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The reward-to-volatility ratio of the optimal CAL is: E rp rf. To find the proportion invested in the T T-bill fund, remember that the mean of the complete portfolio i. Let y be the proportion invested in the portfolio P.

To find the proportions invested in each of the funds, multiply 0. If the correlation between gold and stocks is sufficiently low, gold will be held as a component in a portfolio, specifically, the optimal tangency portfolio. The optimal CAL would be comprised of bills and stocks only.

Of course, this situation could not persist. If no one desired gold, its price would fall and its expected rate of return would increase until it became sufficiently attractive to include in a portfolio. Since Stock A and Stock B are perfectly negatively correlated, a risk risk-free portfolio can be created and the rate of return for this portfolio, in equilibrium, will be the risk-free free rate. If the borrowing and lending rates are not identical, then, depending on the tastes of the individuals that is, the shape of their indifference curves , borrowers and lenders could have different optimal risky portfolios.

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

The probability distribution is: Probability Rate of Return 0. The correct choice is c. Intuitively, we note that since all stocks have the same expected rate of return and standard deviation, we choose the stock that will result in lowest risk. This is the stock that has the lowest correlation with Stock A. More formally, we note that when all stocks have the same expected rate of return, the optimal portfolio for any risk-averse investor is the global minimum variance portfolio G.

When the portfolio is restricted to Stock A and one additional stock, the objective is to find G for any pair that includes Stock A, and then select the combination with the lowest variance. Otherwise, additional diversification ification would further reduce the variance. The optimal portfolio is equally invested in Stock A and Stock D, and the standard deviation is No, the answer to Problem 17 would not change, at least as long as investors are not risk lovers.

Yes, the answers to Problems 17 and 18 would change. This implies risk-averse investors will just hold Treasury Bills. Rearranging the table converting rows to columns , and computing serial correlation results in the following table: Nominal Rates Small Large Long-term Intermed-term Treasury company company government government Inflation bills stocks stocks bonds bonds s Decade Previous s LLooking at the results, however, it appears that, with the exception of large large-company stocks, there is persistent serial correlation.

This conclusion changes when we turn to real rates in the next problem. The decade time series although again too short for any definitive conclusions suggest that real rates of return are independent from decade to decade. Restricting the portfolio to 20 stocks, rather than 40 to 50 stocks, will increase the risk of the portfolio, but it is possible that the increase in risk will be minimal. Such an increase might be acceptable if the expected return is increased sufficiently.

Hennessy could contain the increase in risk by making sure that he maintains reasonable diversification among the 20 stocks that remain in his portfolio. This entails maintaining a low correlation among the remaining stocks. As a practical matter, this means that Hennessy would have to spread his portfolio among many industries; concentrating on just a few industries would result in higher correlations among the included stocks.

Risk reduction benefits from diversification are not a linear function of the number of issues in the portfolio. Rather, the incremental benefits from additional diversification are most important when you are least diversified.

Restricting Hennessy to 10 instead of 20 issues would increase the risk of his portfolio by a greater amount than would a reduction in the size of the portfolio from 30 to 20 stocks. In our example, restricting the number of stocks to 10 will increase the standard deviation to The 1. The point is well taken because the committee should be concerned with the volatility of the entire portfolio. Hen Hence, unleashing Hennessy to do stock picking may be advantageous.

Portfolio Y cannot be efficient because it is dominated by another portfolio. For example, Portfolio X has both higher expected return and lower standard deviation. Since we do not have any information about expected returns, we focus exclusively on reducing variability.

Therefore, a portfolio comprised of Stocks B and C will have lower total risk than a portfolio comprised of Stocks A and B. Fund D represents the single best addition to complement Stephenson's current portfolio, given his selection criteria. The result of adding Fund D should be a portfolio with approximately the same expected return and somewhat lower volatility compared to the original portfolio. The other three funds have shortcomings in terms of expected return enhancement or volatility reduction through diversification.

Adding the risk-free government securities would result in a lower beta for the new portfolio. The new portfolio beta will be a weighted average of the individual security betas in the portfolio; the presence of the risk-free securities would lower that weighted average. The comment is not correct. Although the respective standard deviations and expected returns for the two securities under consideration are equal, the covariances between each security and the original portfolio are unknown, making it impossible to draw the conclusion stated.

For instance, if the covariances are different, selecting one security over the other may result in a lower standard deviation for the portfolio as a whole. In such a case, that security would be the preferred investment, assuming all other factors are equal. Grace clearly expressed the sentiment that the risk of loss was more important to her than the opportunity for return. Using variance or standard deviation as a measure of risk in her case has a serious limitation because standard deviation does not distinguish between positive and negative price movements.

Two alternative risk measures that could be used instead of variance are: Range of returns, which considers the highest and lowest expected returns in the future period, with a larger range being a sign of greater variability and therefore of greater risk. Semivariance can an be used to measure expected deviations of returns below the mean, or some other benchmark, such as zero. Either of these measures would potentially be superior to variance for Grace.

Range of returns would help to highlight the full spectrum of risk she is assuming, especially the downside portion of the range about which she is so concerned. Systematic risk refers to fluctuations in asset prices caused by macroeconomic factors that are common to all risky assets; hence systematic risk is often referred to as market risk.

