solution manual for 《investment analysis and portfolio management》 ch06

1、chapter 6efficient capital marketsanswers to questions1.there are several reasons why one would expect capital markets to be efficient, the foremost being that there are a large number of independent, profit-maximizing investors engaged in the analysis and valuation of securities. a second assumptio

2、n is that new information comes to the market in a random fashion. the third assumption is that the numerous profit-maximizing investors will adjust security prices rapidly to reflect this new information. thus, price changes would be independent and random. finally, because stock prices reflect all

3、 information, one would expect prevailing prices to reflect “true” current value.capital markets as a whole are generally expected to be efficient, but the markets for some securities might not be as efficient as others. recall that markets are expected to be efficient because there are a large numb

4、er of investors who receive new information and analyze its effect on security values. if there is a difference in the number of analysts following a stock and the volume of trading, one could conceive of differences in the efficiency of the markets. for example, new information regarding actively t

5、raded stocks such as ibm and exxon is well publicized and numerous analysts evaluate the effect. therefore, one should expect the prices for these stocks to adjust rapidly and fully reflect the new information. on the other hand, new information regarding a stock with a small number of stockholders

6、and low trading volume will not be as well publicized and few analysts follow such firms. therefore, prices may not adjust as rapidly to new information and the possibility of finding a temporarily undervalued stock are also greater. some also argue that the size of the firms is another factor to di

7、fferentiate the efficiency of stocks. specifically, it is believed that the markets for stocks of small firms are less efficient than that of large firms.2.the weak-form efficient market hypothesis contends that current stock prices reflect all available security-market information including the his

8、torical sequence of prices, price changes, and any volume information. the implication is that there should be no relationship between past price changes and future price changes. therefore, any trading rule that uses past market data alone should be of little value.the two groups of tests of the we

9、ak-form emh are (1) statistical tests of independence and (2) tests of trading rules. statistical tests of independence can be divided further into two groups: the autocorrelation tests and the runs tests. the autocorrelation tests are used to test the existence of significant correlation, whether p

10、ositive or negative, of price changes on a particular day with a series of consecutive previous days. the runs tests examine the sequence of positive and negative changes in a series and attempt to determine the existence of a pattern. for a random series one would expect 1/3(2n - 1) runs, where n i

11、s the number of observations. if there are too few runs (i.e., long sequences of positive changes or long sequences of negative changes), the series is not random, i.e., you would not expect a positive change to consistently follow a positive change and a negative change consistently after a negativ

12、e change. alternatively, if there are too many runs (+-+-+-+- etc.), again the series is not random since you would not expect a negative change to consistently follow a positive change.in the trading rule studies, the second major set of tests, investigators attempted to examine alternative technic

13、al trading rules through simulation. the trading rule studies compared the risk-return results derived from the simulations, including transaction costs, to results obtained from a simple buy-and-hold policy.3.the semistrong-form efficient market hypothesis contends that security prices adjust rapid

14、ly to the release of all new public information and that stock prices reflect all public information. the semistrong-form goes beyond the weak-form because it includes all market and also all nonmarket public information such as stock splits, economic news, political news, etc.using the organization

15、 developed by fama, studies of the semistrong-form emh can be divided into two groups: (1) studies that attempt to predict futures rates of return using publicly available information (goes beyond weak-form emh). these studies involve either time-series analysis of returns or the cross-section distr

16、ibution of returns. (2) event studies that examine abnormal rates of return surrounding specific event or item of public information. these studies determine whether it is possible to make average risk-adjusted profits by acting after the information is made public.4.abnormal rate of return is the a

17、mount by which a securitys return differs from the expected rate of return based upon the markets rate of return and the securitys relationship with the market.5.the capm is grounded in the theory that investors demand higher returns for higher risks. as a result of risks specific to each individual

18、 security, the announcement of a significant economic event will tend to affect individual stock prices to a greater or lesser extent than the market as a whole. fama, fisher, jensen, and roll portrayed this unique relationship of stock returns and market return for a period prior to and subsequent

19、to a significant economic event as follows:rit = ai + bi rmt + ewhererit=the rate of return on security i during period tai=the intercept or constant for security in the regressionbi=the regression slope coefficient for security i equal to covim/sm2rmt=the rate of return on a market index during per

20、iod t e=a random error that sums to zeroas an example of how one would derive abnormal risk-adjusted returns for a stock during a specific period, assume the following values for a firm:ai = .01 and bi = 1.40if the market return (rmt) during the specified period were 8 percent, the expected return f

