Questions and Answers of Accounting For Investments

If markets are efficient, what should be the correlation coefficient between stock returns for two nonoverlapping time periods? PLI9
A successful firm like Microsoft has consistently generated large profits for years. Is this a violation of the EMH? PLI9
“If all securities are fairly priced, all must offer equal expected rates of return.” Comment. PLI9
Steady Growth Industries has never missed a dividend payment in its 94-year history. Does this make it more attractive to you as a possible purchase for your stock portfolio? PLI9
At a cocktail party, your co-worker tells you that he has beaten the market for each of the last three years. Suppose you believe him. Does this shake your belief in efficient markets? PLI9
“Constantly fluctuating stock prices suggest that the market does not know how to price stocks.”Comment. PLI9
Why are the following “effects” considered efficient market anomalies? Are there rational explanations for any of these effects? PLI9a. P/E effect.b. Book-to-market effect.c. Momentum effect.d.
If prices are as likely to increase as decrease, why do investors earn positive returns from the market on average? PLI9
Respond to each of the following comments.a. If stock prices follow a random walk, then capital markets are little different from a casino.b. A good part of a company’s future prospects is
Suppose you find that prices of stocks before large dividend increases show on average consistently positive abnormal returns. Is this a violation of the EMH? PLI9
“If the business cycle is predictable, and a stock has a positive beta, the stock’s returns also must be predictable.” Respond. PLI9
Investors expect the market rate of return in the coming year to be 12%. The T-bill rate is 4%.Changing Fortunes Industries’ stock has a beta of .5. The market value of its outstanding equity is
You know that firm XYZ is very poorly run. On a scale of 1 (worst) to 10 (best), you would give it a score of 3. The market consensus evaluation is that the management score is only 2. Should you buy
Good News, Inc., just announced an increase in its annual earnings, yet its stock price fell. Is there a rational explanation for this phenomenon? PLI9
Shares of small firms with thinly traded stocks tend to show positive CAPM alphas. Is this a violation of the efficient market hypothesis? PLI9
The feature of the general version of the arbitrage pricing theory (APT) that offers the greatest potential advantage over the simple CAPM is the:a. Identification of anticipated changes in
The general arbitrage pricing theory (APT) differs from the single-factor capital asset pricing model (CAPM) because it:a. Places more emphasis on market risk.b. Minimizes the importance of
According to the theory of arbitrage:a. High-beta stocks are consistently overpriced.b. Low-beta stocks are consistently overpriced.c. Positive alpha investment opportunities will quickly
Small firms generally have relatively high loadings (high betas) on the SMB (small minus big)factor.a. Explain why this is not surprising.b. Now suppose two unrelated small firms merge. Each will be
Assume a universe of n (large) securities for which the largest residual variance is not larger than n σM 2. Construct as many different weighting schemes as you can that generate welldiversified
With respect to the comments of Stiles and McCracken concerning for whom the GDP Fund would be appropriate:a. McCracken is correct and Stiles is wrong.b. Both are correct.c. Stiles is correct and
If the GDP Fund is constructed from the other three funds, which of the following would be its weight in the Utility Fund? (a) −2.2; (b) −3.2; or (c) .3. P-69
With respect to McCracken’s APT model estimate of Orb’s Large Cap Fund and the information Kwon provides, is an arbitrage opportunity available? P-69
According to the APT, if the risk-free rate is 4%, what should be McCracken’s estimate of the expected return of Orb’s High Growth Fund? P-69
As a finance intern at Pork Products, Jennifer Wainwright’s assignment is to come up with fresh insights concerning the firm’s cost of capital. She decides that this would be a good opportunity
Calculate the revised expectations for the rate of return on the stock once the “surprises” become known.Factor Expected Value Actual Value Inflation 5% 4%Industrial production 3 6 Oil prices 2
Consider the following multifactor (APT) model of security returns for a particular stock.Factor Factor Beta Factor Risk Premium Inflation 1.2 6%Industrial production 0.5 8 Oil prices 0.3 3a. If
The SML relationship states that the expected risk premium on a security in a one-factor model must be directly proportional to the security’s beta. Suppose that this were not the case. For
Assume that stock market returns have the market index as a common factor, and that all stocks in the economy have a beta of 1 on the market index. Firm-specific returns all have a standard deviation
Assume that portfolios A and B are both well diversified and that E(rA) = 12% and E(rB) = 9%.If the economy has only one factor, and βA = 1.2, whereas βB = .8, what must be the risk-free rate? P-69
Consider the following data for a one-factor economy. Both portfolios are well diversified.Portfolio E(r ) Beta A 12% 1.2 F 6% 0.0 Suppose that another portfolio, portfolio E, is well diversified
Suppose that there are two independent economic factors, F1 and F2. The risk-free rate is 6%, and all stocks have independent firm-specific components with a standard deviation of 45%.Portfolios A
If the APT is to be a useful theory, the number of systematic factors in the economy must be small. Why? P-69
