REVISION QUESTIONS CHAPTER 7 (MARKET EFFICIENCY)

Concept Questions

1. The market is not weak-form efficient.

2. Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators
provide liquidity to markets and thus help promote efficiency.

3. The efficient markets paradigm only says, within the bounds of increasingly strong assumptions about
the information processing of investors, that assets are fairly priced. An implication of this is that, on
average, the typical market participant cannot earn abnormal profits from a particular trading strategy.
However, that does not mean that a few particular investors cannot outperform the market over a
particular investment horizon. Certain investors who do well for a period of time get a lot of attention
from the financial press, but the scores of investors who do not do well over the same period of time
generally get considerably less attention.

4.

a. If the market is not weak form efficient, then this information could be acted on and a profit
could be earned from following the price trend. Under 2, 3, and 4, this information is fully
impounded in the current price and no abnormal profit opportunity exists.

b. Under 2, if the market is not semistrong form efficient, then this information could be used to
buy the stock “cheap” before the rest of the market discovers the financial statement anomaly.
Since 2 is stronger than 1, both imply a profit opportunity exists; under 3 and 4, this information
is fully impounded in the current price and no profit opportunity exists.

c. Under 3, if the market is not strong form efficient, then this information could be used as a
profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock
is underpriced or that good news is imminent. Since 1 and 2 are weaker than 3, all three imply a
profit opportunity. Under 4, the information doesn’t signal a profit opportunity for traders;
pertinent information the manager-insiders may have is fully reflected in the current share price.

d. Despite the fact that this information is obviously less open to the public and a clearer signal of
imminent price gains than is the scenario in part c, the conclusions remain the same. If the
market is strong form efficient, a profit opportunity does not exist. A scenario such as this one is
the most obvious evidence against strong form market efficiency; the fact that such insider
trading is also illegal should convince you of this fact.

5. Taken at face value, this fact suggests that markets have become more efficient. The increasing ease
with which information is available over the internet lends strength to this conclusion. On the other
hand, during this particular period, large-cap growth stocks were the top performers. Value-weighted
indexes such as the S&P 500 are naturally concentrated in such stocks, thus making them especially
hard to beat during this period. So, it may be that the dismal record compiled by the pros is just a
matter of bad luck or benchmark error.
6. It is likely the market has a better estimate of the stock price, assuming it is semistrong form efficient.
However, semistrong form efficiency only states that you cannot easily profit from publicly available
information. If financial statements are not available, the market can still price stocks based upon the
available public information, limited though it may be. Therefore, it may have been difficult to
examine the limited public information and make an extra return.

7. Beating the market during any year is entirely possible. If you are able to consistently beat the
market, it may shed doubt on market efficiency unless you are taking more risk than the market as a
whole or are lucky. Thus, before any conclusion is made, we would want to control for the amount of
risk in your portfolio.

8.

a. False. Market efficiency implies that prices reflect all available information, but it does not
imply certain knowledge. Many pieces of information that are available and reflected in prices
are fairly uncertain. Efficiency of markets does not eliminate that uncertainty and therefore
does not imply perfect forecasting ability.

b. True. Market efficiency exists when prices reflect all available information. To be efficient in
the weak form, the market must incorporate all historical data into prices. Under the
semistrong form of the hypothesis, the market incorporates all publicly-available information
in addition to the historical data. In strong form efficient markets, prices reflect all publicly
and privately available information.

c. False. Market efficiency implies that market participants are rational. Rational people will
immediately act upon new information and will bid prices up or down to reflect that
information.

d. False. In efficient markets, prices reflect all available information. Thus, prices will fluctuate
whenever new information becomes available.

e. True. Competition among investors results in the rapid transmission of new market
information. In efficient markets, prices immediately reflect new information as investors bid
the stock price up or down.

9. Yes, historical information is also public information; weak form efficiency is a subset of semistrong
form efficiency.

10. Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all
have zero NPV. If trading costs exist, then these investors lose by the amount of the costs.

11.

a. Aerotech’s stock price should rise immediately after the announcement of the positive news.

b. Only scenario ii indicates market efficiency. In that case, the price of the stock rises
immediately to the level that reflects the new information, eliminating all possibility of
abnormal returns. In the other two scenarios, there are periods of time during which an
investor could trade on the information and earn abnormal returns.
Revision Questions chapter 13 ( PERFORMANCE EVALUATION AND RISK MANAGEMENT)

Core Questions

1. 54%*(2/12) ^0.5 = 22.05%

2.

3.
Portfolio Sharpe ratio Treynor ratio Jensen's alpha
X .27586 .0640 .50%
Y .29167 .0636 .40%
Z .28571 .0533 −.50%
Market .31579 .0600 .00%

4.
Information ratio = Jensen’s Alpha ÷ Tracking Error = 0.50% ÷ 9.20% = 0.0543

5. R-squared gives the percentage of the fund’s return driven by the market, which is:

6.

