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d. It implies that prices do not fluctuate.
6. 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.
7. Which of the following observations would provide evidence against the semistrong
form of the efficient market theory? Explain.
a. Mutual fund managers do not on average make superior returns.
b. You cannot make superior profits by buying (or selling) stocks after the
announcement of an abnormal rise in earnings.
c. Low P/E stocks tend to provide abnormal risk-adjusted returns.
d. In any year, approximately 50% of pension funds outperform the market.
8. A successful firm like Intel has consistently generated large profits for years. Is this a
violation of the EMH?
9. Prices of stocks before stock splits show on average consistently positive abnormal
returns. Is this a violation of the EMH?
10. “If the business cycle is predictable, and a stock has a positive beta, the stock™s returns
also must be predictable.” Respond.
11. “The expected return on all securities must be equal if markets are efficient.” Comment.
12. We know the market should respond positively to good news, and good news events
such as the coming end of a recession can be predicted with at least some accuracy.
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Why, then, can we not predict that the market will go up as the economy recovers?
13. If prices are as likely to increase or decrease, why do investors earn positive returns
from the market on average?
14. You know that firm XYZ is very poorly run. On a management 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 or sell the stock?
15. Some scholars contend that professional managers are incapable of outperforming the
market. Others come to an opposite conclusion. Compare and contrast the assumptions
about the stock market that support (a) passive portfolio management and (b) active
portfolio management.
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8 The Efficient Market Hypothesis


16. You are a portfolio manager meeting a client. During the conversation that followed
your formal review of her account, your client asked 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.
17. Which of the following phenomena would be either consistent with or in violation of
the efficient market hypothesis? Explain briefly.
a. Nearly half of all professionally managed mutual funds are able to outperform the
S&P 500 in a typical year.
b. Money managers that outperform the market (on a risk-adjusted basis) in one year
are likely to outperform the market in the following year.
c. Stock prices tend to be predictably more volatile in January than in other months.
d. Stock prices of companies that announce increased earnings in January tend to
outperform the market in February.
e. Stocks that perform well in one week perform poorly in the following week.
18. Dollar-cost averaging means that you buy equal dollar amounts of a stock every period,
for example, $500 per month. The strategy is based on the idea that when the stock
price is low, your fixed monthly purchase will buy more shares, and when the price is
high, fewer shares. Averaging over time, you will end up buying more shares when the
stock is cheaper and fewer when it is relatively expensive. Therefore, by design, you
will exhibit good market timing. Evaluate this strategy.
19. 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?
20. Good News, Inc., just announced an increase in its annual earnings, yet its stock price
fell. Is there a rational explanation for this phenomenon?
Use the following information to solve problems 21 and 22:
As director of research for a medium-sized investment firm, Jeff Cheney was concerned
about the mediocre investment results experienced by the firm in recent years. He met with his
two senior equity analysts to consider alternatives to the stock selection techniques employed
in the past.
One of the analysts suggested that the current literature has examined the relationship be-
tween price“earnings (P/E) ratios and securities returns. A number of studies had concluded
that high P/E stocks tended to have higher betas and lower risk-adjusted returns than stocks
with low P/E ratios.
The analyst also referred to recent studies analyzing the relationship between security re-
turns and company size as measured by equity capitalization. The studies concluded that when
compared to the S&P 500 index, small-capitalization stocks tended to provide above-average
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risk-adjusted returns, while large-capitalization stocks tended to provide below-average risk-
adjusted returns. It was further noted that little correlation was found to exist between a com-
pany™s P/E ratio and the size of its equity capitalization.
Jeff™s firm has employed a strategy of complete diversification and the use of beta as a
measure of portfolio risk. He and his analysts were intrigued as to how these recent studies
might be applied to their stock selection techniques and thereby improve their performance.
Given the results of the studies indicated above:
21. Explain how the results of these studies might be used in the stock selection and
portfolio management process. Briefly discuss the effects on the objectives of
diversification and on the measurement of portfolio risk.
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290 Part TWO Portfolio Theory


22. List the reasons and briefly discuss why this firm might not want to adopt a new
strategy based on these studies in place of its current strategy of complete
diversification and the use of beta as a measure of portfolio risk.
23. “Growth” and “Value” can be defined in several ways, but “growth” usually conveys
the idea of a portfolio emphasizing or including only issues believed to possess above-
average future rates of per-share earnings growth. Low current yield, high price-to-book
ratios, and high price-to-earnings ratios are typical characteristics of such portfolios.
“Value” usually conveys the idea of portfolios emphasizing or including only issues
currently showing low price-to-book ratios, low price-to-earnings ratios, above-average
levels of dividend yield, and market prices believed to be below the issues™ intrinsic
values.
a. Identify and explain three reasons why, over an extended period of time, value stock
investing might outperform growth stock investing.
b. Explain why the outcome suggested in (a) above should not be possible in a market
widely regarded as being highly efficient.



