financial

1. Lecture 2
Financial Market Theories
MN0492, LD0492, AT7034
International Financial Markets
and Institutions

2. LEARNING
OUTCOMES
In this lecture, you will learn about:
 Utility Theory What people get out of
something?
 Theory of Rational Expectations How people
think?
 Agency Theory How representatives
represent?
 Efficient Market Hypothesis How the market operates?
 Capital Asset Pricing Model Picking a stock!
 Portfolio Theory Picking lots of
stocks!
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3. WHAT IS RISK?
 It is associated with a probability of occurrence of undesired events. The more
undesired the consequences, the riskier the decision taken (Simona-Valeria et al
2012).
 So, simply put risk is potential for loss or disaster. It exists when a transaction or
situation can result in variation of probable results, i.e. the actual outcome could be
different from an expected or desired outcome
 So, there are two issues that constitute ‘risk’:That results do not meet expectation
 in terms of quantity
 in terms of timing
 A failure in either one (or both) of these risks may result in financial loss.
 Risk is not certain – Its likelihood can only be estimated.
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4. WHAT IS UNCERTAINTY?
 “It is described as the situation when the decision maker cannot identify all or none of
the possible events likely to occur and much less is he able to predict the likelihood of
their occurrence, having the mathematical meaning of incompletely defined variable”
(Simona-Valeria et al 2012).
 An action is uncertain when several results may be achieved, without knowing the
likelihood of occurrence of any of them.
 Uncertainty cannot be measured in quantitative terms through past models. Therefore,
neither probability nor magnitude is known.
 What is Certainty?
o This is a situation where an outcome has 100% probability. So, a decision maker has complete
knowledge about the outcome.
o Information set is complete.
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5. CERTAINTY, RISK AND UNCERTAINTY
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Increasing Uncertainty
100%
Total
Certainty
Total
Ignorance
Risk “
100%
0%
Information
The Slide from Certainty to Ignorance
Source: Frank Knight “Risk Uncertainty & Profit” 1921

6. UTILITY THEORY
 Utility (u): The satisfaction, pleasure or fulfilment of needs derived
from consuming some quantity of a good service.
 Key assumption: Given limited income, consumers make choices
that yield the greatest satisfaction that is, they maximize their utility.
 From a finance standpoint, it refers to how much benefit investors
obtain from portfolio performance. Having a solid understanding of
one’s u of money can help investors make investment decisions that
are more suited to their risk attitudes and investment strategies.
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7. MARGINAL UTILITY (CONT’D)
 Marginal Utility
The change in total utility due to a
one-unit change in the quantity of a
good or service consumed
 Diminishing Marginal Utility
 The principle that as more of any
good or service is consumed, its
extra benefit declines.
 Increases in total utility from
consumption of a good or service
become smaller and smaller as more
is consumed during a given time
period.
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Total Utility
Units of Utility
Marginal utility =
Change in total utility
Change in number of units consumed

8. TYPES OF UTILITY CURVES
 Since the u scale varies greatly between individuals, and as individuals have
different u functions, it is quite difficult to quantify u. Generally speaking, there are
three types of utility curves that explain the relationship investors have with risk.
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9. AGENCY THEORY
 Agency theory in its simplest form discusses the relationship between
two (or more) people, a principal, and an agent who makes decisions
on behalf of the principal.
 An agent has decision-making authority that affects the well-being of
the principal.
 An agency problem arises when there is a conflict of interest between
the agents and the principals, for example:
o Management and shareholders
o Company and broker
o Individual and financial advisor
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10. THE THEORY OF RATIONAL EXPECTATIONS
 Adaptive expectations (Previous theory):
o Expectations are formed from past experiences only.
o Changes in expectations will occur slowly over time as data changes.
o Example: In order to determine inflation in future, individuals will use past
inflation levels.
 However, people use more than just past data to form their expectations
and sometimes change their expectations quickly.
 Rational expectations is an economic theory that states that
individuals make decisions based on the best available information
in the market and learn from past trends. Rational expectations
suggest that people will be wrong sometimes, but that, on average,
they will be correct.
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11. IMPLICATIONS OF RATIONAL EXPECTATIONS
 Expectations will be identical to optimal forecasts using all available information.
However, a prediction based on it may not always be perfectly accurate and these
errors in prediction are random.
o For Example, let's say P is the equilibrium price determined by supply and demand. The theory of
rational expectations claims that the actual price will only deviate from the expectation if there is an
information shock.That is to say, the price is predicted to equal its rational expectation.
 The incentives for equating expectations with optimal forecasts are especially strong in
financial markets. In these markets, people with better forecasts of the future succeed.
 Rational Expectations
o Weak form
o Strong form
 One of the key applications of the theory of rational expectations to financial markets is
the efficient market hypothesis (EMH).
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12. STOCK MARKET EFFICIENCY
 The extent to which the share price at all times FULLY and FAIRLY reflects all
relevant, available information.
 In an efficient market security prices rationally reflect available information.
 New information is:
o Rapidly incorporated into share prices.
o Rationally incorporated into share prices.
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 The efficient-market hypothesis (EMH) is a hypothesis in financial
economics that states that asset prices reflect all available information.
 The Efficient Market Hypothesis was the subject of the NOBEL PRIZE in
2013. Awarded jointly to Eugene F. Fama, Lars Peter Hansen and Robert
J. Shiller "for their empirical analysis of asset prices".

