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- 1. We are what we repeatedly do. Excellence, then, is not an
act but a habit. - Aristotle
2. Risk Measurement & Efficient Market Hypothesis Dr. Jatin
Pancholi Website: http://www.jatinpancholi.com Dr. Jatin Pancholi
has compiled and prepared this teaching note from various sources,
as the basis for class discussion rather than to illustrate either
effective or ineffective handling of a management situation.The
handling of a management situation requires personal guidance by a
professional. To obtain copies, request permission to reproduce and
to send feedback, please contact on
websitehttp://www.jatinpancholi.com . Those wishing to co-author
next edition of this handout may also contact. 3. LEARNING
OUTCOMES
- To develop a critical understanding of the nature of risk and
returns
- Evaluate the Efficient Market Hypothesis and discuss its
implications for corporations and
4. BACKGROUND
- Savings is a virtue and a vice
5. MARKET BEHAVIOUR
- On 25 thNovember 2006, fromwww.ft.com , last 10 years (decade)
data of including:
- (a) Yearly Share Price (Open, High, Low Close),
- (c) Yearly Volatility Fast
- (d) Yearly Volatility Slow
6. USA: NASDAQ 7. USA: S&P 500 8. UK: FTSE100 9. Risk and
Return and the Principles of Finance
- Efficient Capital Markets
10. Asset Pricing Models
- These models provide a relationship between an assets required
rate of return and its risk.
11. The Capital Asset Pricing Model (CAPM)
- It allows us to determine the required rate of return for an
individual security.
-
- Individual securities mightnotlie on the Capital Market Line
(CML).
-
- Only efficient portfolios lie on the CML.
- The CAPM can be developed from the CML.
- When applied to financial securities, the CAPM is referred to
as the Security Market Line (SML).
12. Assumptions of the CAPM
- The probability distributions of security returns can be
described by the mean and the variance of returns.
- All investors have the same assessment of expected returns,
variances, and covariances of all securities.
- Capital markets are in equilibrium.
-
- The Principle of Market Efficiency applies.
- All investors have a one-period horizon.
13. What does the SML tell us?
- The required rate of return on a security depends on:
-
- the beta of the security, and
-
- the market price of risk.
- The required return is a linear function of the beta
coefficient.
-
- All else being the same, the higher the beta coefficient, the
higher is the required return on the security.
14. What does the CAPM tell us?
- The required return for a risky asset is composed of two
parts:
- Compensation for waiting (the riskless return), and
- Compensation for bearing risk.
The required compensation for bearing risk can be measured: 15.
Graphical Representation of SML M r f Risk Premium for a stock
twice as risky as the market 1.0 Riskless return Market Risk
Premium 2.0 Risk Premium for a stock half as risky as the market
0.5 16. Estimating the Beta Coefficient
- Generally, these quantities arenotknown.
- We usually rely on theirhistorical values to provide us with
anestimateof beta.
If we know the securitys correlation with the market, its
standard deviation, and the standard deviation of the market, we
can use the definition of beta: 17. Estimating the Beta Coefficient
Using historical values ofr j ,r f , andr M , we can run the
following linear regression to estimate theb : This equation is
called theCharacteristic Lineof securityj 18. Interpreting the Beta
Coefficient The beta of the market portfolio is always equal to
1.0: The beta of the risk-free asset is always equal to 0: Since
Since 19. Interpreting the Beta Coefficient
- Beta indicates how sensitive a securitys returns are to changes
in the market portfolios return.
-
- It is a measure of the assets risk.
- Suppose the market portfolios return is +10% during a given
period.
-
- if= 1.50, the securitys return will be +15%.
-
- if= 1.00, the securitys return will be +10%.
-
- if= 0.50, the securitys return will be +5%.
-
- if= 0.50, the securitys return will be 5%.
