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3a)
A security with only diversifiable risk has expected return that exceeds the risk-free interest rate. This statement is inconsistent with both.
Why? Only diversifiable risk implies no undiversifiable (market) risk. Thus, this is a zero-beta security, which is expected to earn the risk- free rate. If it has higher expected return than the risk-free rate, this is not consistent with CAPM. It is above the SML and underpriced, In an efficient market, savy investors would buy this stock pushing its price up, lowering its return. In equilibrium, its expected return should match the required return, i.e. the risk free-rate. If this is not the case markets are not efficient (potentially due to limits in arbitrage)

b)
A security with a beta of 1 had an excess return of 15% last year when the market excess return in the same year was 9%. This statement is consistent (or is not inconsistent) with both Why? Realized returns might differ from expected returns due to continuous arrival of new information. If during the year there were good news (i.e. earnings surprises) about the stock, investors could have incorporated this into prices, implying higher than expected returns for the year.

c)
A small stock with beta of 1.5 tends to have higher returns on average than a large stock with a beta of 1.5. This statement is inconsistent with the CAPM but not necessarily with efficient capital markets. Why? Beta might not be the correct specification for risk. Small firms might be riskier due to other sources of risk factors (i.e. volatility risk, liquidity risk, business cycle risk, etc.), therefore investors might require higher returns for small stocks taking into account those risk factors. 4)

Describe the three forms of the efficient-market hypothesis. Weak: The market price of an asset reflects all information contained in the history of past prices - you cannot beat the market by merely analysing past prices. Semi-strong: The market price of an asset...
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