4. Suppose, after conducting an analysis of past stock prices, you come up with the following observations. Which would appear to contradict the weak form of the efficient market hypothesis? Explain.
a. The average rate of return is significantly greater than zero.
b. The correlation between the market return one week and the return the following week is zero.
c. One could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall.
d. One could have made higher than average capital gains by holding stock with low dividend yields.
5. Which of the following statements are true if the efficient market hypothesis holds?
a. It implies perfect forecasting ability.
b. It implies that prices reflect all available information.
c. It implies that the market is irrational.
d. It implies that prices do not fluctuate.
6. A market anomaly refers to:
a. An exogenous shock to the market that is sharp but not persistent.
b. A price or volume event that is inconsistent with historical price or volume trends.
c. A trading or pricing structure that interferes with efficient buying and selling of securities.
d. Price behavior that differs from the behavior predicted by the efficient market hypothesis.
7. Which of the following observations would provide evidence against the semistrong form of the efficient market theory? Explain.
a. Mutual fund managers do not on average make superior returns.
b. You cannot make superior profits by buying (or selling) stocks after the announcement of an abnormal rise in earnings.
c. Low P/E stocks tend to provide abnormal risk-adjusted returns.
d. In any year, approximately 50% of pension funds outperform the market.
8. A successful firm like Intel has consistently generated large profits for years. Is this a violation of the EMH?
9. Prices of stocks before stock splits show on average consistently positive abnormal returns. Is this a violation of the EMH?
10. "If the business cycle is predictable, and a stock has a positive beta, the stock's returns also must be predictable." Respond.
11. "The expected return on all securities must be equal if markets are efficient." Comment.
12. We know the market should respond positively to good news, and good news events such as the coming end of a recession can be predicted with at least some accuracy. Why, then, can we not predict that the market will go up as the economy recovers?
13. If prices are as likely to increase or decrease, why do investors earn positive returns from the market on average?
14. You know that firm XYZ is very poorly run. On a management scale of 1 (worst) to 10 (best), you would give it a score of 3. The market consensus evaluation is that the management score is only 2. Should you buy or sell the stock?
15. Some scholars contend that professional managers are incapable of outperforming the market. Others come to an opposite conclusion. Compare and contrast the assumptions about the stock market that support (a) passive portfolio management and (b) active portfolio management.
Bodie-Kane-Marcus: Essentials of Investments, Fifth Edition
II. Portfolio Theory
8. The Efficient Market Hypothesis
© The McGraw-H Companies, 2003
16. You are a portfolio manager meeting a client. During the conversation that followed your formal review of her account, your client asked the following question:
My grandson, who is studying investments, tells me that one of the best ways to make money in the stock market is to buy the stocks of small-capitalization firms late in December and to sell the stocks one month later. What is he talking about?
a. Identify the apparent market anomalies that would justify the proposed strategy.
b. Explain why you believe such a strategy might or might not work in the future.
17. Which of the following phenomena would be either consistent with or in violation of the efficient market hypothesis? Explain briefly.
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 the market in the following year.
c. Stock prices tend to be predictably more 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.
18. Dollar-cost averaging means that you buy equal dollar amounts of a stock every period, for example, $500 per month. The strategy is based on the idea that when the stock price is low, your fixed monthly purchase will buy more shares, and when the price is high, fewer shares. Averaging over time, you will end up buying more shares when the stock is cheaper and fewer when it is relatively expensive. Therefore, by design, you will exhibit good market timing. Evaluate this strategy.
19. Steady Growth Industries has never missed a dividend payment in its 94-year history. Does this make it more attractive to you as a possible purchase for your stock portfolio?
20. Good News, Inc., just announced an increase in its annual earnings, yet its stock price fell. Is there a rational explanation for this phenomenon?
Use the following information to solve problems 21 and 22:
As director of research for a medium-sized investment firm, Jeff Cheney was concerned about the mediocre investment results experienced by the firm in recent years. He met with his two senior equity analysts to consider alternatives to the stock selection techniques employed in the past.
One of the analysts suggested that the current literature has examined the relationship between price-earnings (P/E) ratios and securities returns. A number of studies had concluded that high P/E stocks tended to have higher betas and lower risk-adjusted returns than stocks with low P/E ratios.
The analyst also referred to recent studies analyzing the relationship between security returns and company size as measured by equity capitalization. The studies concluded that when compared to the S&P 500 index, small-capitalization stocks tended to provide above-average risk-adjusted returns, while large-capitalization stocks tended to provide below-average risk-adjusted returns. It was further noted that little correlation was found to exist between a company's P/E ratio and the size of its equity capitalization.
Jeff's firm has employed a strategy of complete diversification and the use of beta as a measure of portfolio risk. He and his analysts were intrigued as to how these recent studies might be applied to their stock selection techniques and thereby improve their performance. Given the results of the studies indicated above:
21. Explain how the results of these studies might be used in the stock selection and portfolio management process. Briefly discuss the effects on the objectives of diversification and on the measurement of portfolio risk.
Part TWO Portfolio Theory
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