Question

The three main elements in the modern theory of finance are the efficient markets hypothesis, the capital asset pricing model and portfolio theory. Explain and evaluate the proposition that each of these elements depends for its reliability on the validity of the other two.

Answer 1

The iEfficient iMarket iHypothesis, iknown ias iEMH iin ithe iinvestment icommunity, iis ione iof ithe iunderlying ireasons iinvestors imay ichoose ia ipassive iinvesting istrategy. iAlthough ifans iof iindex ifunds imay inot iknow iit, iEMH ihelps ito iexplain ithe ivalid irationale iof ibuying ithese ipassive imutual ifunds iand iexchange-traded ifunds i(ETFs).

The iefficient imarket ihypothesis i(EMH), ialternatively iknown ias ithe iefficient imarket itheory, iis ia ihypothesis ithat istates ithat ishare iprices ireflect iall iinformation iand iconsistent ialpha igeneration iis iimpossible. iAccording ito ithe iEMH, istocks ialways itrade iat itheir ifair ivalue ion iexchanges, imaking iit iimpossible ifor iinvestors ito ipurchase iundervalued istocks ior isell istocks ifor iinflated iprices. iTherefore, iit ishould ibe iimpossible ito ioutperform ithe ioverall imarket ithrough iexpert istock iselection ior imarket itiming, iand ithe ionly iway ian iinvestor ican iobtain ihigher ireturns iis iby ipurchasing iriskier iinvestments.

1. The iefficient imarket ihypothesis i(EMH) ior itheory istates ithat ishare iprices ireflect iall iinformation.

2. The iEMH ihypothesizes ithat istocks itrade iat itheir ifair imarket ivalue ion iexchanges.

3. Proponents iof iEMH iposit ithat iinvestors ibenefit ifrom iinvesting iin ia ilow-cost, ipassive iportfolio.

4. Opponents iof iEMH ibelieve ithat iit iis ipossible ito ibeat ithe imarket iand ithat istocks ican ideviate ifrom itheir ifair imarket ivalues.

Although iit iis ia icornerstone iof imodern ifinancial itheory, ithe iEMH iis ihighly icontroversial iand ioften idisputed. iBelievers iargue iit iis ipointless ito isearch ifor iundervalued istocks ior ito itry ito ipredict itrends iin ithe imarket ithrough ieither ifundamental ior itechnical ianalysis.

Theoretically, ineither itechnical inor ifundamental ianalysis ican iproduce irisk-adjusted iexcess ireturns i(alpha) iconsistently, iand ionly iinside iinformation ican iresult iin ioutsized irisk-adjusted ireturns.

There iare ithree iforms iof iEMH: iweak, isemi-strong, iand istrong1. iHere's iwhat ieach isays iabout ithe imarket.

Weak iForm iEMH: iSuggests ithat iall ipast iinformation iis ipriced iinto isecurities. iFundamental ianalysis iof isecurities ican iprovide ian iinvestor iwith iinformation ito iproduce ireturns iabove imarket iaverages iin ithe ishort iterm, ibut ithere iare ino i"patterns" ithat iexist. iTherefore, ifundamental ianalysis idoes inot iprovide ilong-term iadvantage iand itechnical ianalysis iwill inot iwork.

Semi-Strong iForm iEMH: iImplies ithat ineither ifundamental ianalysis inor itechnical ianalysis ican iprovide ian iadvantage ifor ian iinvestor iand ithat inew iinformation iis iinstantly ipriced iin ito isecurities.

Strong iForm iEMH. iSays ithat iall iinformation, iboth ipublic iand iprivate, iis ipriced iinto istocks iand ithat ino iinvestor ican igain iadvantage iover ithe imarket ias ia iwhole. iStrong iForm iEMH idoes inot isay isome iinvestors ior imoney imanagers iare iincapable iof icapturing iabnormally ihigh ireturns ibecause ithat ithere iare ialways ioutliers iincluded iin ithe iaverages.

EMH idoes inot isay ithat ino iinvestors ican ioutperform ithe imarket; iit isays ithat ithere iare ioutliers ithat ican ibeat ithe imarket iaverages; ihowever, ithere iare ialso ioutliers ithat idramatically ilose ito ithe imarket. iThe imajority iis icloser ito ithe imedian. iThose iwho i"win" iare ilucky iand ithose iwho i"lose" iare iunlucky.

