bkmsolch119e corrected 729.docx
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bkmsolch119e corrected 729.docx
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bkmsolch119ecorrected729
CHAPTER11:
THEEFFICIENTMARKETHYPOTHESIS
PROBLEMSETS
1.Thecorrelationcoefficientbetweenstockreturnsfortwonon-overlappingperiodsshouldbezero.Ifnot,onecouldusereturnsfromoneperiodtopredictreturnsinlaterperiodsandmakeabnormalprofits.
2.No.Microsoft’scontinuingprofitabilitydoesnotimplythatstockmarketinvestorswhopurchasedMicrosoftsharesafteritssuccesswasalreadyevidentwouldhaveearnedanexceptionallyhighreturnontheirinvestments.
3.Expectedratesofreturndifferbecauseofdifferentialriskpremiums.
4.No.Thevalueofdividendpredictabilitywouldbealreadyreflectedinthestockprice.
5.No,marketscanbeefficientevenifsomeinvestorsearnreturnsabovethemarketaverage.ConsidertheLuckyEventissue:
Ignoringtransactioncosts,about50%ofprofessionalinvestors,bydefinition,will“beat”themarketinanygivenyear.Theprobabilityofbeatingitthreeyearsinarow,thoughsmall,isnotinsignificant.Beatingthemarketinthepastdoesnotpredictfuturesuccessasthreeyearsofreturnsmakeuptoosmallasampleonwhichtobasecorrelationletalonecausation.
6.Volatilestockpricescouldreflectvolatileunderlyingeconomicconditionsaslargeamountsofinformationbeingincorporatedintothepricewillcausevariabilityinstockprice.TheEfficientMarketHypothesissuggeststhatinvestorscannotearnexcessrisk-adjustedrewards.Thevariabilityofthestockpriceisthusreflectedintheexpectedreturnsasreturnsandriskarepositivelycorrelated.
7.ThefollowingeffectsseemtosuggestpredictabilitywithinequitymarketsandthusdisprovetheEfficientMarketHypothesis.However,considerthefollowing:
a.Multiplestudiessuggestthat“value”stocks(measuredoftenbylowP/Emultiples)earnhigherreturnsovertimethan“growth”stocks(highP/Emultiples).Thiscouldsuggestastrategyforearninghigherreturnsovertime.However,anotherrationalargumentmaybethattraditionalformsofCAPM(suchasSharpe’smodel)donotfullyaccountforallriskfactorswhichaffectafirm’spricelevel.AfirmviewedasriskiermayhavealowerpriceandthusP/Emultiple.
b.Thebook-to-marketeffectsuggeststhataninvestorcanearnexcessreturnsbyinvestingincompanieswithhighbookvalue(thevalueofafirm’sassetsminusitsliabilitiesdividedbythenumberofsharesoutstanding)tomarketvalue.AstudybyFamaandFrenchsuggeststhatbook-to-marketvaluereflectsariskfactorthatisnotaccountedforbytraditionalonevariableCAPM.Forexample,companiesexperiencingfinancialdistressseetheratioofbooktomarketvalueincrease.ThusamorecomplexCAPMwhichincludesbook-to-marketvalueasanexplanatoryvariableshouldbeusedtotestmarketanomalies.
c.Stockpricemomentumcanbepositivelycorrelatedwithpastperformance(shorttointermediatehorizon)ornegativelycorrelated(longhorizon).Historicaldataseemtoimplystatisticalsignificancetothesepatterns.Explanationsforthisincludeabandwagoneffectorthebehavioralists’(seeChapter12)explanationthatthereisatendencyforinvestorstounderreacttonewinformation,thusproducingapositiveserialcorrelation.However,statisticalsignificancedoesnotimplyeconomicsignificance.SeveralstudieswhichincludedtransactioncostsinthemomentummodelsdiscoveredthatmomentumtraderstendedtonotoutperformtheEfficientMarketHypothesisstrategyofbuyandhold.
d.Thesmall-firmeffectstatesthatsmallerfirmsproducebetterreturnsthanlargerfirms.Since1926returnsfromsmallfirmsoutpacelargefirmstockreturnsbyabout1%peryear.Dosmallcapinvestorsearnexcessrisk-adjustedreturns?
ThemeasureofsystematicriskaccordingtoSharpe’sCAPMisthestock’sbeta(orsensitivityofreturnsofthestocktomarketreturns).Ifthestock’sbetaisthebestexplanationofrisk,thenthesmall-firmeffectdoesindicateaninefficientmarket.Dividingthemarketintodecilesbasedontheirbetasshowsanincreasingrelationshipbetweenbetasandreturns.FamaandFrenchshowthattheempiricalrelationshipbetweenbetaandstockreturnsisflatoverafairlylonghorizon(1963-1990).Breakingthemarketintodecilesbasedonsizesandthenexaminingtherelationshipbetweenbetaandstockreturnswithineachsizedecileexhibitsthisflatrelationship.Thisimpliesthatfirmsizemaybeabettermeasureofriskthanbetaandthesize-effectshouldnotbeviewedasanindicatorthatmarketsareinefficient.Heuristicallythismakessense,assmallerfirmsaregenerallyviewedasriskycomparedtolargerfirmsandperceivedriskandreturnarepositivelycorrelated.
Inadditionthiseffectseemstobeendpointanddatasensitive.Forexample,smallerstocksdidnotoutperformlargerstocksfromthemid1980sthroughthe1990s.Inaddition,databasescontainstockreturnsfromcompaniesthathavesurvivedanddonotincludereturnsofthosethatwentbankrupt.Thussmall-firmdatamayexhibitsurvivorshipbias.
