7 TH Lecture

Ecient Markets vs Behavioral Finance
7th lecture
Iuliia Brushko
IES, UK
April 8, 2013
Capital Asset Pricing Model
Arbitrage Pricing Theory
The Ecient Market Hypothesis
Behavioral Finance
Outline
1
2
3
4
Behavioral Finance
Iuliia Brushko Ecient Markets vs Behavioral Finance
Behavioral Finance
Assumptions
1
There are many investors, who are price takers
2
They plan only for why period ahead what does this imply?
3
Investment possibilities are limited to nancial assets
4
No taxes on returns, no transaction costs
5
Investors mean-variance optimizers
6
Investors have same expectations & beliefs what impact
will it have on the portfolio choice?
Behavioral Finance
Capital Market line
Capital allocation line (CAL) - risk-return combination availabe
to the investors.
Capital market line (CML) - provides the combination risk and
return, formed by including 1-month T-bills and a broad index of
common stocks.
Investing in the index of common stocks is motivated by:
active strategy is costly
free-rider motivation - knowledgeable investors will move the
price to optimal level
mutual fund theorem: passive strategy of investing in a market

index portfolio is ecient
Behavioral Finance
Risk Premium on Market Portfolio
=
E(r
M
) r
f
A
2
M
E(r
M
) - return on a market portfolio; market portfolio - wealth of
the economy; the proportion of each stock in this portfolio equals
the market value of this stock; the proportion invested in a
particular stock is equal the market value of the rm divided by the
market value of all stocks;
r
f
- risk free interest rate; A - risk aversion;
2
M
- variance of
market portfolio
The model implies: (1) existing of r
f
involves borrowing and
lending - in equilibrium net borrowing and lending is 0; (2) the
representative risk aversion is

A; (3) = 1 - the average position
in the risky portfolio is 100%
E(r
M
) r
f
=

A
2
M
risk premium on market portfolio
Behavioral Finance
Expected Returns on Individual Securities
Consider the market portfolio consistent of 3 assets A, B, & C
Var (
a
r
a
+
b
r
b
+
c
r
c
) =
a
Cov(r
a
; r
M
) + Var (
b
r
b
+
c
r
c
)+
+ Cov(
b
r
b
+
c
r
c
;
a
r
a
)
where
a
r
a
+
b
r
b
+
c
r
c
= r
M
,
i
- weights invested in asset i ,
i
= 1
Asset A contribution to variance =
a
Cov(r
a
; r
M
)
Asset A contribution to risk premium =
a
[E(r
a
) r
f
]
Rewardtorisk ratio of asset A =

a
[E(r
a
) r
f
]
a
Cov(r
a
; r
M
)
=
E(r
a
) r
f
Cov(r
a
; r
M
)
Behavioral Finance
Expected Returns on Individual Securities
Rewardtorisk ratio of asset A =

