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Chapter 2: Q11I (page 285)

Question: Even if prices follow a random walk, they still may not be informationally efficient. Explain why this may be true, and why it matters for the efficient allocation of capital in our economy.

Short Answer

Expert verified

Answer

Sometimes prices may not follow a set path and maybe informationally inefficient due to the disposition effect.

Step by step solution

01

Definition

The tendency of premature selling of assets when they have made gains while holding on to the ones that are losing money is known as disposition effect

02

Explanation on random walk of price

Since it has been showed by Grinblatt and Han that disposition effect can lead to momentum in stock prices even if fundamental values follow a random walk. This may appear to lead to abnormal profit but may only cause capital flow to investment as a benefit of the momentum. This would be in contrast to where it would otherwise flow.

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Most popular questions from this chapter

Assume that both X and Y are well-diversified portfolios and the risk-free rate is 8%.

Portfolio

Expected Return

Beta

X

Y

16%

12%

1.00

0.25

In this situation you could conclude that portfolios X and Y:

a. Are in equilibrium.

b. Offer an arbitrage opportunity.

c. Are both under priced.

d. Are both fairly priced.

Briefly explain whether investors should expect a higher return from holding portfolio A versus portfolio B under capital asset pricing theory (CAPM). Assume that both portfolios are fully diversified.

An analyst estimates that a stock has the following probabilities of return depending on the state of the economy. What is the expected return of the stock?

Based on current dividend yields and expected capital gains, the expected rates of return on portfolios A and B are 11% and 14%, respectively. The beta of A is .8 while that of B is 1.5. The T-bill rate is currently 6%, while the expected rate of return of the S&P 500 Index is 12%. The standard deviation of portfolio A is 10% annually, while that of B is 31%, and that of the index is 20%.

a. If you currently hold a market-index portfolio, would you choose to add either of these portfolios to your holdings? Explain.

b. If instead you could invest only in bills and one of these portfolios, which would you choose?

Assume both portfolios A and B are well diversified, that E ( r A ) = 14% and E ( r B ) = 14.8%. If the economy has only one factor, andβA= 1 whileβB = 1.1, what must be the risk-free rate?
See all solutions

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