10-For a portfolio with two investments having zero correlation, the Sharpe ratio would be calculated as
follows:
x E (R S )+ x B E ( RB ) - R f
Sharpe ratio = S
( x 2S σ 2S + x 2B σ 2B )1/2
. 5E(R )+. 5E(R ) - R f
Sharpe ratio = 2 2S 2 2 B
11-- [ .5 σ S +. 5 σ B +.2(. 5 )(. 5 )(σ S )(σ B )(Corr ( RS ,R B ))]1/2

REVISION QUESTIONS CHAPTER 11(Diversification and risky assets Allocation)

Core Question

1. .25(–.08) + .5(.13) + .25(.23) = .1025, or 10.25%

2.

a. 9- boom:
 good:

poor:

bust:

b.

3. 10. Notice that we have historical information here, so we calculate the sample average and sample
standard deviation (using n – 1) just like we did in Chapter 1. Notice also that the portfolio has less
risk than either asset.

Annual Returns
on Stocks A and
B
Year Stock A Stock B Portfolio AB
2018 11% 21% 17.00%
2019 37% –38% –8.00%
2020 –21% 48% 20.40%
2021 26% 16% 20.00%
2022 13% 24% 19.60%

Avg return 13.20% 14.20% 13.80%

CONCEPT QUESTIONS

Concept Questions

1. Based on market history, the average annual standard deviation of return for a single, randomly
chosen stock is about 50 percent. The average annual standard deviation for an equally-weighted
portfolio of many stocks (at least 30-50 randomly selected stocks) is about 20 percent.

2. If the returns on two stocks are highly correlated, they have a strong tendency to move up and down
together. If they have no correlation, there is no particular connection between the two. If they are
negatively correlated, they tend to move in opposite directions.

3. An efficient portfolio is one that has the highest return for its level of risk. Said differently, it is the
portfolio with the lowest risk for a given level of return.

4. True. Remember, portfolio return is a weighted average of individual returns.

6. The common answer might be that over time volatility cancels out; however, this is incorrect and is
an example of the time diversification fallacy. The more appropriate response is that younger
investors have a greater ability to modify their work flow, time, etc. to offset the loss. Older
investors are less able to withstand a large one-time loss.

7. An investment with high volatility could actually reduce the risk of the overall portfolio if its
correlation to the existing assets is very low.

8. The importance of the minimum variance portfolio is that it determines the lower bound of the
efficient frontier. While there are portfolios on the investment opportunity set to the right and below
the minimum variance portfolio, they are inefficient. That is, there is a portfolio with the same level
of risk and a higher return. No rational investor would ever invest in a portfolio below the minimum
variance portfolio.

9. False. Individual assets can lie on the efficient frontier depending on its expected return, standard
deviation, and correlation with all other assets.
If two assets have zero correlation and the same standard deviation, then evaluating the general
expression for the minimum variance portfolio shows that x = ½; in other words, an equally-weighted
portfolio is minimum variance.

Revision Questions chapter 12 (Return Risks and the Security market line)

Concept Questions

1. Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of
assets, this unique portion of the total risk can be almost completely eliminated at little cost. On the
other hand, there are some risks that affect all investments. This portion of the total risk of an asset
cannot be costlessly eliminated. In other words, systematic risk can be controlled, but only by a
costly reduction in expected returns.

2. If the market expected the growth rate in the coming year to be 2 percent, then there would be no
change in security prices if this expectation had been fully anticipated and priced. However, if the
market had been expecting a growth rate different than 2 percent and the expectation was
incorporated into security prices, then the government's announcement would most likely cause
security prices in general to change; prices would drop if the anticipated growth rate had been more
than 2 percent, and prices would rise if the anticipated growth rate had been less than 2 percent.

3.
a. systematic
b. unsystematic
c. both; probably mostly systematic
d. unsystematic
e. unsystematic
f. systematic
 9
a. 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 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 include
litigation, patents, management, and financial leverage.

b. Trudy should explain to the client that picking only the top five best ideas would most likely
result in the client holding a much riskier portfolio. The total risk of the portfolio, or portfolio
variance, is the combination of systematic risk and firm-specific risk. i.) 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. ii.) On the other hand, the components of the 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
expiring 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.

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.

Core Questions

1.

2.
16. From the chapter, . Also,

. Substituting this second result into the expression for

19.

Although stock II has more total risk than I, it has much less systematic risk, since its beta is much
smaller than I’s. Thus, I has more systematic risk, and II has more unsystematic and more total risk.
Since unsystematic risk can be diversified away, I is actually the “riskier” stock despite the lack of
volatility in its returns. Stock I will have a higher risk premium and a greater expected return.