13. EFFICIENT MARKET HYPOTHESIS (EMH)
There are several ‘types’ of efficiency a market can display:
 Operational efficiency Low transaction costs
Speed of execution
 Allocational efficiency Funds go to most efficient/
profitable companies
(most productive use)
 Informational efficiency Low cost and unrestricted access to
information
 Pricing efficiency Prices of assets reflect all relevant
available information incl. past/future
Market efficiency is mainly concerned with pricing efficiency.
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14. LEVELS OF MARKET EFFICIENCY
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Weak Form Prices of financial assets reflect all information from the past e.g. past
stock price or past earnings, historical dividends etc.
Semi-Strong Form Prices of financial assets reflect all current information.This
information set includes also all information from the past.
Strong Form Prices of financial assets reflect all information (including inside
information, which is not publicly available).

15. EFFICIENT MARKET
There are a number of implications that arise from the Efficient Market
Hypothesis if we assume that: The Market is EFFICIENT.
 Capital market asset prices rationally reflect all available information.
 New information is incorporated rapidly and rationally into the share price
 It is impossible to “beat the market”.
 If the market is efficient, and assuming that each item of news is independent of the
previous item of news, this implies that prices should follow a “random walk”
process (Kendall (1953)) until a new item of news is released.
 If prices follow random walk process, then there should be no regular patterns
observed in historical asset prices.
 Minimal to no arbitrage opportunities.
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16. EVIDENCE FOR EFFICIENT MARKET (CONT’D)
There is a body of evidence that supports EMH:
 Investment analysts and mutual funds do not consistently beat the
market.
 Stock prices properly reflect some publicly available information:
anticipated announcements do not significantly affect stock prices.
 Technical analysis does not outperform market.
 There is some evidence that stock prices and exchange rates follow a
random walk. However, results strongly depend on the frequency of
the analysed data.
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17. INEFFICIENT MARKET
There are a number of implications that arise from the Efficient Market
Hypothesis if we assume that: The Market is INEFFICIENT.
 It is possible to “beat the market” from strategies based on past
information.
 Prices do not follow a random walk process until a news item is released
– therefore, regular patterns can be observed in historical asset prices.
o Seasonality (January effect, Monday effect/Friday effect, “Sell in May, Go Away” effect aka
“Halloween Indicator”).
o Small-firm effect: small firms often have an abnormally high return.
o There is evidence that Market overreaction does occur.
 New information is not always immediately incorporated into stock
prices.
 Mean reversion effects can be observed.
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18. ASSESSING MARKET EFFICIENCY
To understand whether a market is efficient or not, market
participants can assess if there is evidence of excess returns
 Compare with indices e.g., FTSE100 and FTSE250
 Mean-variance measures: e.g., Sharpe ratio and information ratio
o Information Ratio: (Returnx – Returnindex)/ Tracking Error
o Sharpe Ratio = (Returnx– Riskfree rate) / StdDev Returnx
 CAPM measures
o Jensen’s alpha = Returnx– Expected Returnx
o Treynor Index = (Returnx– Riskfree rate)/ Beta
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19. CAPITAL ASSET PRICING MODEL (CAPM)
 Fundamental CAPM model is:
 Expected return= Risk-free rate + Beta x ( Expected return on market portfolio -
Risk-free rate)
 The term in parentheses is the risk premium, i.e. extra return on
equities over the risk-free rate.
 This term is positive; the model states that the expected return on a
security is a positive function of its beta.
 Makes sense because rational investor will only take on extra risk if
receiving extra compensation.
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20. CAPITAL ASSET PRICING MODEL (CONT’D)
 Extension of portfolio theory that provides a way of valuing
individual assets.
 Assumes rational investor will hold a diversified portfolio and
remove specific risk.
 Simplifies asset diversification by focussing on systematic risk of
shares to determine fair price.
 Values shares according to their relative sensitivity to market risk.
 This can be measured through  (Beta).
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21. BETA ( )
Β
The appropriate measure of risk for an individual share is
its beta.
Beta measures the share’s sensitivity to market risk
factors. It measures the systematic risk.
The higher the beta, the more sensitive the share is to
market movements.
Portfolio betas are weighted averages of the betas for the
individual shares in the portfolio.
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22. BETA ( )
Β
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23. BETA ESTIMATION USING A PLOT OF
SECURITY AND MARKET RETURNS
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24. INTERPRETING BETA (Β) VALUES
 Market portfolio has  = 1
 Defensive Shares  <1
 Less systematic risk than the market
 Attractive on a bear market
 Aggressive Shares  >1
 More systematic risk than the market
 Attractive on a bull market
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25. EXAMPLE 1: CAPM – ASSET RETURN
The Treasury bill rate is 4.50% and the return on the market is
estimated to be 9.50%. If you invest in a stock with a beta of 1.2, what
should be your rate of return according to the CAPM?
The CAPM equation is
Rate of return for the stock is 10.50 %.
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26. EXAMPLE 2: ASSET RETURNS & BETA
 Assume risk-free rate 3% and expected market return is 9%.
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Beta is the
primary
determinant
of expected
return!

