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Question 8-25C

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Essentials Of Investments
Found in: Page 261
Essentials Of Investments

Essentials Of Investments

Book edition 9th
Author(s) Zvi Bodie, Alex Kane, Alan Marcus, Alan J. Marcus
Pages 748 pages
ISBN 9780078034695

Short Answer

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?

The correct answer is as follows:

a. Violation, if shift was predictable. But it would be “no violation” if it was caused due to unpredictable recession.

b. The perceived overreaction is because of – (i) reduced profits and cash flows due to recession and (ii) rise in the risk premium.

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Step by Step Solution

Definition

The risk premium is the excess rate of return over and above the guaranteed returns to compensate for an increased event of risk.

Explanation of ‘a’ and ‘b’

a. In the above figure, had the shift been predictable, it would be a violation of EMH. However it could also be the outcome of recession, which is not predictable. In this case, this may not actually be a violation of EMH.

b. During the course of recovery, adjusting premiums is consistent with EMHs. The reason why it is being seen as an overreaction is primarily because of the following reasons:

(i) Recession impacted the profits i.e. numerator in a fundamental analysis.

(ii) Recession also caused rise in risk premiums i.e. denominator in a fundamental analysis, thereby further reducing the price.

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