21、or stock i would be:e(rit)=.01 + 1.4(.08)=.01 + .112=.122the fact that this is the expected value implies that the actual value will tend to deviate around the expected value. we will define the abnormal return (arit) as the actual return minus the expected return. in our example, if the actual retu

22、rn for the stock during this period were 10 percent, the abnormal return for the stock during the period would bearit = .10 - .122 = -.022thus, the stock price reacted to the economic event in a manner that was 2.2 percent less than expected where expectations were based upon what the aggregate mark

23、et did and the stocks relationship with the market. this abnormal return surrounding an economic event can be used to determine the effect of the event on the individual security.6.first, only use information or data that is publicly available at the time of the decision. as an example, if you use i

24、nformation that is typically not available until six weeks after a period and you assume you have it four weeks after, your investment results should be superior because you implicitly have prior information. second, account for all transactions costs for the trading rule. this is important because

25、almost all trading rules involve more transactions than a buy-and-hold policy and if you dont consider this, it will bias the results against buy-and-hold. third, be sure to adjust all results for the risk involved because many trading rules will tend to select high-risk stocks that will have higher

26、 returns.7.a number of studies have examined the adjustment of stock prices to major world events. these studies analyzed the effect of several unexpected world events on stock prices - namely, whether prices adjusted before or during the announcement or after it. the results consistently showed tha

27、t the adjustments took place between the close of the previous day and the opening of the subsequent day. notably, an investor could not derive above average profits from transacting after the news became public, thus supporting the semistrong-form emh.8.in the early 1970s, several studies were perf

28、ormed that examined quarterly earnings reports. the results of the studies provided evidence against the semistrong-form emh. specifically, buying a stock after a report of unexpected higher quarterly earnings was profitable. generally, the abnormal return for the stock occurred 13 or 26 weeks follo

29、wing the earnings announcement and reflected the size of the unanticipated earnings change.9.studies on market efficiency are considered to be dual tests of the emh and the capm. these tests involve a joint hypothesis because they consider not only the efficiency of the market, but also are dependen

30、t on the asset pricing model that provides the measure of risk used in the test. for example, if a test determines that it is possible to predict future differential risk-adjusted returns, the results could either have been caused by the market being inefficient or because the risk measure is bad th

31、ereby providing an incorrect risk-adjusted return.10.the strong-form efficient market hypothesis asserts that stock prices fully reflect all information, whether public or private. it goes beyond the semistrong-form because it requires that no group of investors have a monopolistic access to any inf

32、ormation. thus, the strong-form efficient market hypothesis calls for perfect markets in which all information is available to everyone at the same time.11.the strong-form efficient market hypothesis goes beyond the semistrong-form in that it calls for perfect markets - i.e., no group of investors h

33、as a monopolistic access to information. thus, tests for the strong-form efficient market hypothesis would center around examining whether any group has a monopolistic access to information and can consistently obtain above average profits by using it. four groups of investors have been featured in

34、these tests -corporate insiders, the stock exchange specialist, security analysts and professional money managers.12.in the early 1970s, a study by the securities and exchange commission found that by having access to the limit order books as his source of monopolistic information, coupled with low

35、transaction costs, the stock market specialist consistently obtained above average returns. this is evidence against the strong-form hypothesis because this group apparently has a monopoly source of information and uses it to derive above normal returns.13.studies by several authors examined the ris

36、k-adjusted performance of professional money managers for various periods and found support for the strong-form efficient market hypothesis. for example, a historical study of mutual fund money managers found that on a risk-adjusted basis, only about one-third of the funds outperformed the market. m

37、ore recent studies have also generally provided similar results on performance.14. behavioral finance deals with individual investor psychology and how it affects individuals actions as investors, analysts, and portfolio managers. the goal of behavioral finance is to understand how psychological dec

38、isions affect markets and to be able to predict those effects. behavioral finance looks to explain anomalies that can arise in markets due to psychological factors.15. the proponents of behavioral finance contend that, although standard finance theory is acceptable in that it focuses on aggregate ma

39、rket behavior, it is incomplete because it fails to account for individual behavior. 16. the basic premise of technical analysis is that the information dissemination process is slow-thus the adjustment of prices is not immediate but forms a pattern. this view is diametrically opposed to the concept

40、 of efficient capital markets, which contends that there is a rapid dissemination process and, therefore, prices reflect all information. thus, there would be no value to technical analysis because technicians act after the news is made public which would negate its value in an efficient market.17.