The iCapital iAsset iPricing iModel i(CAPM) idescribes ithe irelationship ibetween isystematic irisk iand iexpected ireturn ifor iassets, iparticularly istocks. iCAPM iis iwidely iused ithroughout ifinance ifor ipricing irisky isecurities iand igenerating iexpected ireturns ifor iassets igiven ithe irisk iof ithose iassets iand icost iof icapital.

Investors iexpect ito ibe icompensated ifor irisk iand ithe itime ivalue iof imoney. iThe irisk-free irate iin ithe iCAPM iformula iaccounts ifor ithe itime ivalue iof imoney. iThe iother icomponents iof ithe iCAPM iformula iaccount ifor ithe iinvestor itaking ion iadditional irisk.

The ibeta iof ia ipotential iinvestment iis ia imeasure iof ihow imuch irisk ithe iinvestment iwill iadd ito ia iportfolio ithat ilooks ilike ithe imarket. iIf ia istock iis iriskier ithan ithe imarket, iit iwill ihave ia ibeta igreater ithan ione. iIf ia istock ihas ia ibeta iof iless ithan ione, ithe iformula iassumes iit iwill ireduce ithe irisk iof ia iportfolio.

A istock’s ibeta iis ithen imultiplied iby ithe imarket irisk ipremium, iwhich iis ithe ireturn iexpected ifrom ithe imarket iabove ithe irisk-free irate. iThe irisk-free irate iis ithen iadded ito ithe iproduct iof ithe istock’s ibeta iand ithe imarket irisk ipremium. iThe iresult ishould igive ian iinvestor ithe irequired ireturn ior idiscount irate ithey ican iuse ito ifind ithe ivalue iof ian iasset.

The igoal iof ithe iCAPM iformula iis ito ievaluate iwhether ia istock iis ifairly ivalued iwhen iits irisk iand ithe itime ivalue iof imoney iare icompared ito iits iexpected ireturn.

Advantages iof ithe iCAPM

The iCAPM ihas iseveral iadvantages iover iother imethods iof icalculating irequired ireturn, iexplaining iwhy iit ihas ibeen ipopular ifor imore ithan i40 iyears:

1. It iconsiders ionly isystematic irisk, ireflecting ia ireality iin iwhich imost iinvestors ihave idiversified iportfolios ifrom iwhich iunsystematic irisk ihas ibeen iessentially ieliminated.

2. It iis ia itheoretically-derived irelationship ibetween irequired ireturn iand isystematic irisk iwhich ihas ibeen isubject ito ifrequent iempirical iresearch iand itesting.

3. It iis igenerally iseen ias ia imuch ibetter imethod iof icalculating ithe icost iof iequity ithan ithe idividend igrowth imodel i(DGM) iin ithat iit iexplicitly iconsiders ia icompany’s ilevel iof isystematic irisk irelative ito ithe istock imarket ias ia iwhole.

4. It iis iclearly isuperior ito ithe iWACC iin iproviding idiscount irates ifor iuse iin iinvestment iappraisal.

Disadvantages iof ithe iCAPM

The iCAPM isuffers ifrom iseveral idisadvantages iand ilimitations ithat ishould ibe inoted iin ia ibalanced idiscussion iof ithis iimportant itheoretical imodel.

Problems ican iarise iin iusing ithe iCAPM ito icalculate ia iproject-specific idiscount irate. iFor iexample, ione icommon idifficulty iis ifinding isuitable iproxy ibetas, isince iproxy icompanies ivery irarely iundertake ionly ione ibusiness iactivity. iThe iproxy ibeta ifor ia iproposed iinvestment iproject imust ibe idisentangled ifrom ithe icompany’s iequity ibeta. iOne iway ito ido ithis iis ito itreat ithe iequity ibeta ias ia iportfolio ibeta i(βp), ian iaverage iof ithe ibetas iof iseveral idifferent iareas iof iproxy icompany iactivity, iweighted iby ithe irelative ishare iof ithe iproxy icompany imarket ivalue iarising ifrom ieach iactivity.

βp i= i(W1β1) i+ i(W2β2)

W1 iand iW2 iare ithe imarket ivalue iweightings iof ieach ibusiness iarea

β1 iand iβ2 iare ithe iequity ibetas iof ieach ibusiness iarea.

Assigning ivalues ito iCAPM ivariables

To iuse ithe iCAPM, ivalues ineed ito ibe iassigned ito ithe irisk-free irate iof ireturn, ithe ireturn ion ithe imarket, ior ithe iequity irisk ipremium i(ERP), iand ithe iequity ibeta.

