If the simple CAPM is valid, which of the situations in Problems 13 – 19 below are possible? Explain. Consider each situation independently.
The correct answer would be: “Not Possible”
The CAPM or the Capital Asset Pricing Model is used to determine the rate of return of an asset by weighing the associated risks and other factors. It is measured in terms of beta and the required rate of return.
Portfolio A clearly dominates the market portfolio. It has a lower standard deviation with a higher expected return.
Therefore this is not possible, if the CAPM is valid.
A market anomaly refers to:
a. An exogenous shock to the market that is sharp but not persistent.
b. A price or volume event that is inconsistent with historical price or volume trends.
c. A trading or pricing structure that interferes with efficient buying and selling of securities.
d. Price behavior that differs from the behavior predicted by the efficient market hypothesis.
In Problems 21–23 below, assume the risk-free rate is 8% and the expected rate of return on the market is 18%.
I am buying a firm with an expected perpetual cash flow of $1,000 but am unsure of its risk. If I think the beta of the firm is zero, when the beta is really 1, how much more will I offer for the firm than it is truly worth?
a. Briefly explain the concept of the efficient market hypothesis (EMH) and each of its three forms—weak, semi-strong, and strong—and briefly discuss the degree to which existing empirical evidence supports each of the three forms of the EMH.
b. Briefly discuss the implications of the efficient market hypothesis for investment policy as it applies to:
i. Technical analysis in the form of charting.
ii. Fundamental analysis.
c. Briefly explain the roles or responsibilities of portfolio managers in an efficient market environment.
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