bkmsolch119e corrected 729.docx

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