37 terms

For the next 3 Question, are they true or false?

NT

Stocks with a beta of zero offer an expected rate of return of zero.

False. β = 0 implies E(r) = rf , not zero. `

The CAPM implies that investors require a higher return to hold highly volatile securities.

False. Investors require a risk premium only for bearing systematic (undiversifiable or market) risk. Total volatility includes diversifiable risk.

You can construct a portfolio with beta of .75 by investing .75 of the investment budget in T-bills and the remainder in the market portfolio.

False. Your portfolio should be invested 75% in the market portfolio and 25% in T-bills. Then:

βP = (0.75 × 1) + (0.25 × 0) = 0.75

βP = (0.75 × 1) + (0.25 × 0) = 0.75

The Security market line depicts

A security's expected return as a function of its systematic risk

Within the context of the capital asset pricing model (CAPM) assume

- Expected return on the market = 15%

- Risk-free rate = 8%

- Expected rate of return on XYZ security = 17%

- Beta of XYZ security = 1.25

which of the follwoing is correct

- Expected return on the market = 15%

- Risk-free rate = 8%

- Expected rate of return on XYZ security = 17%

- Beta of XYZ security = 1.25

which of the follwoing is correct

XYZ is overpriced

XYZ is fairly priced

XYZ's alpha is -0.25%

XYZ's alpha is 0.25% (X)

XYZ is fairly priced

XYZ's alpha is -0.25%

XYZ's alpha is 0.25% (X)

What us the expected return of a zero-beta security?

Risk-Free rate of return

Capital Asset pricing theory asserts that portfolio returns are best explained by:

Systematic Risk

According to CAPM, the expected rate of return of a portfolio with a beta of 1.0 and an alpha of 0 is

The expected return on the market, R(m)

A zero-investment portfolio with a positive alpha could arise if

A risk-free arbitrage opportunity exists

According to the theory of arbitrage

Positive alpha investment opportunities will quickly disappear

The arbitrage pricing theory (APT) differs from the single-factor capital asset pricing model (CAPM) because the APT

Recognizes multiple systematic risk factors

An investor take as large a position as possible when an equilibrium price relationship is violated. This is an example of

Arbitrage Activity

The feature of arbitrage pricing theory (APT) that offers the greatest potential advantage over the simple CAPM is the

Use of several factors instead of a single market index to explain the risk-return relationship

In contrast to the capital asset pricing model, arbitrage pricing theory

Does not require the restrictive assumptions concerning the market portfolio.

The Semi-strong form of the efficient market hypothesis asserts that stock prices

Fully reflect all publicly available information

Assume that a company announces an unexpectedly large cash dividend to its shareholders. In an efficient market without information leakage, one might expect

An abnormal price change at the announcement

Which one of the following would provide evidence against the semi-strong form of the efficient market theory?

Low P/E stocks tend to have positive abnormal returns over the long run

According to the efficient market hypothesis

Positive alphas on stocks will quickly disappear

A "random walk" occurs when

Future price changes are uncorrelated with past price changes

Capital Asset Pricing Model (CAPM)

-It is the equilibrium model that underlies all modern financial theory

-Derived using principles of diversification with simplified assumptions

-Derived using principles of diversification with simplified assumptions

Assumptions of (CAPM)

1) Individual investors are price takers

2) Single period investment horizon

3) Investments are limited to trade financial assets

4) No taxes and transaction costs

5) Information is costless and available to all investors

6) Investors are rational mean-variance optimizers

7) There are homogeneous expectations

2) Single period investment horizon

3) Investments are limited to trade financial assets

4) No taxes and transaction costs

5) Information is costless and available to all investors

6) Investors are rational mean-variance optimizers

7) There are homogeneous expectations

Resulting Equilibrium Conditions of CAPM

- All investors will hold the same portfolio for risky assets - market portfolio

- Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value

- Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value

Resulting Equilibrium Conditions of CAPM (continued)

- Risk premium on the market depends on the average risk aversion of all market participants

- Risk premium on an individual security is a function of its covariance with the market

- Risk premium on an individual security is a function of its covariance with the market

Return and Risk for Individual Securities

- The Risk premium on individual securities is a function of the individual security's contribution to the risk of the market portfolio

- An individual security's risk premium is a function of the covariance of returns with the assets that make up the market portfolio

- An individual security's risk premium is a function of the covariance of returns with the assets that make up the market portfolio

Risk Premium (E(r(m)-r(f)) no the market

depends on the (harmonic) average risk aversion of all market participants

Return and Risk for Individual Securities

- Beta of security i measures how the return of i moves with the market

- Only systematic risk matters in determining the equilibrium expected return

- Unsystematic risk affects only a single security or a limited number of securities

- Systematic risk affects the entire market

- Only systematic risk matters in determining the equilibrium expected return

- Unsystematic risk affects only a single security or a limited number of securities

- Systematic risk affects the entire market

Alpha

The difference between the actual expected rate of return and that dictated by the SML

Information ratio

best if stock is mixed with market index fund

Sharpe ratio

most important in choosing stock if its only risky stock in portfolio

Treynor's measure

Best if one of many stocks that investor is analyzing to form an actively managed stock 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, one could use returns from one period to predict returns in later periods and make abnormal profits.

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.

" If all securities are fairly priced, all must offer equal expected rates of return" Comment.

Expected rates of return differ because of differential risk premiums.

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

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

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?

The question regarding market efficiency is whether investors can earn abnormal risk-adjusted profits. If the stock price run-up occurs when only insiders are aware of the coming dividend increase, then it is a violation of strong form, but not semi strong form, efficiency. If the public already knows of the increase, then it is a violation of semi-strong form efficiency.

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 dissapointment