Financial Markets & Investment Concepts: Core Principles
1. Efficient Market Hypothesis: Strong Form & Abnormal Returns
According to the strong form of the efficient market hypothesis, which of the following activities can still generate abnormal returns?
- a) Technical analysis
- b) Fundamental analysis
- c) Insider trading
- d) Active asset management
- e) None of the above
Since strong form efficiency implies all information (public and private) is already incorporated in prices, none of the above activities can generate abnormal returns.
2. Security Market Line (SML) Misconceptions
Which of the following statements about the Security Market Line (SML) is NOT true?
- a) The SML provides a benchmark for evaluating expected investment performance
- b) The SML leads all investors to invest in the same portfolio of risky assets
- c) The SML is a graphic representation of the relationship between expected return and beta
- d) Two assets with different idiosyncratic risks can lie on the same point on the SML
The SML does not lead all investors to invest in the same portfolio of risky assets, as it does not account for total risk (systematic + idiosyncratic). Optimal portfolios are decided according to total risk.
3. Call Option Value: Factors Affecting Price
The value of a call option decreases in all of the following cases, except ___________.
- a) decrease in stock price
- b) decrease in time to maturity
- c) increase in volatility
- d) increase in strike price
An increase in a stock’s volatility makes the call option more valuable.
4. P/E Ratio Impact of Plowback Ratio (ROE < k)
Firm A has an ROE of 12% while the expected return on its stock (k) is 15%. If the firm increases its plowback ratio, this will result in _______ P/E ratio.
- a) A higher
- b) A lower
- c) An unchanged
- d) The answer cannot be determined from the information given
Since ROE < k, an increase in the plowback ratio (b) will decrease the stock price, therefore decreasing the P/E ratio. As an alternative explanation, consider two cases: b=0 and b=0.5, and suppose that EPS = $1. In the first case, P = 1/0.15 = 6.67. In the second case, P = 0.5/(0.15-0.06) = 5.55. Thus, an increase in ‘b’ decreased the P/E for Firm A.
5. Arbitrage Frictions: Identifying Non-Prohibitive Factors
Which of the following is NOT an example of a friction that prohibits rational traders from arbitraging away mispricing?
- a) Bid-ask spread
- b) Brokerage fee
- c) Systematic risk
- d) Taxes on trading profits
Systematic risk can be easily hedged. Therefore, an arbitrageur can easily form a risk-free portfolio by utilizing the market portfolio.
6. Short Straddle with Plateau: Option Strategy Construction
The following diagram shows the profit to an option strategy called “short straddle with plateau”. By looking at the profit diagram, you can infer that this strategy is constructed by:
- a) Sell a call option with a high strike price and sell a put option with a lower strike price and the same maturity date
- b) Sell a call option and sell a put option with the same strike price and maturity date
- c) Buy a call option with a low strike price and sell a put option with a high strike price and the same maturity date
- d) Sell a call option with a low strike price and sell a put option with a higher strike price and the same maturity date
7. Risk-Free Portfolio Creation: Correlation Condition
Asset A has an expected return of 10% while Asset B has an expected return of 15%. The standard deviation of their returns are 30% and 45%, respectively. If you can combine these two assets to create a risk-free portfolio, then which of the following is a necessary condition?
- a) Both assets have a market beta of one
- b) Correlation coefficient of their returns equals 0
- c) Correlation coefficient of their returns equals -1
- d) Covariance of their returns equals 0
A combination of two risky securities will only yield a risk-free portfolio if they are perfectly negatively correlated.
8. Asset Allocation Contribution to Relative Performance
Consider the following information regarding the performance of a money manager in a recent month. The table presents the actual return of each sector of the manager’s portfolio in column (1), the fraction of the portfolio allocated to each sector in column (2), the benchmark or neutral sector allocations in column (3), and the returns of sector indexes in column (4). What was the contribution of asset allocation to relative performance?
- a) -0.13%
- b) -0.1%
- c) 0.1%
- d) 0.13%
Calculation: (0.70 – 0.60) x 2.5% + (0.20 – 0.30) x 1.2% + (0.10 – 0.10) x 0.5% = 0.13%
9. Identifying Mispriced Securities: CAPM Application
You know the following about securities X, Y, and Z. In this situation, you could definitely conclude that:
- a) X, Y, and Z are fairly priced
- b) At least one of X, Y, or Z is mispriced.
- c) All three securities are underpriced
- d) At least two of the three securities are mispriced
According to the table above (not provided in the original document), if Z is the risk-free security and X is the market portfolio, then the expected return for Y should be 8% + 0.5 * (15% – 8%) = 11.5%. However, this does not equal 12.5% as indicated by the table. Therefore, there is at least one mispricing among securities X, Y, or Z. Given the table’s information, we can certainly conclude that at least one of these securities is mispriced. More information would be needed to specifically conclude which particular securities are mispriced.