1. You think that the stock market exhibits reversal, so if the price of a stock sharply drops you expect it to rise shortly thereafter. If it sharply rises, you expect it to drop shortly thereafter. To test this hypothesis, you build a trading strategy that buys when the stocks go down and sel ls in the opposite case. You collect historical data on the current S&P 500 stocks, and your hypothesis gave a good annual return of 12%.

(a) When you trade using this system, do you expect it to perform at this level? Why or why not?

(b) How can you test your strategy so that its performance in sample is more reflective of what you should expect in reality?

2. One often hears "Extra polation is harder than interpolation." Give a possible explanation for this phenomenon using the principles in this chapter.