FIN 451 Chapter 8 Solutions

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FIN 451 Chapter 8 Solutions


Chapter 8 Solutions

7 CFA – The assumptions of the supporting passive management are:

  1. Informational efficiency
  2. Primacy of diversification motives

Active management is supported by the opposite assumptions, in particular, that pockets of market inefficiency exist.

8 CFA –  a) The grandson is recommending taking advantage of (i) the small firm anomaly and (ii) the January anomaly. In fact, it seems to be one anomaly; the small –firm – in- January anomaly.

  1. b) (i) Concentration of one’s portfolio in stocks having very similar attributes may expose the portfolio to more risk than is desirable. The strategy limits the potential for diversification.

(ii) Even if the study results are correct as described, each such study covers a specific time period. There is no assurance that future time periods would yield similar results.

(iii) After the results of the studies became publicly known, investment decisions might nullify these relationships. If these firms in fact offered investment bargains, their prices may be bid up to reflect the now-known opportunity.

10 CFA – a) The earnings (and dividend) growth rates of growth stocks may be consistently overestimated by investors. Investors may extrapolate recent earnings (and dividend) growth too far into the future and thereby downplay the inevitable slowdown.  At any given time, growth stocks are likely to revert to (lower) mean returns and value stocks are likely to revert to (higher) mean returns, often an extended future time horizon.

  1. b) In efficient markets, the current prices of stocks already reflect all-known, relevant information. In this situation, growth stocks and value stocks provide the same risk-adjusted expected return.

18 PS – An anomaly is considered an EMH exception because there is historical data to substantiate a claim that said anomalies have produced excess risk adjusted abnormal returns in the past. Several anomalies regarding fundamental analysis have been uncovered. These include the P/E effect, the small-firm-in -January effect, the neglected-firm effect, post-earnings announcement price drift, and the book-to-market effect. Whether these anomalies represent market inefficiency or poorly understood risk premiums is still a matter of debate. These are rational explanations for each, but not everyone agrees on the explanation. One dominant explanation is that many of these firms are also neglected firms, due to low trading volume, thus they are not part of an efficient market or offer more risk as a result of their reduced liquidity.