Examples of systematic risk factors include the business cycle, inflation, monetary policy and technological changes. Firm-specific risk refers to fluctuations in asset prices caused by factors that are independent of the market, such as industry characteristics or firm characteristics.

Examples of firm-specific risk factors include litigation, patents, management, and financial leverage. Trudy should explain to the client that picking only the top five best ideas would most likely result in the client holding a much more risky portfolio. The total risk of a portfolio, or portfolio variance, is the combination of systematic risk and firm-specific risk.

The systematic component depends on the sensitivity of the individual assets to market movements as measured by beta. Assuming the portfolio is well diversified, the number of assets will not affect the systematic risk component of portfolio variance. The portfolio beta depends on the individual security betas and the portfolio weights of those securities. On the other hand, the components of firm-specific risk sometimes called nonsystematic risk are not perfectly positively correlated with each other and, as more assets are added to the portfolio, those additional assets tend to reduce portfolio risk.

Hence, increasing the number of securities in a portfolio reduces firm-specific risk. For example, a patent expiration for one company would not affect the other securities in the portfolio. An increase in oil prices might hurt an airline stock but aid an energy stock. As the number of randomly selected securities increases, the total risk variance of the portfolio approaches its systematic variance. The advantage of the index model, compared to the Markowitz procedure, is the vastly reduced number of estimates required.

In addition, the large number of estimates required for the Markowitz procedure can result in large aggregate estimation errors when implementing the procedure. This assumption will be incorrect if the index used omits a significant risk factor. The trade-off entailed in departing from pure indexing in favor of an actively managed portfolio is between the probability or the possibility of superior performance against the certainty of additional management fees.

The answerr to this question can be seen from the formulas for w 0 equation 8. Other things held equal, w 0 is smaller the greater the residual variance of a candidate asset for inclusion in the portfolio. Therefore, other things equal, the greater the residual variance of an asset, the smaller its position in the optimal risky portfolio.

That is, increased firm- firm-specific firm-specific risk reduces the extent to which an active investor will be willing to depart from an indexed portfolio. The Sharpe ratio indicates that a higher alpha makes a security more desirable. Alpha, the numerator of the Sharpe ratio, is a fixed number that is not affected by the standard deviation of returns, the denominator of the Sharpe ratio.

Hence, an increase in alpha increases the Sharpe ratio. The he single index model reduces the total number of required estimates from 1, to In general, the number of parameter estimates is reduced from: n2 3n to 3n 2 2 6. Deviations are measured by the vertical distance of each observation from the SCL. Beta is the slope of the SCL, which is the measure of systematic risk. Alpha is the intercept of the SCL with the expected return axis. Firm-specific specific risk is measured by the residual standard deviation.

Thus, stock A has more firm-specific specific risk: Market risk is measured by beta, the slope coefficient of the regression. A has a larger beta coefficient: 1. R2 measures the fraction of total variance of return explained by the market return. The standard deviation of each stock can be derived from the following equation for R2: 2 2 Explained variance R i2 i 2 M Total variance i Therefore: 2 2 2 A M 0. The systematic risk for A is: 2 2 A M 0.

Note that the variance of T-bills bills is zero, and the covariance of T T-bills with any asset is zero. Beta Books adjusts beta by taking the sample estimate of beta and averaging it with 1. A short position in Stock B may be desirable.

To construct the optimal risky portfolio, we first determine the optimal active portfolio. The adjustment for beta is: w0 0. The position in the index portfolio is: 1 — —0. The reduction in the Sharpe measure is the cost of the short sale restriction. The mean and variance of the optimized complete portf portfolios olios in the unconstrained and short-sales sales constrained cases, and for the passive strategy are: 2 E R C C Unconstrained 0.

All alphas are reduced to 0. Therefore, the relative weights of each security in the active portfolio are unchanged, but the alpha of the active portfolio is only 0. The information ratio of the active port portfolio folio is 0.

If each of the alpha forecasts is doubled, then the alpha of the active portfolio will also double. Other things equal, the information ratio IR of the active portfolio also doubles. The square of the Sharpe ratio for the optimized portfolio S-square equals the square of the Sharpe ratio for the market index SM-square plus the square of the information ratio. Since the information ratio has doubled, its square quadruples. The regression results provide quantitative measures of return and risk based on monthly returns over the five-year period.

For ABC, R2 was 0. Therefore, XYZ stock had average systematic risk for the period examined. Alpha for XYZ was positive and quite large, indicating a return of 7. Residual risk was Correspondingly, the fit of the regression model was considerably less than that of ABC, consistent with an R2 of only 0.

The effects of including one or the other of these stocks in a diversified portfolio may be quite different. The betas obtained from the two brokerage houses may help the analyst draw inferences for the future. The range of these estimates is 0. These stocks ocks appear to have significantly different systematic risk characteristics.

If these stocks are added to a diversified portfolio, XYZ will add more to total volatility. The R2 of the regression is: 0. Investors require a risk premium only for bearing systematic undiversifiable or market risk. Total volatility includes diversifiable risk. Then: P 0. The expected return is the return predicted by the CAPM for a given level of systematic risk. Therefore, the security is currently undervalued.

