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L4 Tutorial Solution

Investment Management (University of Greenwich)

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Solution-Tutorial: Lecture 4 (Investment Theory)

Question 1
Keeping in mind the Efficient Market Hypothesis, evaluate the following
statement: “A small number of investors with common characteristics
can beat the market over long time periods.”
Solution:
Even in an efficient market, one would expect to see stocks to be
mispriced randomly.
 Probabilistically speaking, almost half of the investors can beat the
market at any point of time.
 Some investors may be able to do so over long term by pure chance
or luck.
 However, if some investors share common characteristics such as
they work together, they use same approach, they learned from
someone else, then there is the possibility of market inefficiencies.
 If the market is efficient, these small investors cannot beat the
market over long time periods.

Question 2:
Discuss the Random Walk (RW) theory. What are the implications and
criticisms of this theory?
Solution:
The Random Walk Theory or the Random Walk Hypothesis is a mathematical
model of the stock market. Proponents of the theory believe that the prices of
securities in the stock market evolve according to a random walk.
A “random walk” is a statistical phenomenon where a variable follows no
discernible trend and moves seemingly at random. The random walk theory as
applied to trading, most clearly laid out by Burton Malkiel, an economics
professor at Princeton University. Random walk theory argues that, price of
securities moves randomly (hence the name of the theory), and that, therefore,
any attempt to predict future price movement, either through fundamental or
technical analysis, is futile.
Implications of the Random Walk Theory
 It is impossible to outperform the overall market average other than by
sheer chance.
 Those who believe to the random walk theory recommend using a “buy
and hold” strategy, investing in a selection of stocks that represent the
overall market – for example, an index mutual fund or ETF based on one of
the broad stock market indexes, such as the S&P 500 Index.

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Criticism of the Random Walk Theory

 Stock market consists of a large number of investors and the amount of
time each investor spends in the market is different. Thus, it is possible for
trends to emerge in the prices of securities in the short run, and a savvy
investor can outperform the market by strategically buying stocks when
the price is low and selling stocks when the price is high within a short
time span.
 Stock prices do follow patterns or trends, even over the long run. Because
the price of a security is affected by an extremely large number of factors,
it may be impossible to discern the pattern or trend followed by the price
of that security, but just because a pattern cannot be clearly identified,
that does not mean that a pattern does not exist.

Question 3:
If there are only a few investors who perform security analysis, and all
others hold the market portfolio, M, would the CML still be the efficient
CAL for investors who do not engage in security analysis? Why or why
not?
Solution
We can characterize the entire population by two representative investors. One is
the “uninformed” investor, who does not engage in security analysis and holds
the market portfolio, whereas the other optimizes using the Markowitz algorithm
with input from security analysis. The uninformed investor does not know what
input the informed investor uses to make portfolio purchases. The uninformed
investor knows, however, that if the other investor is informed, the market
portfolio proportions will be optimal. Therefore, to depart from these proportions
would constitute an uninformed bet, which will, on average, reduce the efficiency
of diversification with no compensating improvement in expected returns.

Question 4:
Suppose that the risk premium on the market portfolio is estimated at
8% with a standard deviation of 22%. What is the risk premium on a
portfolio invested 25% in Toyota and 75% in Ford, if they have betas of
1.10 and 1.25, respectively?
Solution:
For these investment proportions, wFord, wToyota, the portfolio β is

= (.75*1.25)+(.25*1.10)=1.2125
As the market risk premium, E(rM)- rf, is 8%, the portfolio risk premium will be

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=1.2125*8=9.7%

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Question 5:
Stock XYZ has an expected return of 12% and risk of 1. Stock ABC has
expected return of 13% and 1.5. The market’s expected return is 11%,
and rf 5%.
a. According to the CAPM, which stock is a better buy?
b. What is the alpha of each stock? Plot the SML and each stock’s risk–
return point on one graph. Show the alphas graphically.
Solution:
The alpha of a stock is its expected return in excess of that required by the CAPM

αXYZ=12- [5+1.0(11-5))] = 1%

αABC=13- [5+1.5(11-5))] = -1%

ABC plots below the SML, while XYZ plots above.

Question 6:
• On February 10th SBU plc shares were listed on the stock exchange at
120p. There were 25 million 25p shares in issue at that date.
• On February 11th SBU announced to the press that it had unexpectedly
discovered a new deposit of minerals with a net present value of £7.25
million.

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• On February 17th the company announced that it was intending to raise

£4m to finance development of the deposit by means of a rights issue
which was to be priced at 80p.
• Required:
Assuming the market is semi-strong form efficient, calculate the
market capitalisation on February 11th after the announcement to the
press.
How many shares will be issued to raise the £4 million?
Calculate the market capitalisation of the company after the rights
issue.
Solution:
o Market capitalization = number of outstanding shares x share price

o Before Announcement

Market Capitalisation = 25million shares X 120p = £30m.

o After the announcement

Market capitalization= £30m + £7.25m = £37.25m

share price jumps to 149p - £37.25/25)
o After the rights issue

The rights issue will consist of £4m divided by 80p = 5 million shares.
So new number of outstanding shares = 25m+5m=30m
After the rights issue the company will have an additional £4 million in
cash. This will value the company at £37.25m + £4m = £41.25m.
Share price reduces to 137.5p (41.25/30m)

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HOME TASK:

Question 1:
Discuss Roll's critique of the CAPM.

