Week 2

Question 1

Which of the following options is not an example of limits to arbitrage?

Fundamental risk
Model risk
Regret avoidance
Implementation costs
Limits to short-selling

Answer 1

Regret avoidance

Question 2

The feature of the APT that offers the greatest potential advantage over the CAPM is the …

Answer 2

… use of several factors instead of a single market index to explain the risk-return relationship.

Question 3

Which of the following statements is true?

To take advantage of an arbitrage opportunity, an investor would…

1) construct a zero-investment portfolio that will yield a sure profit.
2) construct a zero-beta-investment portfolio that will yield a sure profit.
3) make simultaneous trades in two markets without any net investment.
4) short sell the asset in the low-priced market and buy it in the high-priced market.

Answer 3

1 and 3

1: Correct.
2: A zero-beta investment is an investment with no exposure to a systemic risk factor. This is not a way to take advantage an arbitrage opportunity.
3: Correct.
4: This should be exactly opposite. Sell high, buy low.

Question 4

What is the definition of a well-diversified portfolio?

Answer 4

A portfolio that is diversified over a large enough number of securities such that the nonsystematic variance is essentially zero.

Question 5

Select all correct answers.

The weak form of the efficient-market hypothesis asserts that…

…stock prices do not rapidly adjust to new information contained in past prices or past data.

…future changes in stock prices cannot be predicted from past prices.
Correct answer
…technicians cannot expect to outperform the market.

Answer 5

…future changes in stock prices cannot be predicted from past prices.

…technicians cannot expect to outperform the market.

A: false. All past information is priced in already.
B: correct. This is the definition of the weak-form EMH.
C: correct. Past prices do not contain any new information, so technical analysis will not outperform the market.

Question 6

Stock ABC just announced yesterday that its fourth quarter earnings will be 35% higher than last year’s fourth quarter. You observe that ABC had an abnormal return of −1.7% yesterday. This suggests that:

Answer 6

investors expected the earnings increase to be larger than what was actually announced.

Explanation:
Anticipated earnings changes are impounded into a security’s price as soon as expectations are formed. Therefore, a negative market response indicates that the earnings surprise was negative; that is, the increase was less than anticipated.

Question 7

How to test the weak form

Answer 7

Patterns in stock returns (e.g. short run momentum, long run reversal)

Question 8

definition weak form

Answer 8

All past information is immediately reflected in the price

Question 9

How to test the semi-strong form

Answer 9

Market anomalies (e.g. post-earnings announcement drift)

Question 10

definition semi-strong form

Answer 10

All public information is immediately reflected in the price

Question 11

How to test the strong form

Answer 11

Returns to insider information trading

Question 12

definition strong form

Answer 12

All public and private information is immediately reflected in the
price