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Module 3, 2011 Empirics of Financial Markets Final Exam

This is a three-hour closed-book exam. You are permitted a 2-sided A4 note sheet, calculator, and pens/pencils. No computers (or iPads), or cell phones. PLEASE LABEL THE TOP RIGHT COURNER OF EACH PAGE WITH THE QUESTION NUMBER(s) YOU ARE ANSWERING on that page. Short answer questions (Answer 5 of 7) (4 points each) If you do all 7, the lowest scoring 5 will count toward your exam grade. 1. Is it possible to eliminate all risk using diversification? Explain your answer. 2. What is the difference between unit trust, closed-end fund, and exchange traded funds? 3. What is the main statement of the prospect theory? 4. Suppose you are a manager of one company and you have bad news for investors. At what day of the week do you prefer to release this information to minimize impact on prices of your company? Why? 5. What are the main difficulties with long horizons event studies? 6. What is the January effect? Is this an anomaly or is there a rational explanation? 7. Why did Fama and French introduce three-factor model in place of CAPM? What is the criticism for using SMB and HML as risk factors? Medium Answer Questions (Answer 4 of 5) (7.5 points each) If you do all 5, the lowest scoring 4 will count toward your exam grade. 8. Under what conditions will behavioral biases impact stock returns? Under what conditions will behavioral biases NOT impact stock returns? 9. Suppose you are testing the hypothesis that the Steve Ballmer's announcement on coming official PC support of the new Kinect controller had a significant impact on Microsoft's stock performance. However, the t-test does not show you any evidence that returns of the stock were different. Give at least 5 different reasons for why it might be the case. 10. How are the RW1, RW2 and RW3 hypotheses related? Which is the weakest form of the random walk hypotheses? 11. What are weak, semi-strong and strong forms of market efficiency? Describe at least 3 ways to test weak form of market efficiency.

Medium Answer Questions (continued) 12. Explain Rolls Critique [from Roll (1977)]. Then answer, if we run OLS regressions of stock returns on the market portfolio, but find no significant alpha, does this mean that the CAPM is valid? Does alpha significantly different from zero always mean inefficiency? Long Answer Questions (Answer 2 of 3) (25 points each) If you do all 3, the lowest scoring 2 will count toward your exam grade. Instructions PLEASE READ: Long answer questions are broken up into several parts. I did this to make grading 80 exams easier, more consistent and more fair. Please label your answers with the question number and letter (e.g. 12b) carefully which question and which question part you are answering. Please keep answers to each part separate, if not you might receive a lower grade, because I will not be looking for the answer to part b in part a. 13a) When we say, Factor X is priced. What does that mean? What does it mean to say a factor is priced? (5 points) 13b) Suppose you find evidence that a proposed factor is highly correlated with the time series of stock returns. Is this evidence that the factor is priced? (5 points) 13c) Describe in detail empirical tests to demonstrate whether or not a factor is priced. in detail means that you should describe each step of the test (for example, Step 1: Get returns for all stocks, Step 2: estimate ____, etc.). (10 points) 13d) For each step in 13c, please explain the economic or statistical motivation for each step. For example, if you say the first step is to get returns for all stocks, the economic motivation might be because you expect a factor to be able to price all assets in an economy. Stocks are one class of assets in the economy, and the returns are easy to get. (5 points)

14) Suppose you are working for a hedge fund investigating very short-term strategies that can generate unusually high return with a minimum of risk. While you have access to the same public information as others do in the market, where you might be superior to others in the market is in your ability to a) execute trades quickly (your fund has a large and successful trading desk that knows how to get large orders bought or sold quickly with a minimum effect on prices) and b) to understand the value implications of firm related events. You have observed that stock prices firms tend to jump around information that event X or event Y occurs. You investigate using the tools and methods learned in this class. 14a) Suppose you run an event study with 25 firms that have experienced event X and 25 that have experienced event Y. Describe in detail how you would set up your event study. (5 points) 14b) Describe different test statistics used in event studies. Discuss how they differ from each other. (10 points) 14c) What test(s) would you use to test whether the event has a significant impact on returns? (5 points) 14d) Suppose that the average abnormal return on the event day for event X is positive and significant. Please interpret your results. (5 points)

15. This question is regarding measuring mutual fund performance. 15a) Performance measurement: During this course we discussed 4 measures of mutual fund performance. List each. What are the advantages and disadvantages of each? Comment on whether mutual fund managers can manipulate their investments to make their performance appear better than it is. (15 points) 15b) Risk adjustment: In our lectures on mutual fund performance evaluation we discussed, portfolio-based methods to risk adjust mutual fund performance and factor based methods to risk adjust performance. List at least two of the three portfolio based methods of risk adjustment and compare these methods to the factor model based methods. Comment on whether mutual fund managers can manipulate their investments to make their performance appear better than it is. (10 points)