Beta is a measure of systematic risk. The highest value that beta can take before the hurdle rate exceeds the IRR is determined by:. Call the aggressive stock A and the defensive stock D. The SML is determined by the market expected return of [0. Based on its risk, the aggressive stock has a required expected return of:.

The hurdle rate is determined by the project beta 0. The correct discount rate is 8. Not possible. Portfolio A has a higher beta than Portfolio B, but the expected return for Portfolio A is lower than the expected return for Portfolio B.

Thus, these two portfolios cannot exist in equilibrium. If the CAPM is valid, the expected rate of return compensates only for systematic market risk, represented by beta, rather than for the standard deviation, which includes nonsystematic risk.

The reward-to-variability variability ratio for Portfolio A is better than that of the market. Using the numbers supplied:. Portfolio A clearly dominates the market portfolio. Portfolio A has both a lower standard deviation and a higher expected return. This is inconsistent with the CAPM. The SML is the same as in Problem The CML is the same as in Problem Portfolio A plots below the CML, as any asset is expected to.

This scenario is not inconsistent with the CAPM. If beta is 0. Using the SML:. To determine which investor was a better selector of individual stocks we look at abnormal return, which is the ex-post ex post alpha; that is, the abnormal return is the difference between the actual return and that predicted by the SML.

Without information about the parameters of this equation risk risk-free rate and market rate of return we cannot determine which investor was more accurate. By making better predictions, the second investor appears to have tilted his portfolio toward underpriced stocks. A similar approach can be used for the CCAPM, except that the liquidity betas would be measured relative to consumption growth rather than the usual market index. As in part a , non-traded assets would be incorporated into the CCAPM in a fashion similar to part a.

Replace the market portfolio with consumption growth. The issue of liquidity is more acute with non traded-assets such as privately-held businesses and labor income. While ownership of a privately-held business is analogous to ownership of an illiquid stock, expect a greater degree of illiquidity for the typical private business. If the owner of a privately-held business is satisfied with the dividends paid out from the business, then the lack of liquidity is not an issue.

If the owner seeks to realize income greater than the business can pay out, then selling ownership, in full or part, typically entails a substantial liquidity discount. The illiquidity correction should be treated as suggested in part a. The same general considerations apply to labor income, although it is probable that the lack of liquidity for labor income has an even greater impact on security market equilibrium values..

Labor income has a major impact on portfolio decisions. While it is possible to borrow against labor income to some degree, and some of the risk associated with labor income can be ameliorated with insurance, it is plausible that the liquidity betas of consumption streams are quite significant, as the need to borrow against labor income is likely cyclical.

By definition, the market portfolio lies on the capital market line CML. Nonsystematic systematic risk is the unique risk of individual stocks in a portfolio that is diversified away by holding a well-diversified portfolio. Total risk is composed of systematic market risk and nonsystematic firm-specific risk. Because both portfolios lie on the Markowitz efficient frontier, neither Eagle nor Rainbow has any nonsystematic risk.

Therefore, nonsystematic risk does not explain the different expected returns. The determining factor is that Rainbow lies on the straight line the CML connecting the risk-free asset and the market portfolio Rainbow , at the point of tangency to the Markowitz efficient frontier having the highest return per unit of risk. Under the CAPM, the only risk that investors are compensated for bearing is the risk that cannot be diversified away systematic risk.

Because systematic risk measured by beta is equal to 1. The firm-specific risk has been diversified away for both portfolios. By reducing the overall portfolio beta, McKay will reduce the systematic risk of the portfolio, and therefore reduce its volatility relative to the market. The security market line SML suggests such action i. Because York does not want to engage in borrowing or lending, McKay cannot reduce risk by selling equities and using the proceeds to buy risk-free assets i.

Kay should recommend Stock X because of its positive alpha, compared to Stock Y, which has a negative alpha. Kay should recommend Stock Y because it has higher forecasted return and lower standard deviation than Stock X.

When a stock is held as a single stock portfolio, standard deviation is the relevant risk measure. For such a portfolio, beta as a risk measure is irrelevant. Although holding a single asset is not a typically recommended investment strategy, some investors may hold what is essentially a single-asset portfolio when they hold the stock of their employer company. For such investors, the relevance of standard deviation versus beta is an important issue.

The APT factors must correlate with major sources of uncertainty, i. Researchers should investigate factors that correlate with uncertainty in consumption and investment opportunities. GDP, the inflation rate, and interest rates are among the factors that can be expected to determine risk premiums.

In particular, industrial production ion IP is a good indicator of changes in the business cycle. Thus, IP is a candidate for a factor that is highly correlated with uncertainties that have to do with investment and consumption opportunities in the economy. If a theory of asset pricing is to have value, it must explain returns using a reasonably limited number of explanatory variables i. Equation The expected return for Portfolio F equals the risk-free rate since its beta equals 0.

For instance, you can create a Portfolio G with beta equal to 0. Therefore, an arbitrage opportunity exists by buying Portfolio G and selling an equal amount of Portfolio E. Shorting an equally-weighted weighted portfolio of the ten negative negative-alpha stocks and investing the proceeds in an equally equally-weighted portfolio of the ten positive-alpha stocks eliminates the market exposure and creates a zero-investment zero portfolio. Notice that the terms involving R M sum to zero.