Answer:

In 1977, Richard Roll published a critique of the capital asset pricing model, in which
he argued not only that the empirical tests of the expected return-beta relationship
are invalid, but also that it is doubtful that the CAPM can be tested. These essences
of Roll's critique are as follows: There is a single testable hypothesis associated with
the CAPM, which is that the market portfolio is mean-variance efficient. All other
relationships of the model, including the linear risk-return trade-off follow from the
mean-variance efficiency tenet and are not independently testable. In any sample of
observations of individual returns, there will an infinite number of ex-post mean-
variance efficient portfolios using the sample period of returns and covariances (as
opposed to ex-ante expected returns and covariances). Betas calculated from such
portfolios will satisfy the SML relationship whether or not the true market portfolio is
mean-variance efficient, ex ante. The CAPM, as we know it, is not testable unless the
exact composition of the market portfolio is known, which implies that the theory is
not testable unless all individual assets are included in the market portfolio. Using a
market proxy, such as the S&P 500, has two problems: (1) the proxy might be mean-
variance efficient, even if the market portfolio is not, and vice versa; and (2) most
market proxies are highly positively correlated with each other and with the true
market portfolio. This makes the exact composition of the market portfolio appear to
be unimportant, although the use of different market proxies result in different
conclusions (benchmark error).

Feedback: The purpose of this question is to ascertain the student's understanding

of one of the most important critiques of the CAPM.

Question 2:
When portfolio performance is measured, what type of benchmark may be
used? Explain what Roll meant by benchmark error.

Answer:
The benchmark portfolio should be broadly based since it is a proxy for the
unobservable market portfolio. Examples include, but are not limited to, the S&P 500
Index, the NYSE Composite Index, and the Wilshire 5000 Index.

Benchmark error refers to the fact that the proxy for the market portfolio may be
mean-variance efficient when the true market portfolio is not efficient. The proxy
index may also be inefficient. Also, different proxies may lead to substantially
different conclusions even though they tend to be highly correlated with each other.

Question 3:
Describe some of the ways the CAPM is applied in practice.

Answer:

The four items mentioned at the beginning of the chapter are:

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• Professional portfolio managers use the CAPM to determine appropriate security

returns. These managers also have their performances evaluated based on the
reward-to-variability ratios of their portfolios relative to the CML or SML.

• Regulatory commissions use the CAPM to help determine the appropriate cost of
capital for regulated firms.

• Courts use the CAPM to determine the discount rate to use in calculating the
present value of lost future income.

• Firms use the SML to find a benchmark hurdle rate to use in discounting cash flows
for capital budgeting projects.

Feedback: This confirms that the student understands that there are "real-world"
applications to the theoretical CAPM model.

Question 4:
The following annual excess rates of return were obtained for nine
individual stocks and a market index:

a. Perform the first-pass regressions and tabulate the summary statistics.

b. Specify the hypotheses for a test of the second-pass regression for the SML.
c. Perform the second-pass SML regression by regressing the average excess return
of each portfolio on its beta.
d. Summarize your test results and compare them to the results reported in the
text.
e. Explain Roll’s critique as it applies to the tests performed in Problems a to d.

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Answer:
a. Using the regression feature of Excel with the data presented in the text, the first-pass
(SCL) estimation results are:
Stock: A B C D E F G H I
R-square 0.06 0.06 0.06 0.37 0.17 0.59 0.06 0.67 0.70
Observations 12 12 12 12 12 12 12 12 12
Alpha 9.00 -0.63 -0.64 -5.05 0.73 -4.53 5.94 -2.41 5.92
Beta -0.47 0.59 0.42 1.38 0.90 1.78 0.66 1.91 2.08
t-Alpha 0.73 -0.04 -0.06 -0.41 0.05 -0.45 0.33 -0.27 0.64
t-Beta -0.81 0.78 0.78 2.42 1.42 3.83 0.78 4.51 4.81

b. The hypotheses for the second-pass regression for the SML are:
 The intercept is zero.
 The slope is equal to the average return on the index portfolio.

c. The second-pass data from first-pass (SCL) estimates are:

Average Beta
A 5.18 -0.47
B 4.19 0.59
C 2.75 0.42
D 6.15 1.38
E 8.05 0.90
F 9.90 1.78
G 11.32 0.66
H 13.11 1.91
I 22.83 2.08
M 8.12

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The second-pass regression yields:

Regression Statistics
Multiple R 0.7074
R-square 0.5004
Adjusted R-square 0.4291
Standard error 4.6234
Observations 9

Coefficients Standard Error t Statistic for β=0 t Statistic for

β=8.12
Intercept 3.92 2.54 1.54

Slope 5.21 1.97 2.65 -1.48

d. As we saw in the chapter, the intercept is too high (3.92% per year instead of 0)
and the slope is too flat (5.21% instead of a predicted value equal to the
sample-average risk premium: rM  rf = 8.12%). The intercept is not significantly
greater than zero (the t-statistic is less than 2) and the slope is not significantly
different from its theoretical value (the t-statistic for this hypothesis is 1.48).
This lack of statistical significance is probably due to the small size of the
sample.

e. Roll’s critique suggests that the problem begins with the market index, which is
not the theoretical portfolio against which the second pass regression should hold.
Remember that Roll suggests the true market portfolio contains every asset available
to investors, including real estate, commodities, artifacts, and collectible items such
as Hollywood memorabilia, which this index obviously does not have. Hence, even if
the relationship is valid with respect to the true (unknown) index, we may not find it.
As a result, the second pass relationship may be meaningless.

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