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Portfolio Chapter 11

1. The chapter discusses the efficient market hypothesis and whether certain stock behaviors violate it. Under the EMH, stock returns should not be correlated over non-overlapping periods, as past returns cannot predict future returns. A successful firm like Microsoft continuing strong performance does not violate EMH. 2. While expected returns should differ due to risk, securities in an efficient market should have equal expected risk-adjusted returns. A company with a long history of dividend payments does not make it more attractive, as that predictability would already be priced in. An individual claiming to have beaten the market multiple years does not disprove EMH, as random outcomes are expected. 3. Constant stock price

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152 views

Portfolio Chapter 11

1. The chapter discusses the efficient market hypothesis and whether certain stock behaviors violate it. Under the EMH, stock returns should not be correlated over non-overlapping periods, as past returns cannot predict future returns. A successful firm like Microsoft continuing strong performance does not violate EMH. 2. While expected returns should differ due to risk, securities in an efficient market should have equal expected risk-adjusted returns. A company with a long history of dividend payments does not make it more attractive, as that predictability would already be priced in. An individual claiming to have beaten the market multiple years does not disprove EMH, as random outcomes are expected. 3. Constant stock price

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Lim Xiaopei
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Chapter 11: The Efficient Market Hypothesis

1. If markets are efficient, what should be the correlation coefficient between stock returns
for two non-overlapping time periods?
The correlation coefficient between stock returns for two non-overlapping periods should
be zero. If not, one could use returns from one period to predict returns in later periods
and make abnormal profits.

2. A successful firm like Microsoft has consistently generated large profits for years. Is this
the violation of EMH?
No. Microsoft's continuing profitability does not imply that stock market investors who
purchased Microsoft shares after its success was already evident would have earned an
exceptionally high return on their investments.

3. “If all securities are fairly priced, all must offer equal expected rates of return.”
Comment.
No. Expected rates of return differ because of differential risk premiums.
The phrase would be correct if it were modified to say "expected risk adjusted returns."
Securities all have the same risk adjusted expected return if priced fairly. However, actual
results can and do vary. Unknown events cause certain securities to outperform others.
This is not known in advance, so expectations are set by known information

4. 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?
No. The value of dividend predictability would be already reflected in the stock price.

5. At cocktail party, your co-worker tells you that he has beaten the market for each of the
last three years. Suppose you believe him. Does this shake your belief in efficient
markets?
No. Random walk theory naturally expects there to be some people who beat the market
and some people who do not. The information provided, however, fails to consider the
risk of the investment. Higher risk investments should have higher returns. As presented,
it is possible to believe him without violating the EMH.

6. “Constantly fluctuating stock price suggest that the market does not know how to price
stock.” Comment.
Incorrect. In the short term, markets reflect a random pattern. Information is constantly
flowing in the economy and investors each have different expectations that vary
constantly. A fluctuating market accurately reflects this logic. Furthermore, while
increased variability may be the result of an increase in unknown variables, this merely
increases risk and the price is adjusted downward as a result.
7. Why the following “effects” are considered efficient market anomalies? Are there
rational explanations for these effects?
a. P/E effect (high P/E, means high E lower P)
b. Book-to-market effect
c. Momentum effect
d. Small-firm effect (book value of the firm=A-L)
An anomaly is considered an EMH exception because there is historical data to
substantiate a claim that said anomalies have produced excess risk adjusted abnormal
returns in the past. Several anomalies regarding fundamental analysis have been
uncovered. These include the P/E effect, the small-firm-in-January effect, the neglected-
firm effect, post-earnings-announcement price drift, and the book-to-market effect.
Whether these anomalies represent market inefficiency or poorly understood risk
premiums is still a matter of debate. There are rational explanations for each, but not
everyone agrees on the explanation. One dominant explanation is that many of these
firms are also neglected firms, due to low trading volume, thus they are not part of an
efficient market or offer more risk as a result of their reduced liquidity.
21. 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. Using the CAPM, what is your best guess currently as to the expected rate of return
on Changing Fortunes’s stock? You believe that the stock is fairly priced.
E(rp)= rf+β(rm-rf)
= 4%+0.5(12%-4%)
= 8%

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 on Changing Fortunes’s stock?
E(rp)= rf+β(rm-rf)
= 4%+0.5(10%-4%)
= 7%

c. Suppose now that Changing Fortunes wins a major lawsuit during the year. The
settlement is $5 million. Changing Fortunes’ 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.
Expected market return = 10%
Forecast return = 7% / 7million
Actual return = 10% /10million
Surprise = 10%-7% = 3%
Because the firm is initially worth $100 million, the surprise amount of the settlement
is $3 million, implying that the prior expectation for the settlement was only
$2million.

10m – 5m = 5m
Expected to get 7 million return, but get 5 million, so extra 2 million.

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