Chap 7

Solutions to SQ:

7–2 Describe in words the concept of a realised rate of return. Assume you
are trying to describe the concept to your grandfather, who has never
taken a finance subject!
The realised rate of return tells us how much you have made over some period both from
appreciation (or loss) in the value of your asset (for example, how much your
share went up or down in price) and how much money was distributed to you as a
result of holding the asset (for example, how much you got in terms of interest or
dividends).

7–6 Why is the volatility in an investment’s rate of return a reasonable

indication of the risk of the investment?
There are two methods financial analysts can use to quantify the variability of an
investment’s returns. The first is the variance in investment returns and the
second is the standard deviation, which is the square root of the variance. Both
of these measures give us an idea of the width of the distribution of possible
outcomes—the wider the distribution, the more risk there is. Why don’t investors
like a wide distribution of possible returns? While it is always nice to receive more
than you expect, it is more painful to receive less than you expect—that is the
idea of diminishing marginal utility of wealth that you learned in your economics
classes. Because the pain of missing (negative utility) is more than the positive
utility from a gain of the same size, investors don’t like variability of possible
returns. Moreover, it is much easier to plan into the future if you know how much
money you will have to work with.

7–9 What is equity risk premium and how is it calculated?

Riskier investments have historically realised higher returns. The riskiest investment class
is comprised of shares, then corporate bonds, long-term Treasury bonds, and
finally Treasury notes. The difference between the returns of the riskier share
investments and the less risky investments in government securities is called the
equity risk premium. For example, referring to the figure shown in Figure 7.2,
the premium of shares over long-term Treasury bonds averages 12.52% – 9.25%
= 3.27%.

7–15 what is the efficient markets hypothesis? Explain this concept in your
own words?
The efficient markets hypothesis states that securities prices accurately reflect future
expected cash flows and are based on all of the information available to investors.
An efficient market is a market in which all of the available information is fully
incorporated into security prices, and the returns that investors will earn on their
investments cannot be predicted.
7–16 Compare and contrast the notions of weak form ,semi strong form and
strong- from market efficiency ?
Taking this concept of efficient markets further, we can distinguish between weak-form
efficient markets, semi-strong-form efficient markets, and strong-form efficient
markets, depending on the degree of efficiency:

1. The Weak-Form Efficient Markets Hypothesis asserts that all past security
market information is fully reflected in security prices. This means that all price and
volume information is already reflected in a security’s price.

2. The Semi-Strong-Form Efficient Markets Hypothesis asserts that all publicly

available information is fully reflected in security prices. This is a stronger
statement because it isn’t limited to price and volume information, but includes all
public information. Thus, the firm’s financial statements, news and announcements
about the economy, industry, or company, analysts’ estimates on future earnings,
or any other publicly available information is already reflected in the security’s
price. As a result, taking an investments class won’t be of any value to you in
picking a winner.

3. The Strong-Form Efficient Markets Hypothesis asserts that all information,

regardless of whether this information is public, past or private (inside), is fully
reflected in security prices. This form of the efficient markets hypothesis
encompasses both the weak-form and semi-strong form efficient markets
hypotheses. It asserts that there isn’t any information that isn’t already embedded
into the prices of all securities. In other words, even insider information—that is,
material information that isn’t available to any other investor—is of no use.

7–18 what is the behavioural view of market efficiency ?

If we believe that investors do not rationally process information, then market prices may
not accurately reflect even public information. As an example, economists have
suggested that overconfident investors tend to under-react when a company’s
management announces earnings or makes other statements that are relevant to
the value of the firm’s shares. This is because investors have too much confidence
in their own views of the company’s true value and tend to place too little weight on
new information provided by management. As a result, this new information, even
though it is publicly and freely available, is not completely reflected in share prices.