Professional Documents
Culture Documents
Fall, 2014
Problem Set 5
(Due Tuesday, Nov. 18)
1. (10 points)
Calculate the price of a stock that has a one-period horizon, is expected to pay a
dividend of $.20 per share for the period, with the following prices and associated
probabilities forecast at the end of the period:
Probability 0.3
Price
$40
0.1
$45
0.2
$55
0.3
$62
0.1
$70
500,000,000
317,391,718
290,305,387
a. (5 points)
How many shares are in the treasury stock?
Issued shares = Shares outstanding + Treasury stock
Hence
To answer questions 3 and 4, refer to the articles by Malkiel and Shleifer available on the
course web site, in addition to what we covered in class.
3. (15 points)
a. (5 points)
Why do Malkiel, and those who think like him, believe in efficient market theory?
b. (5 points)
What are three attacks on EMH that Malkiel attributes to the behavioralists?
c. (5 points)
What does Malkiel believe about the market patterns the behavioralists claim to
have discovered?
4. (20 points)
a. (5 points)
How does Shleifer define arbitrage? How does he use the concept to argue
against market efficiency?
b. (5 points)
Why would the market value of Royal Dutch equal 1.5 times the market value of
Shell if efficient market theory is correct?
c. (5 points)
Why is the Royal Dutch/Shell case something of an embarrassment for EMH?
d. (5 points)
How does the fact that arbitrage is risky argue against EMH?
5. (10 points)
What is the beta of a stock with an expected return E(ri) = 18%, when the risk-free
rate rF = 6%, and the expected market return E(rM) = 14%? Show your work.
E(ri) rf = B[E(rm) rf)]
B= [E(ri)-rf)]/[E(rm)-rf]
B= (0.18- 0.06)/(0.14- 0.06)
B = 1.5
6. (10 points)
True or false? Explain: Stocks with a beta of zero offer an expected rate of return of
zero.
If beta is equal to 0 then E(ri)-rf = 0 hence the Expected return will be equal to the risk
free rate, hence it is a false statement
7. (10 points)
Suppose the rate of return on short-term government securities (perceived to be riskfree) is 5%. Suppose also that the expected rate of return required by the market for a
portfolio with a beta of 1 is 12%. According to the CAPM:
a. (5 points)
What is the expected rate of return on the market portfolio?
rf = 5%
B= 1
E(rm) = 12%
We need to find the expected rate of return on the market portfolio E(ri)
E(ri) = rf+ B[E(rm) rf]
E(ri) = 0.05 + 1 x( 0.12-0.05)
E(ri) = 0.05 + 0.07
E (ri) = 12%
b. (5 points)
What would be the expected rate of return on a stock with = 0?
The rate of return on a stock with B = 0 will be equal to the risk free rate hence will be
equal to 5%
8. (10 points)
Describe the two kinds of contracts that an underwriter can negotiate with a firm
wishing to do an IPO. Discuss which is more costly to the issuing firm, and why.