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1a. If price reflects fundamental value, lower bound of P(3Com) would be 95% of P(Palm).
b. Yes, this is a mispricing. Based on answer in (a), the lower bound of P(3Com) is $95*95%=
%90.25. However, the actual price of 3Com was $81 which is even lower than the above lower
bound.
c. I would short sell shares of Palm and buy shares of 3Com to correct the mispricing. In this
case, short selling Palm shares would cause lower P(Palm) and so the lower bound for
P(3Com) would decrease. Then, using the proceed from selling short to purchase eCom shares
would push upu P(3Com) and hence P(3Com) would reach the lower bound more easily.
Meanwhile, the portfolio would have a capital gain of $14($95-$81) from the difference between
P(Pam) and P(3Com).
d. Yes. Because 3Com has release a negative news that it will spin off the remainder of Palm
within 9 months, it could further decrease the fundamental value of 3Com, making it more
difficult to correct the mispricing.
e. Yes. Because some irrational traders in market could over-react on the news released.
Without assessing the fundamental value of 3Com and Palm with multiple sources, noise
traders, could prohibit arbitrageurs from correcting the mispricing.
f. I would like to investigate the shorting cost.
Question 2
a)
Year
Annual return
1994
-31.10%
1995
22.98%
1996
33.53%
1997
-20.29%
1998
-6.29%
1999
68.80%
2000
-11.00%
2001
-24.50%
2002
-18.21%
2003
34.92%
2004
13.15%
2005
4.54%
2006
34.20%
2007
39.31%
2008
-48.27%
2009
52.02%
2010
5.32%
2011
-19.97%
2012
22.91%
2013
2.87%
2014
1.28%
b)
c)
Although the relationship bewteen PE ratio and next years growth rate of earnings is not
obvious, we still can see that many points in the graph with high PE ratio still have low next
years growth rate of earnings and points with low PE ratio have high next years growth rate of
earnings. Therefore, the data doest not support second channel.
d)
If high P/E ratio is associated with lower future index return. From the figure above, it is shown
that the year-end P/E ratio is negatively-related with the next years annual return. Which gives
us the prove that a high P/E ratio will give a low annual return next year. As return equals to the
number of stocks times the price of the stocks, hence a lower annual return also indicates a
lower price. Therefore, the data support the first channel.
e)
Year
Index
PE Ratio
Buy
1993
11888.39
18.756
No
1994
8191.04
11.0465
Yes
0.00%
1995
10073.39
11.7915
Yes
22.98%
1996
13451.45
13.3701
No
33.53%
1997
10722.76
9.5499
Yes
0.00%
1998
10048.58
12.2297
Yes
-6.29%
1999
16962.1
13.5553
No
68.80%
2000
15095.53
18.4033
No
0.00%
2001
11397.21
19.2827
No
0.00%
2002
9321.29
14.4581
No
0.00%
2003
12575.94
17.9366
No
0.00%
2004
14230.14
14.6073
No
0.00%
2005
14876.43
11.6593
Yes
0.00%
2006
19964.72
14.987
No
34.20%
2007
27812.65
16.7174
No
0.00%
2008
14387.48
13.1677
No
0.00%
2009
21872.5
15.8591
No
0.00%
2010
23035.45
12.7542
Yes
0.00%
2011
18434.39
9.0034
Yes
-19.97%
2012
22656.92
11.1462
Yes
22.91%
2013
23306.39
11.0066
Yes
2.87%
2014
23605.04
9.6204
Yes
1.28%
Annual return
Volatility = 18.65%
Comparing with the answer the answer in (a), it is found that the average annual return is
higher, comparing to 7.44% in (a). That means using this method will yield a higher average
return. Moreover, the volatility is lowered, omparing to 29.13% in (a), which suggests that the
risks is also lowered by using this market technique. As to conclude, during the sample period, it
is found that using the investors trading technique will give us a better return while also a lower
risks.
Excel: https://drive.google.com/file/d/0B7pqSgbpp9q2aF9uZzMzMWUxVGM/view