Question

In: Finance

1. You are trying to make decisions on which mutual fund you should invest in based...

1. You are trying to make decisions on which mutual fund you should invest in based on the past performance of two fund managers. Manger A averaged a 17% return with a portfolio beta of 1.5, and manager B averaged a 15% return with a portfolio beta of 1.2. If the T-bill rate was 5% and the market return during the period was 13%, which fund manager was the better stock picker?

A.         Advisor A was better because he generated a larger alpha.

B.         Advisor B was better because she generated a larger alpha.

C.         Advisor A was better because he generated a higher return.

D.         Advisor B was better because she achieved a good return with a lower beta.

2. Among the important characteristics of market efficiency is (are) that:

I. There are no arbitrage opportunities.

II. Security prices react quickly to new information.

III. It will be difficult to find stocks with positive alphas or negative alphas.

A.         I only

B.         II only

C.         I and III only

D.         I, II, and III

E.         I and II only

Solutions

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Answer:

1)

Given that,

Risk free rate Rf = 5%

market return Rm = 13%

Manger A averaged a 17% return with a portfolio beta of 1.5

Based on CAPM, expected return on a fund is calculated as Rf + beta*(Rm - Rf)

=> Expected return of manager A's fund = 5 + 1.5*(13 - 5) = 17%

So, alpha of the fund = average return - expected return = 17% - 17% = 0

Manger B averaged a 15% return with a portfolio beta of 1.2

Based on CAPM, expected return on a fund is calculated as Rf + beta*(Rm - Rf)

=> Expected return of manager B's fund = 5 + 1.2*(13 - 5) = 14.6%

So, alpha of the fund = average return - expected return = 15% - 14.6% = 0.4%

Advisor B was better because she generated a larger alpha.

2)

The important characteristics of market efficiency are:

  • The stock prices react quickly to new information.
  • There are no arbitrage opportunities in an efficient market.

In market efficiency, it is not possible to consistently beat the market using active trading strategies. So, active trading strategies do not consistently beat the passive strategies

There are no arbitrage opportunities in an efficient market.

I and II only


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