8.Overthelonghaul,thereisanexpectedupwarddriftinstockpricesbasedontheirfairexpectedratesofreturn.Thefairexpectedreturnoveranysingledayisverysmall(e.g.,12%peryearisonlyabout0.03%perday),sothatonanydaythepriceisvirtuallyequallylikelytoriseorfall.Overlongerperiods,thesmallexpecteddailyreturnsaccumulate,andupwardmovesaremorelikelythandownwardones.
9.c.Thisisapredictablepatterninreturnswhichshouldnotoccuriftheweak-formEMHisvalid.
10.a.Acutemarketinefficienciesaretemporaryinnatureandaremoreeasilyexploitedthanchronicinefficiencies.Atemporarydropinastockpriceduetoalargesalewouldbemoreeasilyexploitedthanthechronicinefficienciesmentionedintheotherresponses.
11.c.Thisisaclassicfilterrulewhichshouldnotproducesuperiorreturnsinanefficientmarket.
12.b.Thisisthedefinitionofanefficientmarket.
13.a.Thoughstockpricesfollowarandomwalkandintradaypricechangesdoappeartobearandomwalk,overthelongrunthereiscompensationforbearingmarketriskandforthetimevalueofmoney.Investingdiffersfromacasinointhatinthelong-run,aninvestoriscompensatedfortheserisks,whileaplayeratacasinofaceslessthanfair-gameodds.
b.Inanefficientmarket,anypredictablefutureprospectsofacompanyhavealreadybeenpricedintothecurrentvalueofthestock.Thus,astocksharepricecanstillfollowarandomwalk.
c.Whiletherandomnatureofdartboardselectionseemstofollownaturallyfromefficientmarkets,theroleofrationalportfoliomanagementstillexists.Itexiststoensureawell-diversifiedportfolio,toassesstherisk-toleranceoftheinvestorandtotakeintoaccounttaxcodeissues.
14.d.Inasemistrong-formefficientmarket,itisnotpossibletoearnabnormallyhighprofitsbytradingonpubliclyavailableinformation.InformationaboutP/Eratiosandrecentpricechangesispubliclyknown.Ontheotherhand,aninvestorwhohasadvanceknowledgeofmanagementimprovementscouldearnabnormallyhightradingprofits(unlessthemarketisalsostrong-formefficient).
15.Marketefficiencyimpliesinvestorscannotearnexcessrisk-adjustedprofits.Ifthestockpricerun-upoccurswhenonlyinsidersknowofthecomingdividendincrease,thenitisaviolationofstrong-formefficiency.Ifthepublicalsoknowsoftheincrease,thenthisviolatessemistrong-formefficiency.
16.Whilepositivebetastocksrespondwelltofavorablenewinformationabouttheeconomy’sprogressthroughthebusinesscycle,theyshouldnotshowabnormalreturnsaroundalreadyanticipatedevents.Ifarecovery,forexample,isalreadyanticipated,theactualrecoveryisnotnews.Thestockpriceshouldalreadyreflectthecomingrecovery.
17.a.Consistent.Basedonpureluck,halfofallmanagersshouldbeatthemarketinanyyear.
b.Inconsistent.Thiswouldbethebasisofan“easymoney”rule:
simplyinvestwithlastyear'sbestmanagers.
c.Consistent.Incontrasttopredictablereturns,predictablevolatilitydoesnotconveyameanstoearnabnormalreturns.
d.Inconsistent.TheabnormalperformanceoughttooccurinJanuarywhenearningsareannounced.
e.Inconsistent.Reversalsofferameanstoearneasymoney:
justbuylastweek’slosers.
18.Thereturnonthemarketis8%.Therefore,theforecastmonthlyreturnforFordis:
0.10%+(1.1×8%)=8.9%
Ford’sactualreturnwas7%,sotheabnormalreturnwas–1.9%.
19.a.Basedonbroadmarkettrends,theCAPMindicatesthatAmbChaserstockshouldhaveincreasedby:
1.0%+2.0×(1.5%–1.0%)=2.0%
Itsfirm-specific(nonsystematic)returnduetothelawsuitis$1millionper$100millioninitialequity,or1%.Therefore,thetotalreturnshouldbe3%.(Itisassumedherethattheoutcomeofthelawsuithadazeroexpectedvalue.)
b.Ifthesettlementwasexpectedtobe$2million,thentheactualsettlementwasa“$1milliondisappointment,”andsothefirm-specificreturnwouldbe–1%,foratotalreturnof2%–1%=1%.
20.Givenmarketperformance,predictedreturnsonthetwostockswouldbe:
Apex:
0.2%+(1.4×3%)=4.4%
Bpex:
–0.1%+(0.6×3%)=1.7%
Apexunderperformedthisprediction;Bpexoutperformedtheprediction.WeconcludethatBpexwonthelawsuit.
21.a.E(rM)=12%,rf=4%andβ=0.5
Therefore,theexpectedrateofreturnis:
4%+0.5×(12%–4%)=8%
Ifthestockisfairlypriced,thenE(r)=8%.
b.IfrMfallsshortofyourexpectationby2%(thatis,10%–12%)thenyouwouldexpectthereturnforChangingFortunesIndustriestofallshortofyouroriginalexpectationby:
β×2%=1%
Therefore,youwouldfor
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