Chapter 2: Q-9-3B (page 284)
Question: What do we mean by fundamental risk, and why may such risk allow behavioral biases to persist for long periods of time?
Answer
Fundamental risk allows behavioral bias because this limits the actions of arbitrageurs
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Assume a market index represents the common factor and all stocks in the economy have a beta of 1. Firm-specific returns all have a standard deviation of 30%.
Suppose an analyst studies 20 stocks and finds that one-half have an alpha of 3%, and one-half have an alpha of - 3%. The analyst then buys \(1 million of an equally weighted portfolio of the positive-alpha stocks and sells short \)1 million of an equally weighted portfolio of the negative-alpha stocks.
a. What is the expected profit (in dollars), and what is the standard deviation of the analyst’s profit?
b. How does your answer change if the analyst examines 50 stocks instead of 20? 100 stocks?
A zero-investment well-diversified portfolio with a positive alpha could arise if:
a. The expected return of the portfolio equals zero.
b. The capital market line is tangent to the opportunity set.
c. The law of one price remains un-violated.
d. A risk-free arbitrage opportunity exists.
Growth and value can be defined in several ways. Growth usually conveys the idea of a portfolio emphasizing or including only companies believed to possess above-average future rates of per-share earnings growth. Low current yield, high price-to-book ratios, and high price-to-earnings ratios are typical characteristics of such portfolios. Value usually conveys the idea of portfolios emphasizing or including only issues currently showing low price-to-book ratios, low price-to-earnings ratios, above-average levels of dividend yield, and market prices believed to be below the issues’ intrinsic values.
a. Identify and provide reasons why, over an extended period of time, value-stock investing might outperform growth-stock investing.
b. Explain why the outcome suggested in ( a ) should not be possible in a market widely regarded as being highly efficient.
According to the efficient market hypothesis:
a. High-beta stocks are consistently overpriced.
b. Low-beta stocks are consistently overpriced.
c. Positive alphas on stocks will quickly disappear.
d. Negative-alpha stocks consistently yield low returns for arbitrageurs
“Highly variable stock prices suggest that the market does not know how to price stocks.” Respond.
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