Tutorial 9: FTX 3044F

(Covers Chapters 10 and 11)

Question 1 [2 marks]
Suppose you are working with two factor portfolios, Portfolio 1 and Portfolio 2. The portfolios
have expected returns of 15% and 6%, respectively. Based on this information, what would
be the expected return on well-diversified portfolio A, if A has a beta of 0.80 on the first factor
and 0.50 on the second factor? The risk-free rate is 3%.

Solution
E(R
A
) = 3 +0.8*(15-3) + 0.5*(6-3) = 14.1[2 marks]


Question 2 [8 marks]
Security A has a beta of 1.0 and an expected return of 12%. Security B has a beta of 0.75
and an expected return of 11%. The risk-free rate is 6%.
Explain the arbitrage opportunity that exists; explain how an investor can take advantage of
it. Give specific details about how to form the portfolio, what to buy and what to sell.

Solution
An arbitrage opportunity exists because it is possible to form a portfolio of security A and the
risk-free asset that has a beta of 0.75 and a different expected return than security B. [1
marks] The investor can accomplish this by choosing .75 as the weight in A and .25 in the
risk-free asset. [1 marks] This portfolio would have E(r
p
) = 0.75(12%) + 0.25(6%) = 10.5%,
[2 marks]which is less than B's 11% expected return. [1 marks] The investor should buy
B[1 marks] and finance the purchase by short selling A and borrowing at the risk-free asset.
[2 marks]


Question 3 [10 marks]
Discuss the various forms of market efficiency. Include in your discussion:
The information sets involved in each form and the relationships across information
sets and across forms of market efficiency.
Also discuss the implications for the various forms of market efficiency for the
various types of securities' analysts.

Solution
The weak form of the efficient markets hypothesis (EMH) states that stock prices
immediately reflect market data. [1 marks] Market data refers to stock prices and trading
volume. [1 marks] Technicians attempt to predict future stock prices based on historic stock
price movements. [1 marks] Thus, if the weak form of the EMH holds, the work of the
technician is of no value. [1 marks]

The semistrong form of the EMH states that stock prices include all public information. [1
marks] This public information includes market data and all other publicly available
information, such as financial statements, and all information reported in the press relevant
to the firm. Thus, market information is a subset of all public information. [1 marks] As a
result, if the semistrong form of the EMH holds, the weak form must hold also. [1 marks] If
the semistrong form holds, then the fundamentalist, who attempts to identify undervalued
securities by analyzing public information, is unlikely to do so consistently over time. [1
marks] In fact, the work of the fundamentalist may make the markets even more efficient!

The strong form of the EMH states that all information (public and private) is immediately
reflected in stock prices. [1 marks] Public information is a subset of all information, thus if
the strong form of the EMH holds, the semistrong form must hold also. [1 marks] The
strong form of EMH states that even with inside (legal or illegal) information, one cannot
expect to outperform the market consistently over time. [1 marks]

Question 4 [5 marks]
What is an event study? Which form of market efficiency does it test? Discuss the process
of conducting an event study.
Solution
A event study is an empirical test which allows the researcher to assess the impact of a
particular event on a firm's stock price. [1 marks] To do so, one often uses the index model
and estimates e
t
, the residual term which measures the firm-specific component of the
stock's return. [1 marks] This variable is the difference between the return the stock would
ordinarily earn for a given level of market performance and the actual rate of return on the
stock. This measure is often referred to as the abnormal return of the stock. [1 marks]
However, it is very difficult to identify the exact point in time that an event becomes public
information; thus, the better measure is the cumulative abnormal return, which is the sum
of abnormal returns over a period of time (a window around the event date). [1 marks]
This technique may be used to study the effect of any public event on a firm's stock price;
thus, this technique is a test of the semistrong form of the EMH. [1 marks]