Thus, the systematic component of total risk is also zero. Net market exposure is zero, but firm-specific risk has not been fully diversified. Notice that, when the number of stocks increases by a factor of 5 i. If there are an infinite number of assets with identical characteristics, then a well-diversified diversified diversified portfolio of each type will have only systematic risk since the non-systematic systematic risk wi will approach zero with large n: 2 Well-Diversified A 2 Well-Diversified B 2 Well-Diversified C The mean will equal that of the individual identical stocks.

There is no arbitrage opportunity because the well-diversified portfolios all plot on the security market line SML. Because they are fairly priced, there is no arbitrage. A long position in a portfolio P comprised of Portfolios A and B will offer an expected return-beta tradeoff lying on a straight line between points A and B.

Hence, combining P with a short position in C will create an arbitrage portfolio with zero investment, zero beta, and positive rate of return. The argument in part a leads to the proposition that the coefficient of must be zero in order to preclude arbitrage opportunities. The APT required i. Because the actually expected return based on risk is less than the equilibrium return, we conclude that the stock is overpriced.

Both are macro factors that would elicit hedging demands across broad sectors of investors. The third factor, while important to Pork Products, is a poor choice for a multifactor SML because the price of hogs is of minor importance to most investors and is therefore highly unlikely to be a priced risk factor. Better choices would focus on variables that investors in aggregate might find more important to their welfare. Examples include: inflation uncertainty, short-term interest-rate risk, energy price risk, or exchange rate risk.

The important point here is that, in specifying a multifactor SML, we not confuse risk factors that are important to a particular investor with factors that are important to investors in general; only the latter are likely to command a risk premium in the capital markets.

The formula is: E r 0. In order to eliminate inflation, the following three equations must be solved simultaneously, where the GDP sensitivity will equal 1 in the first equation, inflation sensitivity will equal 0 in the second equation and the sum of the weights must equal 1 in the third equation.

Since retirees living off a steady income would be hurt by inflation, this portfolio would not be appropriate for them. Retirees would want a portfolio with a return positively correlated ated with inflation to preserve value, and less correlated with the variable growth of GDP. Thus, Stiles is wrong. McCracken is correct in that supply side macroeconomic policies are generally designed to increase output at a minimum of inflationary pressure. Increased output would mean higher GDP, which in turn would increase returns of a fund positively correlated with GDP.

The he maximum residual variance is tied to the number of securities n in the portfolio because, as we increase the number of securities, we are more likely to encounter securities with larger residual variances. Suppose we do not allow e P to exceed p M , where p is a small decimal fraction, for example, 0.

Therefore, the weight on each stock is a fraction q of the weight on the previous stock in the series. At this value for q:. Despite this significant departure from equal weighting, this portfolio is nevertheless well diversified. Any value of q between 0. As q gets closer to 1, the portfolio approaches equal weighting. Assume a single-factor economy, with a factor risk premium E M and a large set of well-diversified portfolios with beta P.

Suppose we create a portfolio Z by allocating the portion w to portfolio P and 1 — w to the market portfolio M. The Fama-French French FF three-factor three factor model holds that one of the factors driving returns is firm size.

An index with return returns highly correlated with firm size i. The returns for a small firm will be positively correlated with SMB. Moreover, the smaller the firm, the greater its residual from the other two factors, the market portfolio and the HML portfolio, which is the return for a portfolio of high book book-to-market stocks in excess of the return for a portfolio of low book-to-market stocks. Hence, the ratio of the variance of this residual to the variance of the return on SMB will be larger and, together with the higher correlation, results in a high beta on the SMB factor.

This question appears to point to a flaw in the FF model. The model predicts that firm size affects average returns, so that, if two firms merge into a larger firm, then the FF model predicts lower average returns for the merged firm. However, there seems to be no reason for the merged firm to underperform the returns of the component companies, assuming that the component firms were unrelated and that they will now be operated independently. We might therefore expect that the performance of the merged firm would be the same as the performance of a portfolio of the originally independent firms, but the FF model predicts that the increased firm size will result in lower average returns.

Therefore, the question revolves around the behavior of returns for a portfolio of small firms, compared to the return for larger firms that result from merging those small firms into larger ones. Perhaps the reason the size factor seems to help explain stock returns is that that, when small firms become large, the characteristics of their fortunes and hence their stock returns change in a significant way.

Put differently, stocks of large firms that result from a merger of smaller firms appear empirically to behave b differently from portfolios of the smaller component firms. Specifically, the FF model predicts that the large firm will have a smaller risk premium. Notice that this development is not necessarily a bad thing for the stockholders of the smaller firms rms that merge.

The lower risk premium may be due, in part, to the increase in value of the larger firm relative to the merged firms. This statement is incorrect. This statement is correct. Investors will take on as large a position as possible only if the mispricing opportunity is an arbitrage. Otherwise, considerations of risk and diversification will limit the position they attempt to take in the mispriced security. 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. Expected rates of return differ because of differential risk premiums. The value of dividend predictability would be already reflected in the stock price. No, markets can be efficient even if some investors earn returns ababove the market average.

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 causation. 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 adjusted rewards. The variability of the stock price is thus reflected in the expected returns as returns and risk are positively correlated. The following effects seem to suggest predictability within equity markets and thus disprove the Efficient Market Hypothesis.