41、the proponents of fundamental analysis advocate that at one point in time there is a basic intrinsic value for the aggregate stock market, alternative industries, and individual securities and if this intrinsic value is substantially different from the prevailing market value, the investor should ma

42、ke the appropriate investment decision. in the context of the efficient market hypothesis, however, if the determination of the basic intrinsic value is based solely on historical data, it will be of little value in providing above average returns. alternatively, if the fundamental analyst makes sup

43、erior projections of the relevant variables influencing stock prices then, in accordance with the efficient market hypothesis, he could expect to outperform the market. the implication is that even with an excellent valuation model, if you rely solely on past data, you cannot expect to do better tha

44、n a buy-and-hold policy.18. to be superior in an efficient market the analyst must be aware of the relevant variables influencing stock prices, and be able to consistently project these accurately. if the analyst does not have access to inside information and lacks superior analytical ability, there

45、 is little likelihood of obtaining above average returns consistently.to establish the superiority of an analyst it is appropriate to examine the performance of numerous buy and sell recommendations by the analyst over a period of time relative to a randomly selected sample of stocks in the same ris

46、k class. to be superior the analyst must consistently perform better than the random selection. consistency is emphasized because on average you would expect random selection to outperform the market about half the time.19.superior analysts should concentrate their efforts in the second tier of stoc

47、ks, because they do not receive the attention given the top-tier stocks. also these analysts should pay attention to bv/mv ratios and the size of the firms. analysts should concentrate their efforts on these securities, since they are more likely to yield abnormal returns. 20.the major efforts of th

48、e portfolio manager should be directed toward determining the risk preferences of his clients and offering, accordingly, a portfolio approximating the risk and return desires of the clientele. given evidence of the stationarity of beta for a portfolio, this would not be a difficult task. further, th

49、e level of risk can be controlled by committing a portion of the portfolio to a risk free asset and changing this proportion from time to time in accordance with the clients risk preferences.second, the portfolio manager should attempt to achieve complete diversification - eliminate all unsystematic

50、 risk. thus, the portfolio should be highly correlated with the market portfolio of risky assets.finally, it is important to minimize transactions costs - minimize taxes for the client, minimize commissions by reducing trading turnover, and minimizing liquidity costs by only trading currently liquid

51、 stocks.21.index funds are security portfolios specially designed to duplicate the performance of the overall security market as represented by some selected market index series. the first group of index funds was created in the early 1970s because people started realizing that capital markets are e

52、fficient and it is extremely difficult to be a superior analyst. thus, instead of trying to outperform the market, a large amount of money should be managed “passively” so that the investment performance simply matches that achieved by the aggregate market and costs are minimized so as not to drop r

53、eturns below the market.an abundance of research has revealed that the performance of professional money managers is not superior to the market, and often has been inferior. this is precisely what one would expect in an efficient capital market. thus, rather than expending a lot of effort in selecti

54、ng a portfolio, the performance of which may turn out to be inferior to the market, it is contended by some that portfolios should be designed to simply match the market. if you match the market and minimize transactions costs you will beat two-thirds of the institutional portfolio managers on avera

55、ge. the index funds are intended to match the market and minimize costs as suggested above. thus, they are consistent with the emh.22.the portfolio manager should continue to allow his two superior analysts to make investment recommendations for some proportion of the portfolio, making sure that the

56、ir recommendations are implemented in a way that would conform to the risk preference of the client. they should also be encouraged to concentrate their efforts in the second tier of stocks, because the second tier is probably not as efficient as the top tier (because of lower trading volume) and th

57、e possibility of finding a temporarily undervalued security are greater. on the other hand, the portfolio manager should encourage the average and inferior analysts to direct their efforts to matching the performance of the aggregate market. as a result, the overall performance of the portfolio shou

58、ld be superior to the average market performance.23.despite hawawinis acknowledgment that the european markets are smaller and less active than u.s. markets, one should not be surprised by the finding that european and u.s. markets have a similar level of efficiency. two trends that tend to promote

59、efficiency are the increasing size of the european equity market as a percentage of the world equity market, and the tendency for portfolio managers to increase the global diversification of their portfolios through investing in various countries securities. each of these trends implies that there are a large number of independent, profit-maxim