### Efficient Capital Markets

Due Date: Apr 26, 2017

Ch 06: Efficient Capital Markets

Questions: 23

Tom Max, TMP’s quantitative analyst, has developed a portfolio construction model about which he is excited. To create the model, Max made a list of the stocks currently in the S&P 500 Stock Index and obtained annual operating cash flow, price, and total return data for each issue for the past five years. As of each year-end, this universe was divided into five equal-weighted portfolios of 100 issues each, with selection based solely on the price/cash flow rankings of the individual stocks. Each portfolio’s average annual return was then calculated. During this five-year period, the linked returns from the portfolios with the lowest price/cash flow ratio generated an annualized total return of 19.0 percent, or 3.1 percentage points better than the 15.9 percent return on the S&P 500 Stock Index. Max also noted that the lowest price-cash-flow portfolio had a below-market beta of 0.91 over this same time span. a. Briefly comment on Max’s use of the beta measure as an indicator of portfolio risk in light of recent academic tests of its explanatory power with respect to stock returns. b. You are familiar with the literature on market anomalies and inefficiencies. Against this background, discuss Max’s use of a single-factor model (price–cash flow) in his research.

Problems: 1, 2, 3

Problem1: Compute the abnormal rates of return for the following stocks during period t (ignore differential systematic risk): Stock Rit Rmt B 11.5% 4.0% F 10.0 8.5 T 14.0 9.6 C 12.0 15.3 E 15.9 12.4 Problem 2: Compute the abnormal rates of return for the five stocks in Problem 1 assuming the following systematic risk measures (betas): Stock Beta B 0.95 F 1.25 T 1.45 C 0.70 E -0.30

Problem 3: Compare the abnormal rates of return in Problems 1&2 and discuss the reason for the difference in each case.

Ch 07: Intro to Portfolio Management

Questions: 12

Stocks K, L, and M each has the same expected return and standard deviation. The cor-relation coefficients between each pair of these stocks are:

K and L correlation coefficient = +0.8

K and M correlation coefficient = +0.2

L and M correlation coefficient =     −0.4

Given these correlations, a portfolio constructed of which pair of stocks will have the lowest standard deviation? Explain.

Questions: 13

A three-asset portfolio has the following characteristics. Asset Expected Return Expected Standard Deviation Weight X 0.15 0.22 0.50 Y 0.10 0.08 0.40 Z 0.06 0.03 0.10 The expected return on this three-asset portfolio is a. 10.3% b. 11.0% c. 12.1% d. 14.8%

Problems: 3

The following are the monthly rates of return for Madison Cookies and for Sophie Electric during a six-month period. Madison Sophie Month Cookies Electric 1 -0.04 0.07 2 0.06 -0.02 3 -0.07 -0.1 4 0.12 0.15 5 -0.02 -0.06 6 0.05 0.02 Compute the following: a. Average mnthly rate of return Ri for each stock b. Standard deviation of returns for each stock c. Covariance between the rates of return d. The correlation coefficient between the rates of return What level of correlation did you expect? How did your expectations compare with the computed correlation? Would these two stocks be good choices for diversification? Why or Why not?

Problems: 7

The following are monthly percentage price changes for four market indexes. Month DJIA S&P 500 Russell 2000 Nikkei 1 0.03 0.02 0.04 0.04 2 9.07 0.06 0.10 (0.02) 3 (0.02) (0.01) (0.04) 0.07 4 0.01 0.03 0.03 0.02 5 0.05 0.04 0.11 0.02 6 (0.06) (0.04) (0.08) 0.06 Compute the following: a. Average monthly rate of return for each index. b. Standard deviation for each index c. Covariance between the rates of return for the following indexes: DJIA – S&P500 S&P 500 – Russell 2000 S&P 500 – Nikkei Russell 2000 – Nikkei d. The correlation coefficients for the same four combinations e. Using the answers from parts (a), (b), and (d), calculate the expected return and standard deviation of a portfolio consisting of equal parts of: (1) the S&P and the Russell 2000, and (2) the S&P and the Nikkei. Discuss the two portfolios. please show process step by step thanks Comment by Mariea Pack-Elder:

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