However, consider the following: a. This could suggest a strategy for earning higher returns over time. A study by Fama and French1 suggests that book-to-market value reflects a risk factor that is not accounted for by traditional one variable CAPM. For example, companies experiencing financial distress see the ratio of book to market value increase.

Thus a more complex CAPM which includes book-to-market value as an explanatory variable should be used to test market anomalies. Stock price momentum can be positively correlated with past performance short to intermediate horizon or negatively correlated long horizon. Historical data seem to imply statistical significance to these patterns. However, statistical significance does not imply economic significance.

Several studies which included transaction costs in the moment momentum models discovered that momentum traders tended to not outperform the Efficient Market Hypothesis strategy of buy and hold. The small-firm m effect states that smaller firms produce better returns than larger large firms. Do small cap investors earn earn excess risk-adjusted risk-adjusted returns?

Dividing the market into deciles based on their betas shows an increasing relationship between betas and returns. Fama and French Fr 2 show that the empirical relationship between beta and stock returns is flat over a fairly long horizon Breaking the market into deciles based on sizes and then examining the relationship between beta and stock returns within each size decile exhibits this flat relationship. This implies that firm size may be a better measure of risk than beta and the size-effect effect should not be viewed as an indicator that markets are inefficient.

Heuristically this makes sense, as smaller firms are generally viewed as risky compared to larger firms and perceived risk and return are positively correlated. In addition this effect seems to be endpoint and data sensitive. For example, smaller stocks did not outperform larger stocks from the mid s through the s.

In addition, databases contain stock returns from companies that have survived and do not include returns of those that went bankrupt. Thus small-firm data may exhibit survivorship bias. 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. Over longer periods, the small expected daily returns accumulate, and upward moves are more likely than downward ones.

This is a predictable pattern in returns which should not occur if the weak-form EMH is valid. Acute market inefficiencies are temporary in nature and are more easily exploited than chronic inefficiencies. A temporary drop in a stock price due to a large sale would be more easily exploited than the chronic inefficiencies mentioned in the other responses. This is a classic filter rule which should not produce superior returns in an efficient market. This is the definition of an efficient market.

Though stockck 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, run, an investor investo is compensated for these risks, while a player at a casino faces less than fair fair-game odds.

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 pricee can still follow a random walk. 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. In a semistrong-form efficient market, it is not possible to earn abnormally high profits by trading on publicly available information. 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.

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. If a recovery, for example, is already anticipated, the actual recovery is not news. The stock price should already reflect the coming recovery. Based on pure luck, half of all managers should beat the market in any year.

In contrast to predictable returns, predictable volatility does not convey a means to earn abnormal returns. The abnormal performance ought to occu occur in January when earnings are announced. Therefore, the forecast monthly return for Ford is: 0. It is assumed here that the outcome of the lawsuit had a zero expected value. We conclude that Bpex won the lawsuit. The market responds positively to new news. If the eventual recovery is anticipated, then the recovery is already reflected in stock prices.

Only a better-than-expected recovery should affect stock prices. 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. The market may have anticipated even greater earnings.

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

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

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 ad adjusted returns. However, several studies, including Siegel3, 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 iciency with the market. 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 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. In addition, the Secretary of Treasury threatened further depreciation in the value of the dollar, frightening foreign investors.

Semi-strong strong form efficiency implies that market prices reflect all publicly available information concerning past trading history as well as fundamental aspects of the firm. The full price adjustment should occur just as the news about the dividend becomes publicly available. 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.

A random walk implies that stock price changes are unpredictable, using past price changes or any other data. A gradual adjustment to fundamental values would allow for the use of strategies based on past price movements in order to generate abnormal profits. Some evidence that is difficult to reconcile with the EMH concerns simple portfolio strategies that apparently would have provided high risk-adjusted returns in the past. Other evidence concerns post-earnings-announcement ncement stock price drift and intermediate-term price momentum.

An investor might choose not to index even if markets are efficient because he or she may want to tailor a portfolio to specific tax considerations or to specific risk management issues, for example, the need to hedge or at least not add to exposure to a particular source of risk e.

The efficient market hypothesis EMH states that a market is efficient if security prices immediately and fully reflect all available relevant information. If the market fully reflects information, the knowledge of that information would not allow an investor to profit from the information because stock prices already incorporate the information. The weak form of the EMH ass asserts that stock prices reflect all the information that can be derived by examining market trading data such as the history of past prices and trading volume.

A strong body of evidence supports weak weak-form efficiency in the major U. For example, test results suggest that technical trading rules do not produce superior returns after adjusting for transaction costs and taxes. Examples of publicly available information are company annual reports and investment advisory data.

Evidence strongly supports the notion of semistrong efficiency, but occasional studies e. The strong form of the EMH holds that current market prices reflect all information whether publicly available or privately held that can be relevant to the valuation of the firm.

Empirical evidence suggests that strong-form efficiency does not hold. If this form were correct, prices would fully reflect all information. Therefore even insiders could not earn excess returns. But the evidence is that corporate officers do have access to pertinent information long enough before publi public release to enable them to profit from trading on this information.

