Question

#Question

A) "Economists often refer to the stock market as an efficient market, By this they mean that the competition to find the misvalued stocks is intense, So, when new information comes out, investors rush to take advantage of it and therefore eliminate any profit opportunities."

#1A- Explain the term "Efficient market' and distinguish THREE (3) forms of the Efficient Market Hypotheses (EMH).

B) If the rate of return available on risk-free assets is 4% and you expect the rate of return of the market portfolio to be 14%.

#1B- What expected rate of return would you demand before you would be willing to invest in this mutual fund?

#2B- Is this fund attractive? Why?

#3B- How could you mix mutual fund with a risk-free position in Treasury bills to create a portfolio with the same managers but with a higher expected rate of return? what is the rate of the return of the portfolio?

Answer 1

1A

Efficient Market

The term "efficient market" was developed by economist Eugene Fama in 1970.

Market efficiency refers to the degree to which the market reflects all the available information. It is believed that in an efficient market, all the information is already incorporated into the asset price, and there is no way to beat the market because there are no undervalued or overvalued securities available.

Hence all pertinent information is available to all participants at the same time, and where prices respond immediately to available information.

Stock markets are considered the best examples of efficient markets.

Efficient market hypothesis (EMH) states that an investor can't outperform the market, and that market anomalies should not exist because they will immediately be arbitraged.

Below are the Three Forms of the Efficient Market

1. The Weak Form

When the past price movements(past information) are not useful for predicting future prices.

Hence future price changes can only be the result of new information becoming available.

Fundamental analysis of securities can provide an investor with information to produce returns above market averages in the short term, but there are no "patterns" that exist. Therefore, fundamental analysis does not provide long-term advantage and technical analysis will not work.

2. Semi-Strong Form

The semi-strong form of market efficiency assumes that assets adjust quickly to absorb new public information so that an investor cannot benefit over and above the market by trading(with new information).

Implies that neither fundamental analysis nor technical analysis can provide an advantage for an investor and that new information is instantly priced in to securities.

3. Strong Form

When all information, both public and private, is priced into stocks/assets, and that no investor can gain advantage over the market as a whole.

1B

risk-free rate = 4%

expected rate of return = 14%

Assuming beta = 0.8

The CAPM implies that the expected rate of return that investors will demand of the portfolio is:

r=rf+ β(rm−rf)

=> 4% + 0.8 × (14% − 4%) = 12%

2B

If the portfolio is expected to provided less than 12% return it is not attractive.

3B

A portfolio that has invested 80% in a stock index mutual fund (with beta = 1) and 20% in a money market mutual fund( with beta of 0) would have same beta as that of this manager's portfolio.

Beta = 0.8

Expected Return = 12%

This expected return is better than the portfolio manager's expected return