Chapter 2: Q5B (page 284)
Question: What are some possible investment implications of the behavioral critique?
Answer
A possible investment implication of the behavioral critique is thetendency to assume more than what is claimed and mislead on excess returns
Over 30 million students worldwide already upgrade their learning with Vaia!
All the tools & learning materials you need for study success - in one app.
Get started for free
Here are data on two companies. The T-bill rate is 4% and the market risk premium is 6%.
Company | \(1 Discount Store | Everything \)5 |
Forecast return | 12% | 11% |
Standard deviation of returns | 8% | 10% |
Beta | 1.5 | 1.0 |
What would be the fair return for each company, according to the capital asset pricing model (CAPM)?
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?
Suppose there are two independent economic factors, M 1 and M 2 . The risk-free rate is 7%, and all stocks have independent firm-specific components with a standard deviation of 50%. Portfolios A and B are both well diversified.
What is the expected return–beta relationship in this economy?
Suppose that as the economy moves through a business cycle, risk premiums also change. For example, in a recession when people are concerned about their jobs, risk tolerance might be lower and risk premiums might be higher. In a booming economy, tolerance for risk might be higher and risk premiums lower.
a. Would a predictably shifting risk premium such as described here be a violation of the efficient market hypothesis?
b. How might a cycle of increasing and decreasing risk premiums create an appearance that stock prices “overreact,” first falling excessively and then seeming to recover?
Are the following true or false? Explain.
a. Stocks with a beta of zero offer an expected rate of return of zero.
b. The CAPM implies that investors require a higher return to hold highly volatile securities.
c. You can construct a portfolio with beta of .75 by investing .75 of the investment budget in T-bills and the remainder in the market portfolio.
What do you think about this solution?
We value your feedback to improve our textbook solutions.