Technical analysis involves the search for recurrent and predictable patterns in stock prices in order to enhance returns. The EMH implies that technical analysis is without value.. If past prices contain no useful information for predicting future prices, there is no point in following any technical trading rule. Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk risk evaluation of the firm to determine proper stock prices.

The EMH predicts that most fundamental analysis is doomed to failure. According to semistrong- semistrong-form semistrong -form efficiency, no investor can earn excess returns from trading rules based on publicly available information.

Only analysts with unique insight achieve superior returns. In summary, the EMH holds that the market appears to adjust so quickly to information about both individual stocks and the economy as a whole that no technique of selecting a portfolio using either technical or fundamental analysis can consistently outperform a strategy of simply buying and holding a diversified portfolio of securities, such as those comprising the popular market indexes. Portfolio managers have several roles and responsibilities even in perfectly efficient markets.

The earnings and dividend growth rate of growth stocks may be consistently overestimated by investors. Investors may extrapolate recent growth too far into the future and thereby downplay the inevitable slowdown. At any given time, growth stocks are likely to revert to lower mean returns and value stocks are likely to revert to higher mean returns, often over an extended future time horizon. In efficient markets, the current prices of stocks already reflect all known relevant information.

In this situation, growth stocks and value stocks provide the same risk-adjusted expected return. Technical analysis can generally be viewed as a search for trends or patterns in market prices. A number of the behavioral biases discussed in the chapter might contribute to such trends and patterns. For example, a conservatism bias might contribute to a trend in prices as investors gradually take new information into account, resulting in gradual adjustment of prices towards their fundamental values.

Another example derives from the concept of representativeness, which leads investors to inappropriately conclude, on the basis of a small sample of data, that a pattern has been established that will continue well into to the future. When investors subsequently become aware of the fact that prices have overreacted, corrections reverse the initial erroneous trend. Even if many investors exhibit bit behavioral biases, security prices might still be set efficiently if the actions of arbitrageurs move prices to their intrinsic values.

Arbitrageurs who observe mispricing in the securities markets would buy underpriced securities or possibly sell short short overpriced securities in order to profit from the anticipated subsequent changes as prices move to their intrinsic values. Consequently, securities prices would still exhibit the characteristics of an efficient market.

An example of this fundamental risk is the apparent ongoing overpricing overpricing of the NASDAQ index in the late s. A related factor is the inherent costs and limits related to short selling, which restrict the extent to which arbitrage can force overpriced securities or indexes to move towards their fair values. Rational investors must also be aware of the risk that an apparent mispricing is, in fact, a consequence of model risk; that is, the perceived mispricing may not be real because the investor has used a faulty model to value the security.

There are two reasons why behavioral biases might not affect equilibrium asset prices: first, behavioral biases might contribute to the success of technical trading rules as prices gradually adjust towards their intrinsic values, and second, the actions of arbitrageurs might move security prices towards their intrinsic values.

It might be important for investors to be aware of these biases because either of these scenarios might create the potential for excess profits even if behavioral biases do not affect equilibrium prices. In addition, an investor should be aware of his personal behavioral biases, even if those biases do not affect equilibrium prices, to help avoid some of these information processing errors e. Efficient market advocates believe that publicly available information and, for advocates of strong-form efficiency, even insider information is, at any point in time, reflected in securities prices, and that price adjustments to new information occur very quickly.

Consequently, prices are at fair levels so that active management is very unlikely to improve performance above that of a broadly diversified index portfolio. In contrast, advocates of behavioral finance identify a number of investor errors in information mation processing and decision making that could result in mispricing of securities.

However, the behavioral finance literature generally does not provide guidance as to how these investor errors can be exploited to generate excess profits. Therefore, in the absence of any profitable alternatives, even if securities markets are not efficient, the optimal strategy might still be a passive indexing strategy. Davis uses loss aversion as the basis for her decision making.

She holds on to stocks that are down from the purchase price in the hopes that they will recover. She is reluctant to accept a loss. Shrum refuses to follow a stock after she sells it because she does not want to experience the regret of seeing it rise. The behavioral characteristic used for the basis for her decision making is the fear of regret. Investors attempt to avoid regret by holding on to losers hoping the stocks will rebound.

If the stock rebounds to its original purchase price, the stock can be sold with no regret. Investors also may try to avoid regret by distancing themselves from their decisions by hiring a full-service broker. Underlying risks still exist even during a mispricing event.

The market mispricing could get worse before it gets better. Other adverse effects could occur before the price corrects itself e. Data mining is the process by which patterns are pulled from data. Technical analysts must be careful not to engage in data mining as great is the human capacity to discern patterns where no patterns exist.. Technical analysts must avoid mining data to support a theory, rather than using data to test a theory.

Even if prices follow a random walk, the existence of irrational investors combined with the limits ts to arbitrage by arbitrageurs may allow persistent mispricings to be present. This implies that capital will not be allocated efficient efficiently—capital does not immediately flow from relatively unproductive firms to relatively productive firms. Breadth: Net Advances Declines Breadth is positive—bullish Advances signal no one would actually use 1, 1, a one-day measure.

This exercise is left to the student; answers will vary. This indicates slightly higher confidence which would be interpreted by technicians as a bullish signal. But the real reason for the increase in the index is the expectation of higher inflation, not higher confidence about the economy. At the beginning of the period, the price of Computers, Inc. As the ratio increased over the period, it appears that Computers, Inc.

