Question 1

1a. If price reflects fundamental value, lower bound of P(3Com) would be 95% of P(Palm).
b. Yes, this is a mispricing. Based on answer in (a), the lower bound of P(3Com) is $95*95%=
%90.25. However, the actual price of 3Com was $81 which is even lower than the above lower
bound.
c. I would short sell shares of Palm and buy shares of 3Com to correct the mispricing. In this
case, short selling Palm shares would cause lower P(Palm) and so the lower bound for
P(3Com) would decrease. Then, using the proceed from selling short to purchase eCom shares
would push upu P(3Com) and hence P(3Com) would reach the lower bound more easily.
Meanwhile, the portfolio would have a capital gain of $14($95-$81) from the difference between
P(Pam) and P(3Com).
d. Yes. Because 3Com has release a negative news that it will spin off the remainder of Palm
within 9 months, it could further decrease the fundamental value of 3Com, making it more
difficult to correct the mispricing.
e. Yes. Because some irrational traders in market could over-react on the news released.
Without assessing the fundamental value of 3Com and Palm with multiple sources, noise
traders, could prohibit arbitrageurs from correcting the mispricing.
f. I would like to investigate the shorting cost.

Question 2
a)
Year

Annual return

1994

-31.10%

1995

22.98%

1996

33.53%

1997

-20.29%

1998

-6.29%

1999

68.80%

2000

-11.00%

2001

-24.50%

2002

-18.21%

2003

34.92%

2004

13.15%

2005

4.54%

2006

34.20%

2007

39.31%

2008

-48.27%

2009

52.02%

2010

5.32%

2011

-19.97%

2012

22.91%

2013

2.87%

2014

1.28%

Average annaul return from 1994 to 2014 = 7.44%

Volatility from 1994 to 2014 = 29.13%

b)

c)

Although the relationship bewteen PE ratio and next years growth rate of earnings is not
obvious, we still can see that many points in the graph with high PE ratio still have low next
years growth rate of earnings and points with low PE ratio have high next years growth rate of
earnings. Therefore, the data doest not support second channel.
d)

If high P/E ratio is associated with lower future index return. From the figure above, it is shown
that the year-end P/E ratio is negatively-related with the next years annual return. Which gives
us the prove that a high P/E ratio will give a low annual return next year. As return equals to the
number of stocks times the price of the stocks, hence a lower annual return also indicates a
lower price. Therefore, the data support the first channel.

e)

Year

Index

PE Ratio

Buy

1993

11888.39

18.756

No

1994

8191.04

11.0465

Yes

0.00%

1995

10073.39

11.7915

Yes

22.98%

1996

13451.45

13.3701

No

33.53%

1997

10722.76

9.5499

Yes

0.00%

1998

10048.58

12.2297

Yes

-6.29%

1999

16962.1

13.5553

No

68.80%

2000

15095.53

18.4033

No

0.00%

2001

11397.21

19.2827

No

0.00%

2002

9321.29

14.4581

No

0.00%

2003

12575.94

17.9366

No

0.00%

2004

14230.14

14.6073

No

0.00%

2005

14876.43

11.6593

Yes

0.00%

2006

19964.72

14.987

No

34.20%

2007

27812.65

16.7174

No

0.00%

2008

14387.48

13.1677

No

0.00%

2009

21872.5

15.8591

No

0.00%

2010

23035.45

12.7542

Yes

0.00%

2011

18434.39

9.0034

Yes

-19.97%

2012

22656.92

11.1462

Yes

22.91%

2013

23306.39

11.0066

Yes

2.87%

2014

23605.04

9.6204

Yes

1.28%

Average annual return = 8.02%

Annual return

Volatility = 18.65%
Comparing with the answer the answer in (a), it is found that the average annual return is
higher, comparing to 7.44% in (a). That means using this method will yield a higher average
return. Moreover, the volatility is lowered, omparing to 29.13% in (a), which suggests that the
risks is also lowered by using this market technique. As to conclude, during the sample period, it
is found that using the investors trading technique will give us a better return while also a lower
risks.
Excel: https://drive.google.com/file/d/0B7pqSgbpp9q2aF9uZzMzMWUxVGM/view