20. Beta Coefficients for Selected Firms Common Stock Beta Alex
Brown Nike Inc. (Class B) Microsoft PepsiCo. Inc. McDonalds
Corporation Boeing Co. AT&T Corp. Exxon Corp. 1.90 1.50 1.40
1.10 1.05 1.00 0.85 0.60 21. Beta of a Portfolio
- The beta of a portfolio is the weighted average of the beta
values of the individual securities in the portfolio.
wherew iis the proportion of value invested in securityi , andb
iis the beta of the securityi .For two securities, the portfolio
beta is: 22. Applying the CAPM
- The CML prescribes that investors should invest in the riskless
asset and the market portfolio.
- The true market portfolio, which consists of all risky assets,
cannot be constructed.
- How much diversification is necessary to get substantially all
of the benefits of diversification?
23. Diversifiable and Nondiversifiable Risk
- Beta measures the risk that an individual asset adds to the
market portfolio.
- Since the market portfolio is fully diversified, beta measures
the risk that cannot be diversified away.
- Thus, beta is a measure of the assetsnondiversifiablerisk.
- Diversifiable risk + Nondiversifiable risk.
24. Diversifiable Risk
- It is also known asunsystematic , or asset specific, risk and
can be eliminated by diversification .
-
- failure (or success) of a firm in launching a new product.
-
- failure (or success) to get a contract
-
- failure (or success) in settling a strike or a lawsuit.
- Such events are random across firms and their effects tend to
cancel each other out.
25. Nondiversifiable Risk
- It also known as systematic, or market, risk and cannot be
eliminated by diversification.
-
- sharp change in monetary policy
- It reflects the degree to which an assets returns
movesystematicallywith those of other assets.
26. Consequences of Not Diversifying.
- A nondiversified investor bears both types of risk:
diversifiable and nondiversifiable.
-
- He will therefore demand a higher risk premium from the
asset.
- A diversified investor bears only systematic risk.
-
- She will therefore demand a lower risk premium from the
asset.
27. Consequences of Not Diversifying.
- The value of the asset to the diversified investor will be
higher than to the nondiversified investor.
- Since the diversified investor bears less risk than the
nondiversified one, she will demand a lower risk premium.
- The lower the risk premium, the lower the required rate of
return.
- The lower the required rate of return, the higher is the value
of the asset.
28. Consequences of Not Diversifying.
- Since the value of the asset is higher to the diversified
investor, she will always out-bid the nondiversified one.
- The price she is willing to offer will be the market clearing
price.
- Therefore, financial asset prices are set as though all
investors are diversified.
29. Efficient Market Hypothesis 30. Why Capital Markets
Exist
- Capital markets facilitate the transfer of capital (
i.e.financial) assets from one owner to another.
-
- Liquidity refers to how easily an asset can be transferred
without loss of value.
- A side benefit of capital markets is that the transaction price
provides a measure of the value of the asset.
31. The Concept of Efficiency
- In an efficient capital market, the transfer of assets occurs
with little loss of wealth.
- In such markets, pricesreflect all available information .
- Thus, financial asset prices arefairprices.
-
- They are neither too high, nor too low.
- What is meant by all available information?
32. Three Forms of Capital Market Efficiency
- Strongform of capital market efficiency.
-
- Current prices reflectallinformation that can possibly be known
to anyone.
- Semi-strongform of capital market efficiency.
-
- Current prices reflect allpubliclyavailable information.
- Weakform of capital market efficiency.
-
- Current prices reflect only the information contained
inpastprices.
33. Three Forms of Capital Market Efficiency Strong Form (All
information affecting the assets value) Semi-Strong Form (All
publicly available information) Weak Form (Information contained in
past prices) 34. Implication of Efficiency for Investors
- Future market prices cannot be predicted based on available
information.
- Investments in these markets have a zero NPV.
-
- The expected rate of return equals the required rate of
return.
-
- The expected rate of return compensates the investor for the
risk borne.
- Abnormally high returns are earned by pure chance.
