Problem set 9 solution

Q1:

c) is a violation of weak form EMH, because trading on past price/return information is able to
generate abnormal returns (alphas).

And if prices do not fully reflect even past price information (a sub-set of all public information),
prices surely do not fully reflect all public information (thus a violation of semi-strong form
EMH) and all information, both public and private (thus also a violation of strong-form EMH).

e) Here fund managers are trading on private information they obtain from corporate executives
and are able to generate abnormal returns (alphas). So it is a violation of strong-form EMH, but
not other forms of EMH.

In all other cases, it is not clear whether or not you can generate abnormal returns or alphas. For
example, positive returns in a) and above than average capital gains in d) do not necessarily
mean positive alphas (which means that the returns are higher than the expected returns based on
some asset pricing models like CAPM).

Q2

a) does not say anything about EMH, because we dont know what are the alphas of these mutual
funds. And even nearly half of mutual funds are able to generate positive alphas in a year, it does
not necessarily violate EMH because it may be due to luck.

b) is a violation of EMH because it implies those outperforming mutual funds could consistently
generate positive alphas (and thus outperformance in a year is not due to luck).

c) it does not say anything about alphas, and thus say nothing about EMH.

d) violation of semi-strong form (and hence strong-from also) EMH, because you design a
trading strategy buying in those stocks with increased earnings in January and holding them in
February and generate superior performance. This strategy uses public information.

e) implies a violation of weak form EMH (and thus semi-strong and strong forms also).

Q3

a. the optimal fraction to invest in the market portfolio could be calculated from

y* = 1/A*(E(rM) rf)/2M
With the given believes of two investors, we can easily do the calculation.

y* = 1/3*(15%-3%)/(40%*40%) = 25% for rational investor

and

y* = 1/3*(15%-3%)/(25%*25%) = 64% for overconfident investor.

b.

Based on the calculated allocations to the market portfolio in a), we can calculate expected return
and volatility of the complete portfolio for both investors.

Rational investors:

E(rc) = 0.75*rf + 0.25* E(rM) = 6%

c = 0.25* M = 10%

U = E(rc) 1.5 2c = 4.5%

Overconfident investors:

E(rc) = 0.36*rf + 0.64* E(rM) = 10.68%

c = 0.64* M = 25.6%

U = E(rc) 1.5 2c = 0.08%

We can see the following points:

[1] overconfident investors portfolio has a higher expected return and a higher volatility, due to
it invests much more in the risky assets.

[2] however, the utility is lower for overconfident investors. So overconfident investors are
making sub-optimal investment.

c&d.

So updated E(rM) = 17% for both types of investors.

With this new expected market return, the optimal fraction of investment in the market portfolio
is

y* ~= 29% for rational investors, a 4% additional weight in the market portfolio.

and

y* ~= 75% for overconfident investors, an 11% additional weight in the market portfolio.

So we can see that though the magnitude of revision in return expectation is the same for both
types of investors, overconfident investors tend to trade (i.e., rebalance their portfolios) much
more aggressively.

Q4.

a. Based on the given information, we can calculate the alpha of asset X as:

12.5% - 4% - 0.5*(16% - 4%) = 2.5%.

So both investors will deviate from the market portfolio by holding additional asset X beyond its
weight in the market portfolio.

Based on lecture 7, we know the optimal additional weight in asset X is given by

So we need to calculate the idiosyncratic risk (the variance of residual return),

2 = 2 - (beta* M)^2,

of asset X first.

For rational investor, her estimate of 2 = 50%*50% - (0.5*20%)^2 = 24%, which results in

W0A ~= 3.47% and W*A ~= 3.41%.

For overconfident investor, her estimate of 2 = 30%*30% - (0.5*20%)^2 = 8%, which results in

W0A ~= 10.42% and W*A ~= 9.9%.

We can see that overconfident investors deviate much further away from the market portfolio
than the rational investors and hold a much more concentrated position in the active asset,
although they have the same alpha estimates. So overconfident investors tend to hold under-
diversified portfolios.
Selected end-of-chapter questions

BKM chapter 11

1. The correlation coefficient between stock returns for two nonoverlapping periods should be
zero. If not, returns from one period could be used to predict returns in later periods and
make abnormal profits.

2. No. Microsofts continuing profitability does not imply that stock market investors who
purchased Microsoft shares after its success was already evident would have earned an
exceptionally high return on their investments. It simply means that Microsoft has made
risky investments over the years that have paid off in the form of increased cash flows and
profitability. Microsoft shareholders have benefited from the risk-expected return tradeoff,
which is consistent with the EMH.

3. Expected rates of return differ because of differential risk premiums across all securities.

9. c. This is a predictable pattern in returns that should not occur if the weak-form EMH is valid.

14. d. In a semistrong-form efficient market, it is not possible to earn abnormally high profits by
trading on publicly available information. Information about P/E ratios and recent price
changes is publicly known. On the other hand, an investor who has advance knowledge of
management improvements could earn abnormally high trading profits (unless the market is
also strong-form efficient).

BKM chapter 12

3. One of the major factors limiting the ability of rational investors to take advantage of any pricing
errors that result from the actions of behavioral investors is the fact that a mispricing can get worse
over time. An example of this fundamental risk is the apparent ongoing overpricing of the
NASDAQ index in the late 1990s. Related factors are the inherent costs and limits related to short
selling, which restrict the extent to which arbitrage can force overpriced securities (or indexes) to
move towards their fair values. Rational investors must also be aware of the risk that an apparent
mispricing is, in fact, a consequence of model risk; that is, the perceived mispricing may not be real
because the investor has used a faulty model to value the security.

6. a. Davis uses loss aversion as the basis for her decision making. She holds on to stocks that are
down from the purchase price in the hopes that they will recover. She is reluctant to accept a loss.
9. a. iv
b. iii
c. v
d. i
e. ii