risk measurement & efficient market hypothesis

1. We are what we repeatedly do. Excellence, then, is not an act but a habit. - Aristotle

To develop a critical understanding of the nature of risk and returns

Evaluate the Efficient Market Hypothesis and discuss its implications for corporations and

Savings is a virtue and a vice

Where can we save?

Markets

Kinds of markets

Decision Making criteria

Returns

Time period (Duration)

Any other factors?

On 25 thNovember 2006, fromwww.ft.com , last 10 years (decade) data of including:

(a) Yearly Share Price (Open, High, Low Close),

(b) Yearly Volume

(c) Yearly Volatility Fast

(d) Yearly Volatility Slow

Diversification

Risk-Return Trade-Off

Efficient Capital Markets

Incremental Benefits

Two-Sided Transactions

Time-Value-of-Money

These models provide a relationship between an assets required rate of return and its risk.

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).

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.

Homogeneous expectations

Capital markets are in equilibrium.

The Principle of Market Efficiency applies.

All investors have a one-period horizon.

The required rate of return on a security depends on:

the risk free rate

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.

The required return for a risky asset is composed of two parts:

Compensation for waiting (the riskless return), and

Compensation for bearing risk.

Generally, these quantities arenotknown.

We usually rely on theirhistorical values to provide us with anestimateof beta.

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= 0.50, the securitys return will be 5%.

The beta of a portfolio is the weighted average of the beta values of the individual securities in the portfolio.

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?

About 25 to 30 stocks!

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.

Total Risk =

Diversifiable risk + Nondiversifiable risk.

It is also known asunsystematic , or asset specific, risk and can be eliminated by diversification .

It can be caused by:

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.

It also known as systematic, or market, risk and cannot be eliminated by diversification.

It can be caused by:

recession

sharp change in monetary policy

outbreak of war

It reflects the degree to which an assets returns movesystematicallywith those of other assets.

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.

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.

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.

Capital markets facilitate the transfer of capital ( i.e.financial) assets from one owner to another.

They provide liquidity.

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.

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?

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.

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.

Frictions in the capital markets prevent these markets from being perfectly efficient.

Frictions include:

Transaction Costs: time, effort, and money required to make a transaction.

Asymmetric taxes.

Asymmetric information.

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.

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.

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.

Market participants react quickly to events that convey useful information.

The Signaling Principle.

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.

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).

Good news, when it is announced, should increase the price of a stock.

Good news, when it is announced, should increase the price of a stockquickly . Otherwise theres an arbitrage opportunity.

If we see price increases PRIOR to news release, we may be seeing evidence of insider trading (or psychic activity).

Bad news, when it is announced, should decrease the price of a stock.

Bad news, when it is announced, should decrease the price of a stock. In this example, panic selling offers arbitrage profits.

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,

V(A + B) = V(A) + V(B)

Imperfections (taxes, transaction costs) may appear to violate the law of value conservation.

Value conservation holds if all losses due to frictions are included.

No barriers to entry.

Perfect competition.

Each participant is sufficiently small and cannot affect prices by her/his actions.

Financial assets are infinitely divisible.

No transaction costs.

All information is fully available to every participant, at no cost.

No tax asymmetries.

No restrictions on trading.

Asymmetric taxes

These change the zero-sum nature of capital market transactions.

Asymmetric information

Information is not equally (and costlessly) available to all market participants.

Transaction costs

Generally less important an imperfection.

risk measurement & efficient market hypothesis

Business

beta coefficient beta

portfolio beta

market portfolios return

market price of risk

beta values

required return

beta coefficients

anestimateof beta