1. Use data from Market Insight (www.mhhe.com/edumarketinsight) to rank firms
based on one of these criteria:
a. Market-to-book ratio.
b. Price“earnings ratio.
c. Market capitalization (size).
d. Another criterion that interest you.
Divide the firms into five groups based on their ranking for the criterion that you
choose, and calculate the average rate of return of the firms in each group. Do
you confirm or reject any of the anomalies cited in this chapter? Can you uncover
a new anomaly? Note: For your test to be valid, you must form your portfolios
based on criteria observed at the beginning of the period when you form the stock
groups. Why?
2. Use the price history supplied by Market Insight (www.mhhe.com/edumarket
insight) to calculate the beta of each of the firms in the previous question.
Use this beta, the T-bill rate, and the return on the S&P 500 to calculate the
risk-adjusted abnormal return of each stock group. Does any anomaly
uncovered in the previous question persist after controlling for risk?
3. Now form stock groups that use more than one criterion simultaneously. For
example, form a portfolio of stocks that are both in the lowest quintile of
price“earnings ratios and in the lowest quintile of market-to-book ratio. Does
selecting stocks based on more than one characteristic improve your ability to
devise portfolios with abnormal returns?
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291
8 The Efficient Market Hypothesis




WEBMA STER
Funds
Go to http://www.morningstar.com and select the Funds tab. The index page for Funds
contains a pull-down menu that should show “Find a Fund” when you enter the site.
From the pull-down menu, select Long-Term Winners. A list of the long-term winners will
appear. You can click on the name of the fund, and a more detailed report will appear.
Another option on the report will allow you to view ratings details. Select that
information for each of the top three long-term winners.
For each of the funds, identify its beta, alpha, and R-sqr. Then, answer the following
questions:
1. Which if any of the funds outperformed the market for its level of risk?
2. Which fund had the highest level of risk-adjusted performance?




1. a. A high-level manager might well have private information about the firm. Her ability to trade SOLUTIONS TO
profitably on that information is not surprising. This ability does not violate weak-form
< Concept
efficiency: The abnormal profits are not derived from an analysis of past price and trading data.
If they were, this would indicate that there is valuable information that can be gleaned from CHECKS
such analysis. But this ability does violate strong-form efficiency. Apparently, there is some
private information that is not already reflected in stock prices.
b. The information sets that pertain to the weak, semistrong, and strong form of the EMH can be
described by:




Strong Semistrong Weak
form form form
set set set




The weak-form information set includes only the history of prices and trading. The semistrong-
form set includes the weak-form set plus all other publicly available information. In turn, the
strong-form set includes the semistrong set plus inside information. The direction of valid
implication is
Strong-form efficiency ’ semistrong-form efficiency ’ weak-form efficiency
The reverse direction implication is not valid. For example, stock prices may reflect all past
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price data (weak-form efficiency) but may not reflect relevant fundamental data (semistrong-
form inefficiency).
2. If everyone follows a passive strategy, sooner or later prices will fail to reflect new information. At
this point, there are profit opportunities for active investors who uncover mispriced securities. As
they buy and sell these assets, prices again will be driven to fair levels.
3. The answer depends on your prior beliefs about market efficiency. Magellan™s record was
incredibly strong. On the other hand, with so many funds in existence, it is less surprising that some
Bodie’Kane’Marcus: II. Portfolio Theory 8. The Efficient Market © The McGraw’Hill
Essentials of Investments, Hypothesis Companies, 2003
Fifth Edition




292 Part TWO Portfolio Theory


fund would appear to be consistently superior after the fact. In fact, Magellan™s record was so
good that even accounting for its selection after the fact as the “winner” of an investment
“contest,” it still appears to be too good to be attributed to chance. For further analysis and
discussion of Magellan™s performance, refer to the articles by Marcus and Samuelson in
Appendix A.
4. If profit opportunities can be made, one would expect mutual funds specializing in small stocks to
spring into existence. Moreover, one wonders why buyers of small stocks don™t compete for those
stocks in December and bid up their prices before the January rise.
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Fifth Edition




THREE
PA RT


DEBT SECURITIES


ond markets used to be a sedate arena single trader at Merrill Lynch lost $250 hundred

B for risk-averse investors who wanted million in less than a month trading mortgage-
worry-free investments with modest but backed securities in 1987. Procter & Gamble
stable returns. They are no longer so quiet. An- lost about $100 million in interest rate swaps in
nual trading in U.S. government bonds alone is 1994. Long-Term Capital Management lost
about 10 times the total amount of national more than $1 billion on its interest-rate posi-
debt. The market in mortgage-backed securi- tions in 1998. Of course, there were traders on
ties alone is now about $2.6 trillion. the other side of these transactions who did
Higher trading activity is not the only rea- quite well in these instances.
son these markets are more interesting than The chapters in Part Three provide an
they once were. These markets are no longer introduction to debt markets and securities.
free of risk. Interest rates in the last decade or We will show you how to value such securities
so have become more volatile than anyone in and why their values change with interest
1965 would have dreamed possible. Volatility rates. We will see what features determine the
means that investors have great opportunities sensitivity of bond prices to interest rates, and
for gain, but also for losses, and we have seen how investors measure and manage interest

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