Midterm_4410_2015_answers

Midterm_4410_2015_answers - York University AP Econ 4410...

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York University AP Econ 4410 Sections M, N Midterm Examination February, 2015 Instructions. Write your name and student number on the front of your answers book. Answer four out of seven problems. Each problem has the same weight. You cannot use any notes or books. You have 80 minutes. Problem 1M . Market E¢ ciency: (a) What is the Weak-Form EMH? Give de°nition. (b) What is the Semi-Strong Form EMH? Give de°nition. (c) Evaluate the following statement: "If EMH is true then for any two stocks X and Y, both have the same expected return". (d) Under Weak-Form EMH, stock prices are said to follow the Random Walk process. Write down the Random Walk equation. Explain the assumptions about variables in it. (e) In a graph depicting stock price changes over time in reaction to announcements providing new information, three possible patterns exist. 1. Bubble : a sharp increase at announcement followed by a gradual decrease. 2. Delayed response : a slow or late increase in price after the announcement, then a strong movement to the equilibrium price followed by no additional change in price 3. Instant response : price jumps to the new equilibrium level at or shortly after the moment of announcement. Which of these patterns would be indicative of ine¢ cient markets? Explain brie±y. Answers. (a). A hypothesis stating that prices of °nancial securities re±ect all information found in historical stock prices and trade volume. In other words, stating that one cannot tell under- priced and overpriced stocks apart just by analyzing stock price trends, cycles or other historical patterns. (b) A hypothesis stating that prices of °nancial securities re±ect all publicly avalable infor- mation, past and present.In other words, that you cannot tell underpriced stocks apart from overpriced stocks just by analyzing information available to anyone. (c) False. Stocks within the same risk class (e.g., in the CAPM models, stocks with identical beta) have equal expected return. (d) p t +1 = p t + E ( r ) + " t +1 where " t +1 is a random variable independent of p t ; p t ° 1 ; ::: (e) The only pattern consistent with EMH is Instant response , . Under Delayed response , investors can "beat the market" if they buy stock upon announcement. Under Bubble , on could beat the market by betting against the stock after the sharp increase. 1
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Problem 1N . The E¢ cient Market Hypothesis implies that stock prices follow the Random- Walk equation: p t +1 = p t + E ( r ) + " t +1 Answer the following questions. (a) Is E ( r ) the same for all stocks? . (b) What is assumed about the disctribution of " t +1 under Weak-Form EMH? (c) What is assumed about the disctribution of " t +1 under Semi-Strong Form EMH? (d) Assume it were true that Cov ( p t +1 ° p t ; p t ° p t ° 1 ) > 0 : Would that constitute a violation of EMH? Why? If yes, which form? (e) What trading strategy would allow an investor to "beat the market" if the inequality in (d) were true?
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