risk. Each factor in the following table has a mean value of zero (so factor values represent surprises relative to prior expectations), and the risk premiums associated wit
> As a finance intern at Pork Products, Jennifer Wainwright’s assignment is to come up with fresh insights concerning the firm’s cost of capital. She decides that this would be a good opportunity to try out the new material on the APT that she learned last
> The APT itself does not provide information on the factors that one might expect to determine risk premiums. How should researchers decide which factors to investigate? Is industrial production a reasonable factor to test for a risk premium? Why or why n
> Are the following true or false? Explain. a. Stocks with a beta of zero offer an expected rate of return of zero. b. The CAPM implies that investors require a higher return to hold highly volatile securities c. You can construct a portfolio with a bet
> Suppose the yield on short-term government securities (perceived to be risk-free) is about 4%. Suppose also that the expected return required by the market for a portfolio with a beta of 1 is 12%. According to the capital asset pricing model: a. What is
> Two investment advisers are comparing performance. One averaged a 19% return and the other a 16% return. However, the beta of the first adviser was 1.5, while that of the second was 1. a. Can you tell which adviser was a better selector of individual st
> In Problem below, assume the risk-free rate is 8% and the expected rate of return on the market is 18%. Use the SML of the simple (one-factor) CAPM to answer this question. A stock has an expected return of 6%. What is its beta?
> Assume that both X and Y are well-diversified portfolios and the risk-free rate is 8%. In this situation you could conclude that portfolios X and Y: a. Are in equilibrium. b. Offer an arbitrage opportunity. c. Are both underpriced. d. Are both fairly
> Which of the following statements about the standard deviation is/are true? A standard deviation: a. Is the square root of the variance. b. Is denominated in the same units as the original data. c. Can be a positive or a negative number.
> In Problem below, assume the risk-free rate is 8% and the expected rate of return on the market is 18%. Use the SML of the simple (one-factor) CAPM to answer this question. I am buying a firm with an expected perpetual cash flow of $1,000 but am unsure o
> In Problem below, assume the risk-free rate is 8% and the expected rate of return on the market is 18%. Use the SML of the simple (one-factor) CAPM to answer this question. A share of stock is now selling for $100. It will pay a dividend of $9 per share
> Consider the statement: “If we can identify a portfolio with a higher Sharpe ratio than the S&P 500 Index portfolio, then we should reject the single-index CAPM.” Do you agree or disagree? Explain.
> If the simple CAPM is valid, which of the situations in Problem below is possible? Explain. Consider each situation independently.
> If the simple CAPM is valid, which of the situations in Problem below is possible? Explain. Consider each situation independently.
> If the simple CAPM is valid, which of the situations in Problem below is possible? Explain. Consider each situation independently.
> If the simple CAPM is valid, which of the situations in Problem below is possible? Explain. Consider each situation independently.
> If the simple CAPM is valid, which of the situations in Problem below is possible? Explain. Consider each situation independently.
> If the simple CAPM is valid, which of the situations in Problem below is possible? Explain. Consider each situation independently.
> Which of the following statements about the security market line (SML) are true? a. The SML provides a benchmark for evaluating expected investment performance. b. The SML leads all investors to invest in the same portfolio of risky assets. c. The SML
> If the simple CAPM is valid, which of the situations in Problem below is possible? Explain. Consider each situation independently.
> Consider the following table, which gives a security analyst’s expected return on two stocks and the market index in two scenarios: a. What are the betas of the two stocks? b. What is the expected rate of return on each stock? c. If t
> You are a consultant to a large manufacturing corporation considering a project with the following net after-tax cash flows (in millions of dollars): The project’s beta is 1.7. Assuming rf = 9% and E(rM) = 19%, what is the net present v
> The market price of a security is $40. Its expected rate of return is 13%. The risk-free rate is 7%, and the market risk premium is 8%. What will the market price of the security be if its beta doubles (and all other variables remain unchanged)? Assume t
> Suppose investors believe that the standard deviation of the market-index portfolio has increased by 50%. What does the CAPM imply about the effect of this change on the required rate of return on Google’s investment projects?
> A pension fund manager is considering three mutual funds. The first is a stock fund, the second is a long-term government and corporate bond fund, and the third is a Tbill money market fund that yields a sure rate of 5.5%. The probability distributions o
> A pension fund manager is considering three mutual funds. The first is a stock fund, the second is a long-term government and corporate bond fund, and the third is a Tbill money market fund that yields a sure rate of 5.5%. The probability distributions o
> Use the rate-of-return data for the stock and bond funds presented in Spreadsheet 6.1, but now assume that the probability of each scenario is as follows: severe recession: .10; mild recession: .20; normal growth: .35; boom: .35. a. Would you expect the
> Suppose that the returns on the stock fund presented in Spreadsheet 6.1 were −40%, −14%, 17%, and 33% in the four scenarios. a. Would you expect the mean return and variance of the stock fund to be more than, less than, or equal to the values computed i
> The standard deviation of the market index portfolio is 20%. Stock A has a beta of 1.5 and a residual standard deviation of 30%. a. What would make for a larger increase in the stock’s variance: an increase of 0.15 in its beta or an increase of 3% (from
> Dudley Trudy, CFA, recently met with one of his clients. Trudy typically invests in a master list of 30 equities drawn from several industries. As the meeting concluded, the client made the following statement: “I trust your stock-picking ability and bel
> An investor ponders various allocations to the optimal risky portfolio and risk-free T-bills to construct his complete portfolio. How would the Sharpe ratio of the complete portfolio be affected by this choice?
