CHAPTER 12

SOME LESSONS FROM CAPITAL MARKET HISTORY

Answers to Concepts Review and Critical Thinking Questions

1. They all wish they had! Since they didn’t, it must have been the case that the stellar

performance was not foreseeable, at least not by most.

2. As in the previous question, it’s easy to see after the fact that the investment was terrible, but

it probably wasn’t so easy ahead of time.

3. No, stocks are riskier. Some investors are highly risk averse, and the extra possible return

doesn’t attract them relative to the extra risk.

4. On average, the only return that is earned is the required return—investors buy assets with returns in

excess of the required return (positive NPV), bidding up the price and thus causing the return to fall to

the required return (zero NPV); investors sell assets with returns less than the required return

(negative NPV), driving the price lower and thus the causing the return to rise to the required return

(zero NPV).

5. The market is not weak form efficient.

6. Yes, historical information is also public information; weak form efficiency is a subset of semi-strong

form efficiency.

7. Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all

have zero NPV. If trading costs exist, then these investors lose by the amount of the costs.

8. Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators

provide liquidity to markets and thus help to promote efficiency.

9. The EMH only says, within the bounds of increasingly strong assumptions about the information

processing of investors, that assets are fairly priced. An implication of this is that, on average, the

typical market participant cannot earn excessive profits from a particular trading strategy. However,

that does not mean that a few particular investors cannot outperform the market over a particular

investment horizon. Certain investors who do well for a period of time get a lot of attention from the

financial press, but the scores of investors who do not do well over the same period of time generally

get considerably less attention from the financial press.

10. a. If the market is not weak form efficient, then this information could be acted on and a profit

earned from following the price trend. Under ii, iii, and iv, this information is fully impounded

in the current price and no abnormal profit opportunity exists.

b.Under ii, if the market is not semi-strong form efficient, then this information could be used to

buy the stock “cheap” before the rest of the market discovers the financial statement anomaly.

Since ii is stronger than i, both imply that a profit opportunity exists; under iii and iv, this

information is fully impounded in the current price and no profit opportunity exists.

c.Under iii, if the market is not strong form efficient, then this information could be used as a

profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock

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is underpriced or that good news is imminent. Since i and ii are weaker than iii, all three imply

that a profit opportunity exists. Under iv, this information does not signal any profit opportunity

for traders; any pertinent information the manager-insiders may have is fully reflected in the

current share price.

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple

steps. Due to space and readability constraints, when these intermediate steps are included in this

solutions manual, rounding may appear to have occurred. However, the final answer for each problem is

found without rounding during any step in the problem.

Basic

1. The return of any asset is the increase in price, plus any dividends or cash flows, all divided by the

initial price. The return of this stock is:

R = [($72 – 64) + 1.75] / $64 = .1523 or 15.23%

2. The dividend yield is the dividend divided by price at the beginning of the period price, so:

Dividend yield = $1.75 / $64 = .0273 or 2.73%

And the capital gains yield is the increase in price divided by the initial price, so:

Capital gains yield = ($72 – 64) / $64 = .1250 or 12.50%

3. Using the equation for total return, we find:

R = [($55 – 64) + 1.75] / $64 = –.1133 or –11.33%

And the dividend yield and capital gains yield are:

Dividend yield = $1.75 / $64 = .0273 or 2.73%

Capital gains yield = ($55 – 64) / $64 = –.1406 or –14.06%

4. a. Average (arithmetic) return (Table 12.1) = 12.02%

b. Average (arithmetic) return (Table 12.1) = 8.90%

5. a. Average (geometric) return (Table 12.1) = 10.89%. The arithmetic return is larger by 1.13%.

b. Average (geometric) return (Table 12.1) = 8.72%. The arithmetic return is larger by 0.18%.

6. a. The total dollar return is the increase in price plus the coupon payment, so:

Total dollar return = $1,080 – 1,050 + 90 = $120

b. The total percentage return of the bond is:

R = [($1,080 – 1,050) + 90] / $1,050 = .1143 or 11.43%

Notice here that we could have simply used the total dollar return of $120 in the numerator of this

equation.

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c. Using the Fisher equation, the real return was:

(1 + R) = (1 + r)(1 + h)

r = (1.1143 / 1.04) – 1 = .0714 or 7.14%

7. R = 1.1097/1.0421 – 1 = 6.49%

8. R = 1.0888/1.0421 – 1 = 4.48%

9. The average return is the sum of the returns, divided by the number of returns. The average return for each

stock was:

[ ]

%.

.....

NxX

N

i

i

009or .0900

5

1703092014

1

=

++−+

=

=

∑

=

[ ]

%.

.....

NyY

N

i

i

8014or .1480

5

0856120729

1

=

++−−

=

=

∑

=

We calculate the variance of each stock as:

( ) ( )

( ) ( ) ( ) ( ) ( )

{ }

( ) ( ) ( ) ( ) ( )

{ }

071480814856148121480714829

15

1

01420901709003090090902009014

15

1

1

222222

222222

1

22

...........s

...........s

Nxxs

Y

X

N

i

iX

=−+−+−−+−−+−

−

=

=−+−+−−+−+−

−

=

−

−=

∑

=

The standard deviation is the square root of the variance, so the standard deviation of each stock is:

sX = (.01425)1/2 = .1194 or 11.94%

sX = (.07847)1/2 = .2801 or 28.01%

10. YearLarge co. stock returnT-bill returnRisk premium

1970 – 3.57% 6.89% −10.46%

1971 8.01 3.86 4.15

1972 27.37 3.43 23.94

1973 0.27 4.78 –4.51

1974 –25.93 7.68 –33.61

1975 18.48 7.05 11.43

24.63 33.69 –9.06

a.Large company stocks: average return = 24.63 / 6 = 4.105%

T T-bills: average return = 33.69 / 6 = 5.615%

b.Large company stocks:

variance = 1/5[(–.0357 – .04105)2 + (.0801 – .04105)2 + (.2737 – .04105)2 + (.0027 – .04105)2 +

(–.2593 – .04105)2 + (.1848 – .04105)2] = 0.034777

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###### Document Summary

Answers to concepts review and critical thinking questions. Some investors are highly risk averse, and the extra possible return doesn"t attract them relative to the extra risk. Yes, historical information is also public information; weak form efficiency is a subset of semi-strong form efficiency. Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all have zero npv. If trading costs exist, then these investors lose by the amount of the costs. Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators provide liquidity to markets and thus help to promote efficiency. The emh only says, within the bounds of increasingly strong assumptions about the information processing of investors, that assets are fairly priced. An implication of this is that, on average, the typical market participant cannot earn excessive profits from a particular trading strategy.

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