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Unformatted text preview: e Capital Asset Pricing Model). Then determine whether the alpha of each group is significantly different from zero. Here are some things to look out for: a. Don’t select samples of stock at the end of the period. You will have omitted the companies that went bankrupt. b. Include dividends in the actual rate of return. Low P/E stocks have high yields. c. Check that earnings are known on the date that you calculate P/E. Stocks whose earnings subsequently turned out high relative to price naturally perform better. d. Adjust for risk. Low P/E stocks tend to be more risky. e. You may need to disentangle the P/E effect from other effects, e.g., size or dividend yield. 8. This is not necessarily true. The company should consider its particular circumstances. There may be tax advantages to issuing debt or some other security, for example. The transaction costs of issuing some securities may be more than the costs of issuing others. (These and related issues are examined in subsequent chapters.) 9. The efficient market hypothesis does not imply that portfolio selection should be done with a pin. The manager still has three important jobsto do. First, she must make sure that the portfolio is well diversified. It should be noted that a large number of stocks is not enough to ensure diversification. Second, she must make sure that the risk of the diversified portfolio is appropriate for the manager’s clients. Third, she might want to tailor the portfolio to take advantage of special tax laws for pension funds. These laws may make it possible to increase the expected return of the portfolio without increasing risk. 10. They are both under the illusion that markets are predictable and they are wasting their time trying to guess the...
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