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IM Problem Set 4

This document contains 6 questions related to investment management and the efficient market hypothesis. It asks the reader to determine the expected returns of various stocks based on their betas, market returns, and other factors. It also asks the reader to calculate the expected profit and risk of portfolios based on different numbers of stocks with positive and negative alphas.

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Moe Eltayeb
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395 views3 pages

IM Problem Set 4

This document contains 6 questions related to investment management and the efficient market hypothesis. It asks the reader to determine the expected returns of various stocks based on their betas, market returns, and other factors. It also asks the reader to calculate the expected profit and risk of portfolios based on different numbers of stocks with positive and negative alphas.

Uploaded by

Moe Eltayeb
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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Investment Management Problem Set 4 Autumn 2016

True-False (plus reasons; I am expecting no more than two-three sentences for each):

1. If markets are efficient, the correlation coefficient between stock returns for two non-
overlapping time periods should be zero.

2. If markets are semi-strong form efficient, the following are viable strategies to earn
abnormally high trading profits.
a. Buy shares in companies with low P/E ratios
b. Buy shares in companies with recent above-average price changes
c. Buy shares in companies for which you have advance knowledge of an improvement
in management team

3. If the business cycle is predictable, and a stock has a positive beta, the stocks returns also
must be predictable

4. The following are consistent with efficient market hypothesis


a. Nearly half of all professionally managed mutual funds are able to outperform the
S&P 500 in a typical year
b. Money managers that outperform the market (on a risk-adjusted basis) in one year are
likely to outperform in the following year
c. Stock prices tend to be predictably volatile in January than in other months
d. Stock prices of companies that announce increased earnings in January tend to
outperform the market in February
e. Stocks that perform well in one week perform poorly in the following week

Questions

1. The monthly rate of return in T-bills is 1%. The market went up this month by 1.5%. In
addition, AmbChaser, Inc., which has an equity beta of 2, surprisingly just won a lawsuit that
awards it $1 million immediately.
a. If the original value of the equity were $100 million, what would you guess was the
rate of return of its stock this month?
b. What is your answer to (a) if the market had expected AmbChaser to win $2min?

2. Investors expect the market rate of return in the coming year to be 12%. The T-bill rate is 4%.
Changing fortunes Industries stock has a beta of 0.5. The market value of its outstanding
equity is $100 million.
a. What is your best guess currently as to the expected rate of return on Changing
Fortunes stock? You believe the stock is fairly priced.
b. If the market return in the coming year actually turns out to be 10%, what is your best
guess as to the rate of return that will be earned in Changing Fortunes stock?
c. Suppose now that the company wins a major lawsuit during the year. The settlement
is $5 million. The companys stock return during the year turns out to be 10%. What
is your best guess as to the settlement the market previously expected Changing
Fortunes to receive from the lawsuit? (Continue to assume that the market return in
the year turned out to be 10 %.) The magnitude of the settlement is the only
unexpected firm-specific event during the year.

3. Suppose that during a certain week the Fed announces a new monetary growth policy,
Congress surprisingly passes legislation restricting imports of foreign automobiles, and Ford
comes out with a new car model that it believes will increase profits substantially. How might
you go about measuring the markets assessment of Fords new model?

4. Suppose that the market can be described by the following three sources of systematic risk
with associated risk premiums

Factor Risk Premium


Industrial Production (I) 6%
Interest Rate (R) 2%
Consumer Confidence (C) 4%

The return on a particular stock is generated according to the following equation:

r = 15% + 1.0I + 0.5R + 0.75C + e


(Note that I, R and C are shocks, so they have an expected value of zero)
Find the equilibrium rate of return on this stock using the APT. The T-bill rate is 6%. Is the
stock over or underpriced? Explain

5. Suppose that there are many stocks in the security market and that the characteristics of
Stocks A and B are given as follows

Stock Expected Return Standard Deviation


A 10% 5%
B 15% 10%
Correlation = -1

Suppose that it is possible to borrow at the risk-free rate, rf. What must be the value of the
risk-free rate?

6. Assume that the stock market returns have the market index as a common factor, and that all
stocks in the economy have a beta of 1 on the market index. Firm-specific returns all have a
standard deviation of 30%. Suppose that an analyst studies 20 stocks, and finds that one-half
have an alpha of 2%, and the other half an alpha of -2%. Suppose the analyst buys $1 million
of an equally weighted portfolio of positive alphas, and shorts $1 million of an equally
weighted portfolio of the negative alpha stocks.

a. What is the expected profit (in dollars) and standard deviation of the analysts profit?

b. How does your answer change if the analyst examines 50 stocks instead of 20 stocks?
100 stocks?

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