At a cocktail party, your co-worker tells you that he has beaten the market for each of the last three years. Suppose you believe him. Does this shake your belief in efficient markets?
The correct answer is NO.
The Random Walk Theory suggests that the past stock prices or previous market trends cannot be relied upon to predict its future movement.
As per this theory there would naturally be some people who would beat the market while others would not. Also the higher, the risk for investments, there would have higher returns too.
Therefore there is no harm in believing him without violating the EMH.
XYZ stock price and dividend history are as follows:
Year Beginning-of-Year Price Dividend Paid at Year-End
2010 $100 $4
2011 $110 $4
2012 $ 90 $4
2013 $ 95 $4
An investor buys three shares of XYZ at the beginning of 2010, buys another two shares at the beginning of 2011, sells one share at the beginning of 2012, and sells all four remaining shares at the beginning of 2013.
a. What are the arithmetic and geometric average time-weighted rates of return for the investor?
b. What is the dollar-weighted rate of return?
(Hint: Carefully prepare a chart of cash flows for the four dates corresponding to the turns of the year for January 1, 2010, to January 1, 2013. If your calculator cannot calculate internal rate of return, you will have to use a spreadsheet or trial and error.).
In Problems 21–23 below, assume the risk-free rate is 8% and the expected rate of return on the market is 18%.
A share of stock is now selling for $100. It will pay a dividend of $9 per share at the end of the year. Its beta is 1. What do investors expect the stock to sell for at the end of the year?
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