> 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? a. An increase of 1% in expected return. b. A decrease of 1%
> Neighborhood Insurance sells fire insurance policies to local homeowners. The premium is $110, the probability of a fire is .001, and in the event of a fire, the insured damages (the payout on the policy) will be $100,000. a. Make a table of the two pos
> Log in to Connect to find rate-of-return data over a 60-month period for Alphabet, the parent company of Google; the T-bill rate; and the S&P 500, which we will use as the market index portfolio. a. Use these data and Excel’s regression function to comp
> Here are rates of return for six months for Generic Risk, Inc. What is Generic’s beta? (Hint: Find the answer by plotting the scatter diagram.
> Log in to Connect and link to the material for Chapter 6, where you will find a spreadsheet containing monthly rates of return for Apple, the S&P 500, and T-bills over a recent five-year period. Set up a spreadsheet just like that of Example 6.3 and find
> The following figure shows plots of monthly rates of return and the stock market for two stocks. a. Which stock is riskier to an investor currently holding a diversified portfolio of common stock? b. Which stock is riskier to an undiversified investor w
> Investors expect the market rate of return this year to be 10%. The expected rate of return on a stock with a beta of 1.2 is currently 12%. If the market return this year turns out to be 8%, how would you revise your expectation of the rate of return on
> 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.
> A project has a 0.7 chance of doubling your investment in a year and a 0.3 chance of halving your investment in a year. What is the standard deviation of the rate of return on this investment?
> Hennessy & Associates manages a $30 million equity portfolio for the multimanager Wilstead Pension Fund. Jason Jones, financial vice president of Wilstead, noted that Hennessy had rather consistently achieved the best record among the Winsted’s six equit
> What is the relationship of the portfolio standard deviation to the weighted average of the standard deviations of the component assets?
> Your assistant gives you the following diagram as the efficient frontier of the group of stocks you asked him to analyze. The diagram looks a bit odd, but your assistant insists he double-checked his analysis. Would you trust him? Is it possible to get s
> Assume expected returns and standard deviations for all securities, as well as the riskfree rate for lending and borrowing, are known. Will investors necessarily arrive at the same optimal risky portfolio? Explain.
> You can find a spreadsheet containing annual returns on stocks and Treasury bonds in Connect. Copy the data for the last 20 years into a new spreadsheet. Analyze the risk-return trade-off that would have characterized portfolios constructed from large st
> Suppose that many stocks are traded in the market and that it is possible to borrow at the risk free rate, rf. The characteristics of two of the stocks are as follows: Could the equilibrium rf be greater than 10%? (Hint: Can a particular stock portfolio
> 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%. a. In light of the apparent inferiority of gold to stocks with respect to both mean return and vo
> A pension fund manager is considering three mutual funds. The first is a stock fund, the second is a long-term government and corporate bond fund, and the third is a Tbill money market fund that yields a sure rate of 5.5%. The probability distributions o
> A pension fund manager is considering three mutual funds. The first is a stock fund, the second is a long-term government and corporate bond fund, and the third is a Tbill money market fund that yields a sure rate of 5.5%. The probability distributions o
> A pension fund manager is considering three mutual funds. The first is a stock fund, the second is a long-term government and corporate bond fund, and the third is a Tbill money market fund that yields a sure rate of 5.5%. The probability distributions o
> 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.
> Hennessy & Associates manages a $30 million equity portfolio for the multimanager Wilstead Pension Fund. Jason Jones, financial vice president of Wilstead, noted that Hennessy had rather consistently achieved the best record among the Winsted’s six equit
> Using the historical risk premiums as your guide, what is your estimate of the expected annual HPR on the market index stock portfolio if the current risk-free interest rate is 3%?
> a. Suppose you forecast that the standard deviation of the market return will be 20% in the coming year. If the measure of risk aversion in Equation 5.16 is A = 4, what would be a reasonable guess for the expected market risk premium? b. What value of A
> XYZ stock price and dividend history are as follows: An investor buys three shares of XYZ at the beginning of 2018, buys another two shares at the beginning of 2019, sells one share at the beginning of 2020, and sells all four remaining shares at the beg
> The stock of Business Adventures sells for $40 a share. Its likely dividend payout and end-of-year price depend on the state of the economy by the end of the year as follows: a. Calculate the expected holding-period return and standard deviation of the
> Suppose your expectations regarding the stock market are as follows: Use Equations 5.10–5.12 to compute the mean and standard deviation of the HPR on stocks
> You’ve just decided upon your capital allocation for the next year, when you realize that you’ve underestimated both the expected return and the standard deviation of your risky portfolio by a multiple of 1.05. Will you increase, decrease, or leave uncha
> When estimating a Sharpe ratio, would it make sense to use the average excess real return that accounts for inflation?
> Download the annual returns for the years 1927–2018 on the combined market index (of the NYSE/NASDAQ/AMEX markets) as well as the S&P 500 from Connect. For both indexes, calculate: a. Average return. b. Standard deviation of return. c. Skew of return.
> For each style portfolio, are real or nominal returns more volatile during each subperiod of Table 5.5?
> Convert the nominal returns on the broad market index to real rates. Reproduce the last column of Table 5.3 using real rates. Compare the results to those of Table 5.3. Are real or nominal returns more volatile in this sample period?