The iyield ion ishort-term igovernment idebt, iwhich iis iused ias ia isubstitute ifor ithe irisk-free irate iof ireturn, iis inot ifixed ibut ichanges iregularly iwith ichanging ieconomic icircumstances. iA ishort-term iaverage ivalue ican ibe iused ito ismooth iout ithis ivolatility.

Finding ia ivalue ifor ithe iequity irisk ipremium i(ERP) iis imore idifficult. iThe ireturn ion ia istock imarket iis ithe isum iof ithe iaverage icapital igain iand ithe iaverage idividend iyield. iIn ithe ishort iterm, ia istock imarket ican iprovide ia inegative irather ithan ia ipositive ireturn iif ithe ieffect iof ifalling ishare iprices ioutweighs ithe idividend iyield. iIt iis itherefore iusual ito iuse ia ilong-term iaverage ivalue ifor ithe iERP, itaken ifrom iempirical iresearch, ibut iit ihas ibeen ifound ithat ithe iERP iis inot istable iover itime. iIn ithe iUK, ian iERP ivalue iof ibetween i3.5% iand i4.8% iis icurrently iseen ias ireasonable. iHowever, iuncertainty iabout ithe iERP ivalue iintroduces iuncertainty iinto ithe icalculated ivalue ifor ithe irequired ireturn.

Beta ivalues iare inow icalculated iand ipublished iregularly ifor iall istock iexchange-listed icompanies. iThe iproblem ihere iis ithat iuncertainty iarises iin ithe ivalue iof ithe iexpected ireturn ibecause ithe ivalue iof ibeta iis inot iconstant, ibut ichanges iover itime.

i i i i i i i i i i i i i i i i i i i i i i i i i i i i i iResearch ihas ishown ithe iCAPM istands iup iwell ito icriticism, ialthough iattacks iagainst iit ihave ibeen iincreasing iin irecent iyears. iUntil isomething ibetter ipresents iitself, ithough, ithe iCAPM iremains ia ivery iuseful iitem iin ithe ifinancial imanagement itoolkit

i i i i i i i i i i i i i i i i i i i i i i i iPortfolio iTheory iis iconcerned iwith irisk iand ireturn. iThe iinvestor iis iconcerned ionly iwith ithe iexpected ivalues iof isecurities iand ithe iinterested iin ithe iexpected ivalue iof ithe iportfolio. iTo imaximize ithe iexpected ivalue iof ia iportfolio, ione ineeded ionly iinvest iin ione isecurity i(the isecurity iwith imaximum iexpected ireturn). iThus iaction ibased ion iexpected ireturn ionly imust ibe irejected ias idescriptive iof iactual ior irational iinvestment ibehavior. iIs iseemed iobvious ithat iinvestors iare iconcerned iwith irisk iand ireturn, iand ithese ishould ibe imeasured ifor ithe iportfolio ias ia iwhole. iTherefore, ithe iportfolio itheory iis iabout imaximizing ithe ibenefits iof iinvestments iconsidering irisk iand ireturn. iIn iIS iarea, iIT iinvestments ican ibe imanaged ias ia iportfolio, icombining irisk iand ireturn ito imaximize ithe ibenefits iof iIT iinvestment iand ichoose ithe ibest.

Modern iportfolio itheory i(MPT) iis ia itheory ion ihow irisk-averse iinvestors ican iconstruct iportfolios ito ioptimize ior imaximize iexpected ireturn ibased ion ia igiven ilevel iof imarket irisk, iemphasizing ithat irisk iis ian iinherent ipart iof ihigher ireward. iAccording ito ithe itheory, iit's ipossible ito iconstruct ian i"efficient ifrontier" iof ioptimal iportfolios ioffering ithe imaximum ipossible iexpected ireturn ifor ia igiven ilevel iof irisk.

MPT imakes ithe iassumption ithat iinvestors iare irisk-averse, imeaning ithey iprefer ia iless irisky iportfolio ito ia iriskier ione ifor ia igiven ilevel iof ireturn. iThis iimplies ithat ian iinvestor iwill itake ion imore irisk ionly iif ihe ior ishe iis iexpecting imore ireward.

At ithe iheart iof iMPT iis ithe iidea ithat irisk iand ireturn iare idirectly ilinked, imeaning ithat ian iinvestor imust itake ion ihigher irisk ito iachieve igreater iexpected ireturns. iAnother imain iidea iof i