35. Frictions in Capital Markets
- Frictions in the capital markets prevent these markets from
being perfectly efficient.
-
- Transaction Costs: time, effort, and money required to make a
transaction.
36. Arbitrage
- Arbitragerefers to buying an asset in one market and selling it
at a higher price in another market.
- People who engage in arbitrage are know asarbitrageurs(or
simply, arbs).
- In a perfect market, there are no arbitrage opportunities.
-
- As soon as one is discovered, competition among arbitrageurs
will eliminate it.
37. Limits to Arbitrage
- In order to discover arbitrage opportunities, you must
-
- have access to markets in which the price differential
exists,
-
- incur costs in discovering this price differential,
-
- incur variable transaction costs of making the trades.
- The price differential between markets is generally less than
the variable cost of making the transactions.
38. Arbitrage versus Speculation
- In an arbitrage transaction, the asset is bought and
soldimmediately .
- Speculators hold the asset for some time period, and thereby
incur risk.
- Speculators try to anticipate future prices and trade on their
beliefs.
- The future price is based on imperfect information that they
receive about the value of the asset.
39. Signaling and Information Gathering
- Market participants react quickly to events that convey useful
information.
- Actions convey asymmetric information.
-
- Watch what management does.
- Interpreting signals is a valuable talent.
-
- Deductive reasoning: a general fact provides information about
a specific situation.
-
- Inductive reasoning: a specific situation is used to draw
general conclusions.
40. Information and Price Movements
- In an efficient capital market, prices reflect all available
information.
- When new information arrives, prices react instantaneously to
it.
- Since new information is that which cannot be predicted, it
would arrive at random points in time.
- Price movements are random ( i.e . cannot be predicted).
41. Price Reaction to Good News
- Good news, when it is announced, should increase the price of a
stock.
Time Price Correct Price Levelwith new information Good News
Release 42. Price Overreaction to Good News
- Good news, when it is announced, should increase the price of a
stock.
Time Price Correct Price Levelwith new information Good News
Release 43. Price Underreaction to Good News
- Good news, when it is announced, should increase the price of a
stockquickly . Otherwise theres an arbitrage opportunity.
Time Price Correct Price Levelwith new information Good News
Release 44. Early Price Reaction to Good News
- If we see price increases PRIOR to news release, we may be
seeing evidence of insider trading (or psychic activity).
Time Price Correct Price Levelwith new information Good News
Release 45. Price Reaction to Bad News
- Bad news, when it is announced, should decrease the price of a
stock.
Time Price Bad News Release Correct Price Levelwith new
information 46. Price Overreaction to Bad News
- Bad news, when it is announced, should decrease the price of a
stock. In this example, panic selling offers arbitrage
profits.
Time Price Bad News Release Correct Price Levelwith new
information 47. Price Underreaction to Bad News
- Bad news, when it is announced, should decrease the price of a
stock. In this example, panic selling offers arbitrage
profits.
Time Price Bad News Release Correct Price Levelwith new
information 48. The Law of Value Conservation
- In a perfect market, value is conserved across
transactions.
- Let V(A) be the value of asset A, and V(B) be the value of
asset B. Then,
- Imperfections (taxes, transaction costs) may appear to violate
the law of value conservation.
- Value conservation holds if all losses due to frictions are
included.
49. Perfect Capital Markets
-
- Each participant is sufficiently small and cannot affect prices
by her/his actions.
- Financial assets are infinitely divisible.
- All information is fully available to every participant, at no
cost.
50. Perfect Capital Markets
- No restrictions on trading.
51. Some Imperfections
-
- These change the zero-sum nature of capital market
transactions.
-
- Information is not equally (and costlessly) available to all
market participants.
-
- Generally less important an imperfection.
52. Thanks very much Photo Copyrights. Background photo of the
Charles River, Harvard University, Boston, USA by Jatin Pancholi.
seewww.kalanidhee.org for other photographs. Dr. Jatin Pancholi
www.jatinpancholi.com