Q.

(i) He may argue that other investment houses are also investing in these
under performing stocks. So, may be possible that these stocks will give higher
returns in future.
(ii) He may also argue that the prices of most of the stock in current market
scenario is overly priced. So, there is less chances that reinvesting their money
in alternative stock would give them better returns.
(iii) Also, he has lots of information about the stocks, he is currently investing
company’s money in while in order to reinvest company’s money in other
stocks, he need to gather information (like publically available information,
past history of prices) about other stocks which require lots of time and
money.
(iv) May be possible that amount of money required by him in order to gather
information erodes the excess returns that he is expecting by reinvesting in
other stocks.

Q1. Explain how insurance company can deal with the problem of adverse
selection.

Adverse selection means that the people who are at bad risk are more inclined
towards taking insurance as compared to the people who are at good risk. For
Example- People with a good health (age less than 30) may not prefer taking
health insurance as compared to people with not so good health.

In order to avoid the problem of Adverse selection, an insurance company can-

(i) It may put policyholders in small homogeneous group depending upon their
state of health in case of health insurance and charged premium as per their
current state of health.
(ii) The company can make it compulsory for policyholder to provide details of
their complete body check up (test/diagousis) and any past history associated
with their health (in case of heath insurance) and past history of accident if any
made by the driver (in case of car insurance).
(iii) Try to gather as much information as you can from policyholder

Q2. Explain hor moral hazard affects the price of insurance.

X1.2.
(i) Here the fund managers are able to add value to the portfolios by
investing in over-performing sectors. From this we cannot clearly say
that the capital market is not efficient because as per EMH (Efficient
market hypothesis), an investor have the opportunity to earn risk
adjusted return depending upon risk associated with their
investment.
(ii) The thing that contradicts EMH is that if an investor is earning return
on any investment in excess of risk adjusted return.
(iii) It is possible that the stocks that fund managers are choosing are
giving more return as compared to other stocks or sectors in the
market because risk associated with those sectors or stocks are more
as compared to rest of the stocks in the market.
(iv) In particular, the semi-strong form of the EMH suggests that excess
risk-adjusted investment returns cannot be obtained using only
publically available information. They may earn excess returns using
privileged or inside information, which would not contradict the
semi-strong form of the EMH.
(v) If the stocks that fund managers have chosen have same risk rating
with that of the other stocks in the market and still they are giving
excessive returns than the market. In this case, we can say that the
market is not efficient.
(vi) Some fund managers must necessarily achieve higher than average
returns over a given short time period – eg several years. The point of
EMH is that managers cannot consistently achieve above excess
returns.