The multifactor extension of the single-factor CAPM, the ICAPM, predicts the same multidimensional security market line as the multifactor APT. The ICAPM suggests that priced extra-market risk
A multifactor APT generalizes the single-factor model to accommodate several sources of systematic risk. The multidimensional security market line predicts that exposure to each risk factor
The APT does not require the restrictive assumptions of the CAPM and its (unobservable) market portfolio. The price of this generality is that the APT does not guarantee this relationship for all
In a single-factor security market, all well-diversified portfolios have to satisfy the expected return–beta relationship of the CAPM to satisfy the no-arbitrage condition. If all well-diversified
Portfolios are called “well diversified” if they include a large number of securities and the investment proportion in each is sufficiently small. The proportion of any particular security in a
When securities are priced so that there are no risk-free arbitrage opportunities, we say that they satisfy the no-arbitrage condition. Price relationships that satisfy the no-arbitrage condition are
A (risk-free) arbitrage opportunity arises when two or more security prices enable investors to construct a zero-net-investment portfolio that will yield a sure profit. The presence of arbitrage
Once we allow for multiple risk factors, we conclude that the security market line also ought to be multidimensional, with exposure to each risk factor contributing to the total risk premium of the
Multifactor models seek to improve the explanatory power of single-factor models by explicitly accounting for the various components of systematic risk. These models use indicators intended to
Dudley Trudy, CFA, recently met with one of his clients. Trudy typically invests in a master list of 30 equities drawn from several industries. As the meeting concluded, the client made the following
Abigail Grace has a $900,000 fully diversified portfolio. She subsequently inherits ABC Company common stock worth $100,000. Her financial adviser provided her with the following estimates:Risk and
George Stephenson’s current portfolio of $2 million is invested as follows:Summary of Stephenson’s Current Portfolio Value Percent of Total Expected Annual Return Annual Standard Deviation
Statistics for three stocks, A, B, and C, are shown in the following tables.Standard Deviations of Returns Stock: A B C Standard deviation (%): 40 20 40 Correlations of Returns Stock A B C A 1.00
Stocks A, B, and C have the same expected return and standard deviation. The following table shows the correlations between the returns on these stocks.Stock A Stock B Stock C Stock A +1.0 Stock B
Assume that a risk-averse investor owning stock in Miller Corporation decides to add the stock of either Mac or Green Corporation to her portfolio. All three stocks offer the same expected return and
Portfolio theory as described by Markowitz is most concerned with: P-968a. The elimination of systematic risk.b. The effect of diversification on portfolio risk.c. The identification of unsystematic
The measure of risk for a security held in a diversified portfolio is: P-968a. Specific risk.b. Standard deviation of returns.c. Reinvestment risk.d. Covariance.
Which statement about portfolio diversification is correct? P-968a. Efficient diversification can reduce or eliminate systematic risk.b. Diversification reduces the portfolio’s expected return
Which one of the following portfolios cannot lie on the efficient frontier as described by Markowitz? P-968 Portfolio Expected Return (%) Standard Deviation (%)a. W 15 36b. X 12 15c. Z 5 7d. Y 9 21
Another committee member suggested that, rather than evaluate each managed portfolio independently of other portfolios, it might be better to consider the effects of a change in the Hennessy
One committee member was particularly enthusiastic concerning Jones’s proposal. He suggested that Hennessy’s performance might benefit further from reduction in the number of issues to 10.If the
a. Will the limitation to 20 stocks likely increase or decrease the risk of the portfolio? Explain.b. Is there any way Hennessy could reduce the number of issues from 40 to 20 without significantly
Repeat Problem 24 using an annual correlation of .3. P-968
Repeat Problem 23 using an annual correlation of .3. P-968
If the correlation coefficient between annual portfolio returns is actually .3, what is the covariance between the returns? P-968
What should be Greta’s capital allocation? P-968
Assuming the correlation between the annual returns on the two portfolios is indeed zero, what would be the optimal asset allocation? P-968
Compute the estimated annual risk premiums, standard deviations, and Sharpe ratios for the two portfolios. P-968
Suppose that in addition to investing in one more stock you can invest in T-bills as well. Would you change your answers to Problems 17 and 18 if the T-bill rate is 8%? P-968
Would the answer to Problem 17 change for more risk-averse or risk-tolerant investors? Explain. P-968
If your entire portfolio is now composed of stock A and you can add some of only one stock to your portfolio, would you choose (explain your choice): P-968a. Bb. Cc. Dd. Need more data
Suppose that you have $1 million and the following two opportunities from which to construct a portfolio:a. Risk-free asset earning 12% per year.b. Risky asset with expected return of 30% per year
Suppose you have a project that has a .7 chance of doubling your investment in a year and a .3 chance of halving your investment in a year. What is the standard deviation of the rate of return on
True or false: The standard deviation of the portfolio is always equal to the weighted average of the standard deviations of the assets in the portfolio. P-968