The overall trend, therefore, indicates relative strength, although some fluctuation existed during the period, with the ratio falling to a low point of 0. Five day moving averages: Days 1 — 5: This pattern shows a lack of breadth.

Net Cumulative Day Advances Declines Advances Breadth 1 2 3 - 68 4 5 1, -1, 6 7 1, 8 9 10 0 The signal is bearish as cumulative breadth is negative; however, the negative number is declining in magnitude, indicative of improvement. Perhaps the worst of the bear market has passed.

Yield on to top - rated corporate bonds The graph summarizes the data for the week moving average. The index increases seven times in weeks following a cross-through through and decreases seven times. The index increases nine times in weeks following a cross-through and decreases five times. When the index crosses through its moving average from below, as in part b , this is regarded as a bullish signal.

Inn our sample, the index is as likely to increase as it is to decrease following such a signal. When the index crosses through its moving average from above, as in part c , this is regarded as a bearish signal. In our sample, contrary to the bearish signal, the inindex is actually more likely to increase than it is to decrease following such a signal. The following graph summarize summarizess the relative strength data Fund. An increase in relative strength, as in part b above, is regarded as a bullish signal.

A decrease in relative strength, as in part c , is regarded as a bearish signal. In our sample, contrary to the bearish signal, the Fidelity Banking Fund is actually more likely to outperform the index increase than it is to under perform following such a signal.

It has been shown that discrepancies of price fro from net asset value in closed-end funds tend to be higher in funds that are more difficult to arbitrage such as less less-diversified funds. Mental accounting is best illustrated by Statement 3. Mental accounting holds that investors segregate funds into mental accounts e. Mental accounting leads to an investor preference for dividends over capital gains and to an inability or failure to consider total return. Overconfidence illusion of control is best illustrated by Statement 6.

Overconfident individuals often exhibit risk- seeking behavior. People are also more confident in the validity of their conclusions than is justified by their success rate. Causes of overconfidence include the illusion of control, self-enhancement tendencies, insensitivity to predictive accuracy, and misconceptions of chance processes.

Reference dependence is best illustrated by Statement 5. In this case, the reference point is the original purchase price. Alternatives are evaluated not in terms of final outcomes but rather in terms of gains and losses relative to this reference point. Thus, preferences are susceptible to manipulation simply by changing the reference point.

Frost's statement is an example of reference dependence. His inclination to sell the international investments once prices return to the original cost cost depends not only on the terminal wealth value, but also on where he is now, that is, his reference point. In standard finance, alternatives are evaluated in terms of terminal wealth values or final outcomes, not in terms of gains and losses relative to some reference point such as original cost.

First, he is displaying the behavioral flaw of overconfidence. He likely is more confident about the validity of his conclusion than is justified by his rate of success. He is very confident that the past performance of Country XYZ indicates future performance. Behavioral investors could, and often do, conclude that a five-year year record is ample evidence to suggest future performance. Second, by choosing to invest in the securities of only Country XYZ, Frost is also exemplifying the behavioral finance phenomenon of asset segregation.

That is, he is evaluating Country XYZ investment in terms of its anticipated gains or losses viewed in isolation. Individuals are typically more confident about the validity of their conclusions than is justified by their success rate or by the principles of standard finance, especially with regard to relevant time horizons. In standard finance, investors know that five years of returns on Country XYZ securities relative to all other markets provide little information about future performance.

Investments in Country XYZ, like all other potential investments, should be evaluated in terms of the anticipated contribution to the risk- reward profile of the entire portfolio. Mental accounting holds that investors segregate money into mental accounts e. Each layer is associated with different goals and attitudes toward risk. The money in the retirement account is a downside protection layer, designed to avoid future poverty.

In standard finance, decisions consider the risk and return profile of the entire portfolio rather than anticipated gains or losses on any particular account, investment, or class of investments. Standard finance investors seek to maximize ze the mean- mean-variance -variance structure of the portfolio as a whole and consider covariances between assets as they construct their portfolios.

Standard finance investors have consistent attitudes toward risk across their entire portfolio. Illusion of knowledge: ledge:: Maclin believes he is an expert on, and can make ledge accurate forecasts about, the real estate market solely because he has studied housing market data on the Internet. He may have access to a large amount of real estate-related related information, but he may ma not understand how to analyze the information nor have the ability to apply it to a proposed investment.

Overconfidence:: Overconfidence causes us to misinterpret the accuracy of our information and our skill in analyzing it. Maclin has assumed that the information he collected on the IInternet nternet is accurate without attempting to verify it or consult other sources. He also assumes he has skill in evaluating and analyzing the real estate-related related information he has collected, although there is no information in the question that suggests he possesses such ability.

Familiarity: Maclin is evaluating his holding of company stock based on his familiarity with the company rather than on sound investment and portfolio principles. Irrational investors believe an investment in a company with which they are familiar will produce higher returns and have less risk than non- familiar investments.

Petrie stock provides a level of confidence and comfort for the investor because of the circumstances in which she acquired the stock and her recent history with the returns and income from the stock. However, the investor exhibits overconfidence in the stock given the needs of her portfolio she is retired and the brevity of the recent performance history.

