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Risk measurement & efficient market hypothesis

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Power Point Presentation on Risk Measurement & Efficient Market Hypothesis - Dr. Jatin Pancholi - www.jatinpancholi.com - PPT, PowerPoint Presentations, Activity Based Costing Management, Balanced …

Power Point Presentation on Risk Measurement & Efficient Market Hypothesis - Dr. Jatin Pancholi - www.jatinpancholi.com - PPT, PowerPoint Presentations, Activity Based Costing Management, Balanced Scorecard, Financial Management, Corporate Training, Performance Measurement, Management Accounting, Strategic Cost Management, Financial Management, Strategic Management, Management Specialist, Expert, Researcher, Management Consulting, Entrepreneurship, Corporate Trainer, Continuous Professional Development, Business, London, UK, USA, UAE, China, India, Slides, MBA, Ratios, Costing, Money, Wealth, Investment, Facebook, Twitter, Linkedin


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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 website http://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’
    • Where can we save?
      • Markets
      • Kinds of markets
    • Decision Making criteria
      • Returns
      • Time period (Duration)
      • Risk
      • Any other factors?
  • 5. MARKET BEHAVIOUR
    • On 25 th November 2006, from www.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
  • 6. USA: NASDAQ
  • 7. USA: S&P 500
  • 8. UK: FTSE100
  • 9. Risk and Return and the Principles of Finance
    • Diversification
    • Risk-Return Trade-Off
    • Efficient Capital Markets
    • Incremental Benefits
    • Two-Sided Transactions
    • Time-Value-of-Money
  • 10. Asset Pricing Models
    • These models provide a relationship between an asset’s 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 might not lie 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.
      • Homogeneous expectations
    • 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 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.
  • 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 are not known.
    • We usually rely on their historical values to provide us with an estimate of beta.
    If we know the security’s 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 of r j , r f , and r M , we can run the following linear regression to estimate the b : This equation is called the Characteristic Line of security j
  • 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 security’s returns are to changes in the market portfolio’s return.
      • It is a measure of the asset’s risk.
    • Suppose the market portfolio’s return is +10% during a given period.
      • if  = 1.50, the security’s return will be +15%.
      • if  = 1.00, the security’s return will be +10%.
      • if  = 0.50, the security’s return will be +5%.
      • if  = – 0.50, the security’s return will be – 5%.
  • 20. Beta Coefficients for Selected Firms Common Stock Beta Alex Brown Nike Inc. (Class B) Microsoft PepsiCo. Inc. McDonald’s 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.
    where w i is the proportion of value invested in security i , and b i is the beta of the security i . 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?
      • About 25 to 30 stocks!
  • 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 asset’s nondiversifiable risk.
    • Total Risk =
    • Diversifiable risk + Nondiversifiable risk.
  • 24. Diversifiable Risk
    • It is also known as unsystematic , 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.
  • 25. Nondiversifiable Risk
    • 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 asset’s returns move systematically with 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.
    • 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.
  • 31. The Concept of Efficiency
    • In an efficient capital market, the transfer of assets occurs with little loss of wealth.
    • In such markets, prices reflect all available information .
    • Thus, financial asset prices are fair prices.
      • They are neither too high, nor too low.
    • What is meant by “all available information”?
  • 32. Three Forms of Capital Market Efficiency
    • Strong form of capital market efficiency.
      • Current prices reflect all information that can possibly be known to anyone.
    • Semi-strong form of capital market efficiency.
      • Current prices reflect all publicly available information.
    • Weak form of capital market efficiency.
      • Current prices reflect only the information contained in past prices.
  • 33. Three Forms of Capital Market Efficiency Strong Form (All information affecting the asset’s 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.
    • Frictions include:
      • Transaction Costs: time, effort, and money required to make a transaction.
      • Asymmetric taxes.
      • Asymmetric information.
  • 36. Arbitrage
    • Arbitrage refers to buying an asset in one market and selling it at a higher price in another market.
    • People who engage in arbitrage are know as arbitrageurs (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 sold immediately .
    • 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.
      • 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.
  • 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 Level with 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 Level with new information “ Good” News Release
  • 43. Price Underreaction to “Good News”
    • Good news, when it is announced, should increase the price of a stock quickly . Otherwise there’s an arbitrage opportunity.
    Time Price Correct Price Level with 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 Level with 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 Level with 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 Level with 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 Level with 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,
      • 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.
  • 49. Perfect Capital Markets
    • 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.
  • 50. Perfect Capital Markets
    • No tax asymmetries.
    • No restrictions on trading.
  • 51. Some Imperfections
    • 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.
  • 52. Thanks very much… © Photo Copyrights. Background photo of the Charles River, Harvard University, Boston, USA by Jatin Pancholi. see www.kalanidhee.org for other photographs. Dr. Jatin Pancholi www.jatinpancholi.com