Econ 422 Problem Set 8 Solutions: Efficient Markets and Risk - Prof. Eric Zivot, Assignments of Economics

Download Econ 422 Problem Set 8 Solutions: Efficient Markets and Risk - Prof. Eric Zivot and more Assignments Economics in PDF only on Docsity! Econ 422 E. Zivot Summer 2008 Problem Set 8 Solutions BM Chapter 14 Practice Questions 14.9, 14.10, 14.14, 14.19 9. a. An individual can do crazy things, but still not affect the efficiency of markets. The price of the asset in an efficient market is a consensus price as well as a marginal price. A nutty person can give assets away for free or offer to pay twice the market value. However, when the person’s supply of assets or money runs out, the price will adjust back to its prior level (assuming there is no new, relevant information released by his action). If you are lucky enough to know such a person, you will receive a positive gain at the nutty investor’s expense. You had better not count on this happening very often, though. Fortunately, an efficient market protects crazy investors in cases less extreme than the above. Even if they trade in the market in an “irrational” manner, they can be assured of getting a fair price since the price reflects all information. b. Yes, and how many people have dropped a bundle? Or, more to the point, how many people have made a bundle only to lose it later? People can be lucky and some people can be very lucky; efficient markets do not preclude this possibility. c. Investor psychology is a slippery concept, more often than not used to explain price movements that the individual invoking it cannot personally explain. Even if it exists, is there any way to make money from it? If investor psychology drives up the price one day, will it do so the next day also? Or will the price drop to a ‘true’ level? Almost no one can tell you beforehand what ‘investor psychology’ will do. Theories based on it have no content. d. What good is a stable value when you can’t buy or sell at that value because new conditions or information have developed which make the stable price obsolete? It is the market price, the price at which you can buy or sell today, which determines value. 10. a. There is risk in almost everything you do in daily life. You could lose your job or your spouse, or suffer damage to your house from a storm. That doesn’t necessarily mean you should quit your job, get a divorce, or sell your house. If we accept that our world is risky, then we must accept that asset values fluctuate as new information emerges. Moreover, if capital markets are functioning properly, then stock price changes will follow a random walk. The random walk of values is the result of rational investors coping with an uncertain world. b. To make the example clearer, assume that everyone believes in the same chart. What happens when the chart shows a downward movement? Are investors going to be willing to hold the stock when it has an expected loss? Of course not. They start selling, and the price will decline until the stock is expected to give a positive return. The trend will ‘self-destruct.’ c. Random-walk theory as applied to efficient markets means that fluctuations from the expected outcome are random. Suppose there is an 80 percent chance of rain tomorrow (because it rained today). Then the local umbrella store’s stock price will respond today to the prospect of high sales tomorrow. The store’s sales will not follow a random walk, but its stock price will, because each day the stock price reflects all that investors know about future weather and future sales. 14. The efficient market hypothesis does not imply that portfolio selection should be done with a pin. The manager still has three important jobs to do. First, she must make sure that the portfolio is well diversified. It should be noted that a large number of stocks is not enough to ensure diversification. Second, she must make sure that the risk of the diversified portfolio is appropriate for the manager’s clients. Third, she might want to tailor the portfolio to take advantage of special tax laws for pension funds. These laws may make it possible to increase the expected return of the portfolio without increasing risk. 19. The market is most likely efficient. The government of Kuwait is not likely to have non-public information about the BP shares. Goldman Sachs is providing an intermediary service for which they should be remunerated. Stocks are bought by investors at (higher) ask prices and sold at (lower) bid prices. The spread between the two ($0.11) is revenue for the broker. In the U.S., at that time, a bid-ask spread of 1/8 ($0.125) was not uncommon. The ‘profit’ of $15 million reflects the size of the order more than any mispricing. BM Chapter 21 Quiz Questions 21.2, 21.3, 21.7 See solutions in the back of the textbook BM Chapter 21 Practice Questions 887.0/1;127.125.024.0 ==== udeu $45 $50.72 $57.16 $64.41 $35.41 $50.70 $39.92 $44.98 $39.91 $72.60 $57.14 $57.14 $44.97 $44.97 $35.40 $31.41 $35.40 $27.86 b. 809.0/1,236.15.03.0 ==== udeu $45 $55.62 $36.41 $68.75 $45.00 $45.00 $29.46 $45 $52.29 $60.76 $70.60 $33.36 $52.32 $38.75 $45.02 $38.77 $82.04 $60.79 $60.79 $45.05 $45.05 $33.38 $28.72 $33.38 $24.73 861.0/1;162.125.03.0 ==== udeu