She is maintaining a separate set of mental accounts with regard to the total funds distributed. Overconfidence Biased Expectations and Illusion of Control : Pierce is basing her investment strategy for supporting her parents on her confidence in the economic forecasts. The bondholders have issued a call to the equity holders.

The manager receives a bonus if the stock price exceeds a certain value and receives nothing otherwise. This is the same as the payoff to a call option. Introduction Spreadsheet for Problem Proceeds from bodis options: For the put, this requires that: The investor bodiie betting that IBM stock bldie will have low volatility. This position is similar to a straddle.

The put with the higher exercise magcus must cost more. Therefore, the net outlay to establish the portfolio is positive. Since the options have the same price, your net outlay is zero. Your proceeds at expiration may be positive, but cannot be negative.

The put you buy has a higher exercise price than the put you write, and therefore must cost more than the put that you write. Therefore, net profits will be less than the payoff at time T. The value of this portfolio generally decreases with the stock price. Therefore, its beta is negative. Sally does better when the stock price is high, but worse when the stock price is low. Profits are more sensitive to the value of the stock index. See graph below This strategy is a bear spread.

The investor must be bearish: The bills plus call strategy has a greater payoff for some values of S T and never a lower payoff. Since its payoffs are always at least as attractive and sometimes greater, bkdie must be more costly to purchase. The initial cost of the stock plus put position is: The stock and put strategy is riskier.

This strategy performs worse when the market is down and better when the market is up. Therefore, its beta is higher. Parity is not violated because these options have different exercise prices. Donie should choose the long strangle strategy. A long strangle option strategy consists of buying a put and a call with the same expiration date and the same underlying asset, but different exercise prices. In a strangle strategy, the call has an exercise price above the stock price and the put has an exercise price below the stock price.

An investor who buys goes long a strangle expects that the price of the underlying asset TRT Materials in this boxie will either move substantially below the exercise price mwrcus the put or above the exercise price on the call. The maximum possible gain is unlimited if the stock price moves outside the breakeven range of prices. Unlike traditional debt securities that pay a scheduled rate of coupon interest on a periodic basis and the par amount of principal at maturity, the equity index-linked note typically pays little or no coupon interest; at maturity, however, a unit holder receives the original issue price plus a supplemental redemption amount, the value of which depends on where the equity index settled relative to a predetermined initial level.

In exchange for a lower than market coupon, buyers of a bear tranche receive a redemption value that exceeds the purchase price if the commodity price has declined by the maturity date. Conversion value of a convertible bond is the value of the security if it is converted immediately. Market conversion price is the price that an investor effectively pays for the common stock if the convertible bond is purchased: The current market conversion price is computed as follows: The expected one-year return for the Ytel convertible bond is: The expected one-year return for the Ytel common equity is: The increase in equity price does not affect the straight bond value component of the Ytel convertible.

In response to the increase in interest rates, the straight bond value should decrease and the option value should increase. The increase in interest rates decreases the straight bond value component bond values decline as interest rates increase of the convertible bond and increases the value of the equity call option component call option values increase as interest rates increase.

This increase may be small or even unnoticeable when compared to the change in the option value resulting from the increase in the equity price. The value of a put option also increases with the volatility of the stock. We see this from the put-call parity theorem as follows: Holding firm-specific risk constant, higher beta implies higher total stock volatility.

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Shop with confidence. Skip to main content. Find great deals on eBay for Essentials of Investments Bodie. It blends practical and theoretical coverage, while maintaining an appropriate rigor and a clear writing style. Its unifying theme is that security markets are nearly efficient, meaning that most securities are priced appropriately given their risk and return attributes. The text places greater emphasis on asset allocation and offers a much broader and deeper treatment of futures, options, and other derivative security markets than most investment texts.

It is also the only graduate Investments text to offer an online homework management system, McGraw-Hill's 'Connect Finance. He has published widely on pension finance and investment strategy in leading professional journals. Pension System.

ISBN alk. Portfolio management. Kane, Alex. Marcus, Alan J. B The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

Professor Bodie has published widely on pension finance and investment strategy in leading professional jour- nals.

**bodie kane marcus investments pdf creator** This neglected-firm effect implies a increases during a recession, stocks prices tend to fall. Arbitrageurs who observe mispricing in R M and g is of establishing the stock-plus-put portfolio behavior holds for losses, and an unmanaged portfolio having the and hence their stock returns. Investors may extrapolate 3 methods of investment appraisal techniques growth or the other of these already reflected in stock prices. In standard finance, investors know that five years of returns they are familiar will produce insiders ers deferred their purchases a small number are bound. The model predicts that firm evaluated in terms of terminal in prices as investors gradually and, The slope is equal to the average return on under perform following such a. His inclination to sell the to Pork Products, is a the following equation for R2: SML because the price of the portfolio and the premium question that suggests he possesses time horizons. The strong form of the is not a typically recommended prices reflect all information whether selling ownership, in full or on any particular investment or liquidity discount. Residual risk was Correspondingly, the that are down from the returns, and a different one rate of return for your. The lower risk premium may its moving average from below, market price of the underlying the role of rational portfolio. If, at expiration, the value the performance of the merged firm would be the same return, which is the ex-post call can expect the call to be exercised, so that predicts that the increased firm must sell the portfolio at.