27. THE SECURITY MARKET LINE (SML)
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28. IMPLICATIONS FROM CAPM
Thus, CAPM may be considered to be:
 An equilibrium theory based on the theory of portfolio selection.
 A fundamental idea that, in equilibrium, the market rewards people
for bearing risk.
 A model that links the notions of risk and return.
 Helps investors define the required return on an investment.
 As beta increases, the required return for a given investment
increases.
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29. APPLICATIONS OF CAPM
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30. ASSUMPTIONS OF CAPM
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31. FINANCIAL PORTFOLIO
 So CAPM might be a reasonable way of understanding / pricing the
risk of an individual security, but what about a portfolio?
 Financial Portfolio: A collection of investment securities assembled
to meet one or more investment goals.
o Growth-Oriented Portfolio
The primary objective is long-term price appreciation.
o Income-Oriented Portfolio
The primary objective is current dividend and
interest income.
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32. AN EFFICIENT PORTFOLIO
A portfolio that provides the highest
return for a given level of risk.
 Given the choice between two equally
risky investments, an investor will
choose the one with the highest
potential return.
 Given the choice between two
investments offering the same return,
an investor will choice the one that has
the least risk.
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33. PORTFOLIO THEORY
 The principle of spreading risk across asset classes and within asset
classes.
 Don’t put all your eggs in one basket.
 By choosing assets with different specific risks possible to reduce
total portfolio risk.
 Portfolio theory suggests an investor should:
o Diversify across sectors and industries.
o Diversify across asset classes.
o Diversify across regions and countries.
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34. PORTFOLIO THEORY (CONT’D)
 The prices of individual assets are not all perfectly positively correlated
i.e. asset prices do not all move up in line together or fall together;
 Some factors influence the price of some assets but not the price of
others
 In this context, there are 2 components to risk:
o Unsystematic Risk (Unique Risk/Firm Specific Risk)
The risk that comes from the individual exposure of assets to their individual risk
factors. Can be diversified away.
o Systematic Risk (Market Risk)
The risk that comes from the common exposure of assets to economy-wide risk
factors. Can’t be diversified away.
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35. WHY DIVERSIFICATION WORKS?
Diversification involves the inclusion of a number of different investment
vehicles in a portfolio. Through diversification we can create an efficient
portfolio.
 Correlation is a statistical measure of the relationship between two series of
numbers representing data.
 If the two series move in the same direction, they are Positively Correlated
 If the series move in opposite directions, they are Negatively Correlated.
 The degree of correlation, whether positive or negative, is measured by the
Correlation Coefficient.
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36. TWO COMPONENTS OF RISK
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37. TWO COMPONENTS OF RISK (CONT’D)
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By removing the unsystematic risk, you
remove the potential for higher returns
therefore diversification inhibits return.

38. EFFECT OF INCREASING THE NUMBER OF EQUITIES
IN THE PORTFOLIO ON VOLATILITY OF RETURNS
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39. PORTFOLIO RETURN
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40. EXAMPLE 3: PORTFOLIO RETURN
Evaluate the expected return for Amy’s portfolio where she places
1/4th
of her money in Treasury bills with a return of 4%, half in
Starbucks stock with a return of 8%, and the remainder in
Microsoft stock which earns 12%. What is Amy earning on her
portfolio?
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41. EXAMPLE 3: PORTFOLIO RETURN
Evaluate the expected return for Amy’s portfolio where she places
1/4th
of her money in Treasury bills with a return of 4%, half in
Starbucks stock with a return of 8%, and the remainder in Microsoft
stock which earns 12%.What is Amy earning on her portfolio?
Rate of return on the portfolio is 8%.
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