Chapter 2: Q12I (page 285)
Question: What is meant by “limits to arbitrage”? Give some examples of such limits.
Answer
“Law of one price” sets a limit to arbitrage. Examples are equity carve-out and closed end funds.
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Question: Don Sampson begins a meeting with his financial adviser by outlining his investment philosophy as shown below:
Statement Number | Statement |
1 | Investments should offer strong return potential but with very limited risk. I prefer to be conservative and to minimize losses, even if I miss out on substantial growth opportunities. |
2 | All nongovernmental investments should be in industry-leading and financially strong companies. |
3 | Income needs should be met entirely through interest income and cash dividends. All equity securities held should pay cash dividends. |
4 | Investment decisions should be based primarily on consensus forecasts of general economic conditions and company-specific growth. |
5 | If an investment falls below the purchase price, that security should be retained until it returns to its original cost. Conversely, I prefer to take quick profits on successful investments. |
6 | I will direct the purchase of investments, including derivative securities, periodically. These aggressive investments result from personal research and may not prove consistent with my investment policy. I have not kept records on the performance of similar past investments, but I have had some “big winners.” |
Select the statement from the table above that best illustrates each of the following behavioral finance concepts. Justify your selection.
i. Mental accounting.
ii. Overconfidence (illusion of control).
iii. Reference dependence (framing).
When estimating a Sharpe ratio, would it make sense to use the average excess real return that accounts for inflation?
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?
In Problems 21–23 below, assume the risk-free rate is 8% and the expected rate of return on the market is 18%.
I am buying a firm with an expected perpetual cash flow of $1,000 but am unsure of its risk. If I think the beta of the firm is zero, when the beta is really 1, how much more will I offer for the firm than it is truly worth?
Shares of small firms with thinly traded stocks tend to show positive CAPM alphas. Is this a violation of the efficient market hypothesis?
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