Efficient Market Hypothesis EMH and the Capital Asset

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Efficient Market Hypothesis (EMH) and the Capital Asset Pricing Model (CAPM) Sanjai Bhagat Provost

Efficient Market Hypothesis (EMH) and the Capital Asset Pricing Model (CAPM) Sanjai Bhagat Provost Professor of Finance http: //leeds-faculty. colorado. edu/bhagat/

The Security Market Line (SML) aka The Capital Asset Pricing Model (CAPM) n The

The Security Market Line (SML) aka The Capital Asset Pricing Model (CAPM) n The Capital Asset Price Model is n E(RA ) = Rf + [E(RM ) - Rf ]x A Expected Return on Stock A = Riskfree rate + (Expected Return on the Market - Riskfree Rate) * Beta of stock A

u Most empirical tests find evidence inconsistent with CAPM. l Are testing procedures inadequate

u Most empirical tests find evidence inconsistent with CAPM. l Are testing procedures inadequate (How is Rm measured? ) l Or is the CAPM not appropriate for understanding how stocks are priced in the market? l What are the alternatives to CAPM?

EMH continued: n Models of Expected Returns u CAPM: Expected return on stock i

EMH continued: n Models of Expected Returns u CAPM: Expected return on stock i = Riskfree rate + (Beta of i with respect to Market)*(Expected return on Market - Riskfree rate) u APT: Expected return on stock i = Riskfree rate + (Beta of i with respect to Factor 1)*(Expected return on Factor 1 - Riskfree rate) + (Beta of i with respect to Factor 2)*(Expected return on Factor 2 - Riskfree rate) + . . .

EMH continued n Models of Expected Returns u Historical Industry Returns: Expected Return on

EMH continued n Models of Expected Returns u Historical Industry Returns: Expected Return on stock i = Average historical return of other firms in the same industry as company i.

Efficient Market Hypothesis (EMH) n Definition 1: A market is said to be efficient

Efficient Market Hypothesis (EMH) n Definition 1: A market is said to be efficient with respect to some information set, It, if it is impossible to make economic profits on the basis of information set It. u Economic profits: Profits after adjusting for risk and transaction costs (such as, brokerage fees, investment advisory fees). l l Economic profits = Actual return - Expected return - Transaction costs Expected Return: CAPM provides one estimate of expected return. Other estimates: Arbitrage Pricing Theory, Historical Industry Returns.

EMH continued: u Information set: Weak form of EMH : Past history of prices

EMH continued: u Information set: Weak form of EMH : Past history of prices of the particular security. Semistrong form of EMH: All publicly available information. Strong form of EMH: All public and private information.

Efficient Market Hypothesis n Definition 2: If capital markets are efficient then purchase or

Efficient Market Hypothesis n Definition 2: If capital markets are efficient then purchase or sale of any security at the prevailing market price is a zero-NPV transaction. n Definition 3 (Technical definition): The capital market is efficient with respect to an information set if and only if revealing that information to all investors would change neither equilibrium prices nor portfolios.

S. P. Kothari and Jerold Warner, “Evaluating Mutual Fund Performance. ” http: //onlinelibrary. wiley.

S. P. Kothari and Jerold Warner, “Evaluating Mutual Fund Performance. ” http: //onlinelibrary. wiley. com/doi/10. 1111/0022 -1082. 00397/full Using state-of-the-art techniques, can we detect superior mutual fund performance? u 100 basis points annual superior performance: Undetected. u 500 basis points: Detected once every three times. u 1500 basis points: Detected (almost) every time. u Ability to detect superior performance improves if one tracks a mutual fund’s stock trades. Cremers, K. J. Martijn and Fulkerson, Jon A. and Riley, Timothy Brandon, Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds (May 31, 2019). Financial Analysts Journal, Vol. 75, No. 4 (Fourth Quarter 2019)

NYSE+AMEX Market Returns 1926 -2016, 1%

NYSE+AMEX Market Returns 1926 -2016, 1%

NYSE+AMEX Market Returns 1926 -2016, 5%

NYSE+AMEX Market Returns 1926 -2016, 5%

https: //www. influenceatwork. com/robert-cialdini-phd/biography/ Dr. Robert Cialdini has spent his entire career conducting scientific

https: //www. influenceatwork. com/robert-cialdini-phd/biography/ Dr. Robert Cialdini has spent his entire career conducting scientific research on what leads people to say “Yes” to requests. The results of his research, his ensuing articles, and New York Times bestselling books have earned him an acclaimed reputation as a respected scientist and engaging storyteller. His books, including Influence and Pre-Suasion, have sold more than five-million copies in 41 different languages. Dr. Cialdini is known globally as the foundational expert in the science of influence and how to apply it ethically in business. His Six Principles of Persuasion have become a cornerstone for any organization serious about effectively increasing their influence.

6 Principles of Persuasion Reciprocity Scarcity Authority Consistency Liking Consensus

6 Principles of Persuasion Reciprocity Scarcity Authority Consistency Liking Consensus

https: //www. wsj. com/articles/highspeed-stock-traders-turn-to-laser-beams-1392175358 High-Speed Stock Traders Turn to Laser Beams Anova to Use

https: //www. wsj. com/articles/highspeed-stock-traders-turn-to-laser-beams-1392175358 High-Speed Stock Traders Turn to Laser Beams Anova to Use Laser Devices for Fast Communication of Market Data