True or false: Assume that expected returns and standard deviations for all securities (including the risk-free rate for borrowing and lending) are known. In this case, all investors will have the
Suppose that there are many stocks in the security market and that the characteristics of stocks A and B are given as follows:Stock Expected Return Standard Deviation A 10% 5%B 15 10 Correlation =
Stocks offer an expected rate of return of 18% with a standard deviation of 22%. Gold offers an expected return of 10% with a standard deviation of 30%.a. In light of the apparent inferiority of gold
If you were to use only the two risky funds and still require an expected return of 14%, what would be the investment proportions of your portfolio? Compare its standard deviation to that of the
You require that your portfolio yield an expected return of 14%, and that it be efficient, that is, on the steepest feasible CAL.a. What is the standard deviation of your portfolio?b. What is the
What is the Sharpe ratio of the best feasible CAL? P-968
Solve numerically for the proportions of each asset and for the expected return and standard deviation of the optimal risky portfolio. P-968
Draw a tangent from the risk-free rate to the opportunity set. What does your graph show for the expected return and standard deviation of the optimal portfolio? P-968
Tabulate and draw the investment opportunity set of the two risky funds. Use investment proportions for the stock fund of 0% to 100% in increments of 20%. P-968
What are the investment proportions in the minimum-variance portfolio of the two risky funds, and what are the expected value and standard deviation of its rate of return? P-968
Which of the following statements about the minimum-variance portfolio of all risky securities is valid? (Assume short sales are allowed.) Explain.a. Its variance must be lower than those of all
When adding real estate to an asset allocation program that currently includes only stocks, bonds, and cash, which of the properties of real estate returns most affects portfolio risk? Explain.a.
Which of the following factors reflect pure market risk for a given corporation?a. Increased short-term interest rates.b. Fire in the corporate warehouse.c. Increased insurance costs.d. Death of the
Diversification is based on the allocation of a portfolio of fixed size across several assets, limiting the exposure to any one source of risk. Adding additional risky assets to a portfolio, thereby
If a risk-free asset is available and input lists are identical, all investors will choose the same portfolio on the efficient frontier of risky assets: the portfolio tangent to the CAL. All
In practice, portfolio managers will arrive at different efficient portfolios because of differences in methods and quality of security analysis. Managers compete on the quality of their security
A portfolio manager identifies the efficient frontier by first establishing estimates for asset expected returns and the covariance matrix. This input list is then fed into an optimization program
The efficient frontier shows the set of portfolios that maximize expected return for each level of portfolio risk. Rational investors will choose a portfolio on the efficient frontier. P-968
The greater an asset’s covariance with the other assets in the portfolio, the more it contributes to portfolio variance. An asset that is perfectly negatively correlated with a portfolio can serve
Even if the covariances are positive, the portfolio standard deviation is less than the weighted average of the component standard deviations, as long as the assets are not perfectly positively
The variance of a portfolio is the weighted sum of the elements of the covariance matrix using the products of the investment proportions as weights. Thus, the variance of each asset is weighted by
The expected return of a portfolio is the weighted average of the component-security expected returns with investment proportions as weights. P-968
Suppose that two portfolio managers who work for competing investment management houses each employs a group of security analysts to prepare the input list for the Markowitz algorithm. When all is
An analyst estimates that a stock has the following probabilities of return depending on the state of the economy: p-963
Probabilities for three states of the economy and probabilities for the returns on a particular stock in each state are shown in the table below. p-963
Assume that of your $10,000 portfolio, you invest $9,000 in Stock X and $1,000 in Stock Y.What is the expected return on your portfolio? p-963
What are the standard deviations of returns on Stocks X and Y? p-963
What are the expected rates of return for Stocks X and Y? p-963
Based on the scenarios below, what is the expected return for a portfolio with the following return profile? p-963
Given $100,000 to invest, what is the expected risk premium in dollars of investing in equities versus risk-free T-bills (U.S. Treasury bills) based on the following table? p-963
Consider these long-term investment data:• The price of a 10-year $100 face value zero-coupon inflation-indexed bond is $84.49.• A real-estate property is expected to yield 2% per quarter
Suppose the risk-free interest rate is 6% per year. You are contemplating investing $107.55 in a 1-year CD and simultaneously buying a call option on the stock market index fund with an exercise
You are faced with the probability distribution of the HPR on the stock market index fund given in Spreadsheet 5.1 of the text. Suppose the price of a put option on a share of the index fund with

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