Question

“There is an intuitive notion that most individual stocks or bonds move with the aggregate market. Therefore, if the overall market rose, an individual’s portfolio probably also increased in value. To supply investors with a composite report on market performance, some financial publications or investment firms have developed stock market and bond market indexes.” Give an account of

1. Uses of security market indexes
2. Efficient capital market
3. Assumptions of capital market.

Answer 1

Solution i) Following are the uses of the security market indexes:

a) Reflection of market sentiments: Securit market indexes represents the market sentiments. The increase in the values of security indexes reflects positive sentiments among the investors and thus, can be used as an indicator of a bullish market. While the decrease in their values reflects negative sentiments among the investors and thus, is considered as a bearish indicator.

b) Benchmark for performance evaluation: The percentage change in the index value is used as a benchmark for evaluating the performance of the portfolio manager. If the return generated by the manager is greater than the return generated by the index then the portfolio manager is said to outperform the market. If the return generated by the manager is less than the return generated by the index then the portfolio manager is said to underperform the market.

c) Provides an estimate of market return: The percentage change in the index value over a period of time is used as the measure of the market return. This market return serves as an input for the Capital Asset Pricing Model (CAPM) and is used to calculate the expected rate of return of the stock.

Solution b) Efficient capital market: Efficient Capital Market is defined as the type of market where all the investors are assumed to have all the information about the securities and thus, have already taken the rational decisions based on the new information. Thus, in an efficient capital market, it is very difficult to find opportunities for mispricing of the securities.

In the efficient capital markets, as new or unexpected information about the security comes in, all investors immediately revise their expectations, and the price of the security is corrected to reflect the available information about the security.

Solution c) Following are the assumptions of capital market:

i) All investors are assumed to be homogeneous in terms of return's expectations.

ii) Investors can borrow or lend at the risk-free rate.

iii) Investors consider risk-adjusted expected returns while making investments (i.e., Markowitz efficient investors)

iv) There are no taxes and transaction charges while buying or selling the securities.

v) All investments are infinitely divisible.