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CMA Final · Strategic Financial Management · Efficient Market Hypothesis

A fund manager's portfolio has beta 1.2. Over a year the risk-free rate was 6%, the market return was 14%, and the portfolio earned 17%. Under an efficient market, the manager's expected alpha is zero. Across 20 such managers in a semi-strong efficient market, the average realised alpha is found to be about zero but one manager shows the alpha of this portfolio. What is this portfolio's alpha, and what is the correct interpretation under EMH?

Alpha is +1.4%. The CAPM required return is 6% plus 1.2 times 8%, which equals 15.6%, and the portfolio earned 17%. In an efficient market with many managers, some positive alphas occur by chance, so a single year's result is likely luck, not proof of inefficiency.

  1. A+1.4%; likely luck, since persistent alpha is not expected in an efficient marketCorrect
  2. B+3.0%; proof of skill, so the market is inefficient
  3. C+1.4%; proof of skill, so the market is inefficient
  4. D-1.4%; evidence of underperformance caused by costs

Explanation

Required return = 6 + 1.2 x (14 - 6) = 15.6%. Alpha = 17 - 15.6 = +1.4%. With many managers, a few positive alphas arise by chance, so one year's alpha does not disprove EMH. The +3.0% option ignores beta (17 - 14), which is the wrong benchmark.

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