Chapter 2: Q14I. (page 226)
If the simple CAPM is valid, which of the situations in Problems 13 – 19 below are possible? Explain. Consider each situation independently.
Portfolio | Expected Return | Standard Deviation |
A B | 30% 40 | 35% 25 |
The correct answer would be: “Possible”
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You are a portfolio manager meeting a client. During the conversation that follows your formal review of her account, your client asks the following question:
My grandson, who is studying investments, tells me that one of the best ways to make money in the stock market is to buy the stocks of small-capitalization firms late in December and to sell the stocks one month later. What is he talking about?
a. Identify the apparent market anomalies that would justify the proposed strategy.
b. Explain why you believe such a strategy might or might not work in the future.
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).
A market anomaly refers to:
a. An exogenous shock to the market that is sharp but not persistent.
b. A price or volume event that is inconsistent with historical price or volume trends.
c. A trading or pricing structure that interferes with efficient buying and selling of securities.
d. Price behavior that differs from the behavior predicted by the efficient market hypothesis.
What do you think would happen to the expected return on stocks if investors perceived an increase in the volatility of stocks?
A portfolio’s expected return is 12%, its standard deviation is 20%, and the risk-free rate is 4%. Which of the following would make for the greatest increase in the portfolio’s Sharpe ratio?
a. An increase of 1% in expected return.
b. A decrease of 1% in the risk-free rate.
c. A decrease of 1% in its standard deviation.
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