Which of the following sources of market inefficiency would be most easily exploited?
a. A stock price drops suddenly due to a large block sale by an institution.
b. A stock is overpriced because traders are restricted from short sales.
c. Stocks are overvalued because investors are exuberant over increased productivity in the economy.
The correct answer is ‘c’.
Market inefficiency refers to a condition where an asset’s price is not truly reflected with all the available information.
In a weakly inefficient market, it is unlikely that there would be exuberant investors over increased economic productivity. On the contrary, this is a predictable pattern on returns. In the above scenario, the overvalued stocks without any regulatory mechanisms would provide investors to manipulate price and earn huge profits.
The market price of a security is $40. Its expected rate of return is 13%. The risk-free rate is 7%, and the market risk premium is 8%. What will the market price of the security be if its beta doubles (and all other variables remain unchanged)? Assume the stock is expected to pay a constant dividend in perpetuity.
Suppose that as the economy moves through a business cycle, risk premiums also change. For example, in a recession when people are concerned about their jobs, risk tolerance might be lower and risk premiums might be higher. In a booming economy, tolerance for risk might be higher and risk premiums lower.
a. Would a predictably shifting risk premium such as described here be a violation of the efficient market hypothesis?
b. How might a cycle of increasing and decreasing risk premiums create an appearance that stock prices “overreact,” first falling excessively and then seeming to recover?
Jeffrey Bruner, CFA, uses the capital asset pricing model (CAPM) to help identify mispriced securities. A consultant suggests Bruner use arbitrage pricing theory (APT) instead. In comparing CAPM and APT, the consultant made the following arguments:
a. Both the CAPM and APT require a mean-variance efficient market portfolio.
b. The CAPM assumes that one specific factor explains security returns but APT does not.
State whether each of the consultant’s arguments is correct or incorrect. Indicate, for each incorrect argument, why the argument is incorrect
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