a
[E(r
a
) r
f
]
a
Cov(r
a
; r
M
)
=
E(r
a
) r
f
Cov(r
a
; r
M
)
Reward to risk ratio of market portfolio =
E(r
M
) r
f
2
M
Basic principal: all investments should provide the same
reward-to-risk ratio
E(r
a
) r
f
Cov(r
a
; r
M
)
=
E(r
M
) r
f
2
M
E(r
a
) r
f
=
Cov(r
a
; r
M
)
2
M
[E(r
M
) r
f
] = r
f
+
a
[E(r
M
) r
f
] ()
equation (*) is the expected return-beta relationship
Behavioral Finance
Security Market Line
a
= Cov(r
a
; r
M
)/
2
M
- beta measures the contribution of asset A
to the variance of the market portfolio as a fraction of total
variance of the portfolio
Behavioral Finance
is the appropriate measure of risk
p
= 1 - you hold the market portfolio of all the assets in the
economy, where
p
- beta of your portfolio
p
> 1 - aggressive investing (investing in high betas)
p
< 1 - defensive investing
SML - graphs individual asset risk premium
CML - graphs the risk premium of ecient portfolio (composed of
the market & risk-free asset)
Behavioral Finance
SML - provides the evaluation of investment performance
E(r
a
) r
f
=
a
[E(r
M
r
f
)] compare to
E(r
a
) r
f
= +
a
[E(r
M
) r
f
]
Stock
s alpha
What kind of are we looking for doing security analysis?
Behavioral Finance
Test of CAPM
Test CAPM with
R
i
=
i
+
i
R
M
+ e
i
Cov(R
i
, R
M
) =
i
2
M
i
=
Cov(R
i
, R
M
)
2
M
CAPM: all investors hold identical portfolios when new
information arrives, there is no trade
then why do we observe active trade operations?
in reality we have heterogeneous beliefs
Behavioral Finance
Test of CAPM
Test CAPM with
R
i
=
i
+
i
R
M
+ e
i
Cov(R
i
, R
M
) =
i
2
M
i
=
Cov(R
i
, R
M
)
2
M
CAPM: all investors hold identical portfolios when new
information arrives, there is no trade
then why do we observe active trade operations?
in reality we have heterogeneous beliefs
Behavioral Finance
Factor Models
sources of uncertainty
macroeconomic conditions
rm specic risks
Single and multiple factor models:
r
i
= E(r
i
) +
i
F + e
i
r
i
= E(r
i
) +
i 1
F
1
+
12
F
2
+ e
i
E(r
i
) - initially expected return on stock
F
i
- deviation of the common factor from its expected value
ij
- the sensitivity of rm i to the deviation of the common factor
from its expectation; factor loadings, factor betas; think of as a
measure of the exposure of a stock or portfolio to the market-wide
of macroeconomic risk factors
e
i
- rm-specic disturbances
Behavioral Finance
Key positions:
security returns can be described by a factor model
there are sucient securities to diversify away idiosyncratic risk
well-functioning security markets do not allow for the
persistence of arbitrage opportunity
Arbitrage opportunity arises when investor can earn riskless
prots without making a net investment: buying the asset where it
is cheaper & selling where it is expensive
Law of one price: if two assets are equivalent in all economically
relevant respects, they should have the same market price
Property of risk-free arbitrage portfolio: regardless of risk
aversion investors will try to take as high position as possible
Behavioral Finance
r
p
= E(r
p
) +
p
F + e
p
p
=
i
i
; E(r
p
) =
i
i
E(r
i
); e
p
=
i
i
e
i
2
p
=
2
p
2
F
+
2
e
p
, since Cov(F, e
i
) = 0
2
e
p
= Var (
i
e
i
) =
2
i

2
e
i
if
i
= 1/n (the portfolio is equally weighted)
2
e
p
=
1
n
2
e
i
=
1
n

2
e
i
as n ,
2
e
p
0 - well-diversied portfolio
Behavioral Finance
How would you interpret?
APT & CAPM: we get the same beta in both models despite
restrictive assumption of CAPM, expected return-beta relationship
should be at least approximately valid
Behavioral Finance
Forms of Ecient Market Hypothesis
Kendall (1953): no predictable patterns in the stock prices is
the market erratic & driven byanimal spirits?
Ecient market hypothesis: the stock prices you observe already
reect all available information
Forms of EMH:
weak form - stock prices already reect all past information
semistrong form - all publicly available information regarding
the prospects of the rm must be reected in the stock prices
strong form - stock prices reect all information relevant to
the rm, including information available only to the company
insiders
Behavioral Finance
Forms of Ecient Market Hypothesis
Kendall (1953): no predictable patterns in the stock prices is
the market erratic & driven byanimal spirits?
Ecient market hypothesis: the stock prices you observe already
reect all available information
Forms of EMH:
weak form - stock prices already reect all past information
semistrong form - all publicly available information regarding
the prospects of the rm must be reected in the stock prices
strong form - stock prices reect all information relevant to
the rm, including information available only to the company
insiders
Behavioral Finance
The Behavioral Critique of EMH
information processing
forecasting errors
overcondence
conservatism
sample size neglect & representativeness
behavioral biases
framing
mental accounting
regret avoidance
prospect theory

7 TH Lecture

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

7 TH Lecture

Uploaded by

Copyright:

Available Formats

Ecient Markets vs Behavioral Finance

mutual fund theorem: passive strategy of investing in a market

You might also like