a) Assume that the information system is so advanced that the market, as confirm

ID: 2708158 • Letter: A

Question

a) Assume that the information system is so advanced that the market, as confirmed by

numerous unbiased studies, is efficient. Investment firms therefore decide to retire all portfolio

managers and financial analysts and let random choice govern the security section process. What

impact will this action have on market efficiency?

b) Standard deviation of stock returns is often used as a measure of riskiness of the stock.

How does standard deviation measure risk?

c) The idea behind CAPM is that investors should not be compensated for diversifiable

risk. Why not?

a) The efficiency of the market is based upon the continuing services of the analysts and portfolio

managers to actively scout the market. If these players are removed from the market, the prices will

cease to reflect all the available information. This will consequently lead to markets becoming

inefficient

b) The standard deviation of stock returns measures the dispersion of the returns around the mean.

Therefore, ex-ante standard deviation is a measure of dispersion of the ex-ante returns around the

expected stock return. Thus, higher the dispersion, higher will be the uncertainty of the ex-post

returns being close to the ex-ante expected returns. Since, risk is defined as uncertainty, higher the

standard deviation, higher will be the risk.

c) Diversifiable risk, by definition can be fully eliminated through efficient asset allocation in a

portfolio. Therefore, existence of this type of risk in a portfolio is purely an expression of the

manager

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