Solution Manual for Portfolio Construction

Management and Protection 5th Edition by Strong

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Solution Manual for Portfolio Construction Management and Protection 5th Edition by Strong

Chapter Eight The Capital Markets and Market Efficiency

Chapter Eight

The Capital Markets and Market Efficiency

KEY POINTS

The U. S. capital markets are the envy of much of the rest of the industrialized world.
Their three functions are a good introduction to the notion of market efficiency. When
we speak of market efficiency, we refer to informational efficiency (the rapid adjustment
of prices to new information) rather than operational efficiency (the extent to which
orders get lost or improperly filled).

There are three forms to market efficiency, with the semi-efficient market hypothesis
being a useful cousin to the traditional paradigm. There is a difference between the
random walk theory and the efficient market hypothesis.

Anomalies remain a puzzle and are a continuing area of financial research. The key
anomalies that every student should be aware of include the low PE effect, the small firm
effect, the neglected firm effect, market overreaction, the day of the week effect, and the
January effect.

TEACHING CONSIDERATIONS

Remind students of the distinction between the capital market and the money market.
The former is a physical place where long-term securities (like common stock and bonds)
trade, while the latter is an electronic linkup of the largest commercial banks where short-
term securities (like treasury bills) trade.

Students are quite interested in the business of charting and technical analysis in general.
While this text does not cover much of this subject, many instructors will want to digress
into this area a bit. A coin flipping exercise to build a chart on the chalkboard followed
by a test of the randomness of the pattern via a runs test is always useful and seemingly
interesting to the class. I assign a homework problem using the RUNS file from the
software on the text website.

Stress the fact that market efficiency does not mean that no one can make a profit in the
stock market. It means that because the news cannot be consistently anticipated, long-
term rates of return will be consistent with their associated level of risk.

Anomalies are another topic of interest to most students. There are certain things in
finance that we do not know, and this fact should be clearly shown to the class.
Fibonacci numbers are an example of pure market folklore, but a fascinating subject

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Chapter Eight The Capital Markets and Market Efficiency

(with most university libraries subscribing to the highly mathematical Fibonacci

Quarterly).

ANSWERS TO QUESTIONS

1. It is still necessary to gather security statistics (such as betas and covariances) for
portfolio construction purposes, and it is also the activities of security analysts that, to
a large extent, help keep the market efficient.

2. This is a common, and very dangerous, question. Security markets are quite efficient,
but they are not completely efficient. The logic of the semi-efficient market
hypothesis is compelling, and there is the issue of the anomalies.

3. Only the name is similar. The semi-efficient market hypothesis deals with the
existence of different “tiers” of stocks with differing levels of investor interest, while
the semi-strong form deals with the extent of the information set.

4. Market efficiency means that security prices adjust quickly and accurately to news;
the random walk theory states that the news arrives randomly, so security price
changes cannot be predicted.

5. Do students tend to arrive in the classroom in groups of the same sex?

6. The weak form of the EMH holds that the current stock price fully reflects any
information contained in the past price series. If this is true, an analyst cannot use a
chart to predict the future.

7. Informational efficiency deals with the accuracy and speed with which security prices
react to arriving information; operational efficiency deals with the accuracy and
speed at which orders are processed.

8. Continuous pricing refers to the fact that the current value of a security can be readily
determined from the financial pages or from a computer terminal. Fair pricing refers
to the end result of market efficiency: over the long term, security prices reflect their
proper expected return given their level of risk.

9. The evidence suggests that charting does not work. The problem is that most
chartists are unable to define precisely the charting techniques they use and the
associated decision rules. Also, there is much that we do not know about finance, and
it is likely that the supply and demand dimensions of charting may contain some
information that we do not know how to unearth.

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Chapter Eight The Capital Markets and Market Efficiency

10. A positive intercept does not necessarily mean the market is inefficient. It may mean
that the model generating the intercept is misspecified, that the market index is
incorrect, or that the result is time period specific.

11. A true test of market efficiency should determine whether any apparent abnormal
profits are actually realizable. If you must pay a dollar to get a “free” fifty cents, it is
not clear that inefficiency really exists.

12. There is much folklore about the price/earnings ratio. The traditional PE is related to
past earnings, while it is future earnings that matter most. There is no consensus on
what constitutes a good PE, although the empirical evidence is slightly on the side of
low PEs.

13. Many people believe that low stock prices are positively correlated with the level of
risk: low priced stocks are risky.

14. If small firms do generate larger returns than expected by finance theory, it would
make sense for portfolios to concentrate on firms with low capitalization.

15. This would be a weak form test. The information is publicly available.

16. You can argue that if you pick them early, you will experience the period of
underperformance alluded to in the article. The stocks then have to rise enough to
recover this loss. Ideally you would want to buy value stocks just as they come back
in favor.

ANSWERS TO PROBLEMS

1.

RUNS TEST

Input R, N1, and N2 below: A run is an uninterrupted

series of the same sign.
For instance, the series
# of runs (R): 8 below has 6 runs:
N1: 10
N2: 5 H H H T T H T H T T T
mean: 7.67 ^ ^ ^ ^ ^ ^
| | | |
sigma: 1.64 | |
1 2 3 4 5 6

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Solution Manual for Portfolio Construction Management and Protection 5th Edition by Strong

Chapter Eight The Capital Markets and Market Efficiency

Z score: 0.20 R=6, N1=5, N2=6

(or R=6, N1=6, N2=5)

PROBABILITY OF RUNS OUT

GETTING 8OF 15OBSERVATIONS
OCCURING BY
CHANCE: 41.96%

2 – 5. Student responses.

ANSWERS TO INTERNET EXERCISE

Students’ answers may vary, but should reflect an understanding of the concepts and
calculations required.

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