Chapter 13 - MATH3650 Spring 2021 PDF

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MATH3650 Spring 2021...

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Math 3650 Homework for Chapter 13 1. What is the alpha of a stock? 2. According to the CAPM, if the market is completely efficient, what should the value of alpha be for any stock? 3. If you find a stock with positive alpha, under the theories of the CAPM what should you do? Why? 4. Give an example of behavioral finance whereby investors may intentionally hold an inefficient portfolio of stocks. 5. List 4 common mistakes that individual investors may make, leading to inefficient markets.

ANSWERS 1. Alpha is the difference between a stock’s expected return and its required according to the Security Market Line. 2. Zero 3. Buy the stock. It’s expected return exceeds the required return according to the Security Market Line. So you are getting excess returns for no increase in risk. As other investor’s reach the same conclusion that the expected return exceeds the required return they will want to buy the stock too, which pushes up the price. If you can act fast enough- ahead of the others- you will benefit from the price increase. 4. An example of behavioral finance whereby investors may intentionally hold an inefficient portfolio of stocks is socially responsible investing. These investors (including some well-known mutual funds that have been around for years- like the Calvert Socially Responsible Fund) will not buy stocks in certain industries no matter how good the risk reward trade-off looks. They may shun companies that pollute the environment, sell alcohol or tobacco products, or sell guns. Another example is Professor Trimble, who paid $250 for shares of Green Bay Packers stock- with an expected return of zero- just for “braggin’ rights”. (The second answer will get you points on my test- but I’d use the first answer on exam IFM!)

5. a. underdiversification (a.k.a. familiarity bias) b. overconfidence- trade too frequently c. disposition effect- sell “winners” to early and hold “losers” for too long. d. herd behavior...