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Unformatted text preview: Problem Set #6 - Solutions GSI: Florent Rouxelin 13-1. Assume that all investors have the same information and care only about expected return and volatility. If new information arrives about one stock, can this information affect the price and return of other stocks? If so, explain why? Yes. When the new information arrives, it will change the attractiveness of this stock. If other stock prices do not change, then investors would want to increase their weight in this stock, implying they would not be holding the market portfolio. 13-2. Assume that the CAPM is a good description of stock price returns. The market expected return is 7% with 10% volatility and the risk-free rate is 3%. New news arrives that does not change any of these numbers but it does change the expected return of the following stocks: a. At current market prices, which stocks represent buying opportunities? b. On which stocks should you put a sell order in? According to the CAPM, we should hold the market portfolio. But once new news arrives and we update our expectations, we may find profitable trading opportunities if we can trade before prices fully adjust to the news. Assuming we initially hold the market portfolio, we can improve gain by investing more in stocks with positive alphas and less in stocks with negative alphas. Expected Return Volatility Beta Required Return (CAPM) Alpha Green Leaf 12% 20% 1.5 9.0% 3.0% NatSam 10% 40% 1.8 10.2%-0.2% HanBel 9% 30% 0.75 6.0% 3.0% Rebecca Automobile 6% 35% 1.2 7.8%-1.8% a. Green Leaf, HanBel b. Rebecca Automobile and possibly NatSam (although its alpha is close enough to zero that we might regard it as insignificant). 13-4. You know that there are informed traders in the stock market, but you are uninformed. Describe an investment strategy that guarantees that you will not lose money to the informed traders and explain why it works. Invest in the market portfolio. Because the average investor must hold the market, by investing in the market you guarantee the average investor return. If the informed traders make higher returns than the average investor, somebody must make lower returns, so by holding the market you can guarantee that it is...
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This note was uploaded on 09/11/2011 for the course UGBA 103 taught by Professor Berk during the Spring '07 term at University of California, Berkeley.
- Spring '07