St.

Petersburg School of Economics and

Management, Department of Finance

Introduction to Behavioral
and Experimental Economics
Lecture 5

Carlos J. Rincon

Saint Petersburg, February 2021

 VI. Asset Pricing and Market Efficiency

• In finance as well as in economics we study how individuals and economic agents acquire and allocate
resources, while considering associated risks.

• The Capital Asset Pricing Model (CAPM) was the first model to specify the nature of risk and the extent to
which it should be priced.

• Moreover, the Efficient Markets Hypothesis (EMH), or, market efficiency, suggests that asset prices reflect
information so that excess returns cannot be earned on a consistent basis.

• The validity of the EMH is highly debated by some behavioral finance proponents who argue that individual
irrationality impacts market outcomes.

• Other issues to consider include the Agency Theory, which suggests that conflicts of interest have important
implications for corporate finance theory.
 VI. Asset Pricing and Market Efficiency

Risk and Return for Individual Assets

• Modern portfolio theory provides a practical framework that assumes that investors are risk averse and
preferences are defined in terms of the mean and variance of returns.

• This theory is based on statistics, so it is empirically based, and the variables are measurable.

• We can think of the return on an asset as being a random variable (the return next period is not perfectly
predictable, but it is determined by a probability distribution).

• One parameter characterizing this distribution is the expected value of returns, denoted as E(Ri).

• With the same expected return, an investor would prefer the asset that has a more certain outcome or less
uncertainty about possible returns.

• There are different ways we could measure uncertainty, for an individual asset, but variance or dispersion from
the mean is the most common measure.
 VI. Asset Pricing and Market Efficiency

Risk and Return for Individual Assets

• The variance of returns, denoted as reflects squared deviations from the mean so large deviations above

• or below the mean count equally.

• The standard deviation of returns is simply the positive square root of the variance.

• Variance and standard deviation are proxies for risk, and both rank securities in terms of risk identically.

• With n observations of the return for asset i, the mean return is computed as:

• The mean return is our best estimate of the true distributional expected value of returns.

• The sample variance of returns is:

• And the sample standard deviation of returns is:

 VI. Asset Pricing and Market Efficiency

Risk and Return for Portfolios of Assets

• By combining assets in a portfolio, investors can eliminate some, although not all, variability.

• This is the principle of diversification, an important factor when setting an investment strategy.

• As long as the assets’ returns do not move together in exactly the same way all the time, variability is reduced.

• The statistical measures of how random variables are related are covariance and correlation.

• When one variable tends to be above (below) its mean and at the same time the other variable tends to be
above (below) its mean, the covariance and correlation are positive.

• If the two variables tend to move in opposite directions, the covariance and correlation are negative.

• The covariance of a sample including n returns for assets i and j is:

• The sample correlation is the sample covariance divided by the product

of the (sample) standard deviations of returns for each asset or:

 VI. Asset Pricing and Market Efficiency

Risk and Return for Portfolios of Assets

• The correlation lies between −1.0 and +1.0, while the covariance can take any positive or negative value.

• The mean return of the portfolio is the weighted average of the mean returns of each asset, with the weights
(wi) representing the percentage amount invested in each asset:

• The sample variance of portfolio returns is:

• For more than two assets (three assets), the mean return is:

• And the variance is:

 VI. Asset Pricing and Market Efficiency

The Optimal Portfolio

• When choosing optimal portfolios, it is important to use distributions that generate returns in the future, and we
must remember that historical sample estimates are only estimates for the true distributional parameters.

• Therefore, we will now work in terms of true expected values rather than sample means and true distributional
variances rather than sample variances (E(Rp), σ2p).

• Suppose that for two stocks, High Tech (HT) and Low Tech (LT) we have:

• The expected return for the portfolio is:

• And the variance of portfolio returns is:

 VI. Asset Pricing and Market Efficiency

The Optimal Portfolio

• Taking the square root of the variance gives a standard deviation of 0.1288 (or 12.88%).

• Notice that the standard deviation of the portfolio is less than the weighted average of the standard deviations
of each stock.

• This shows that benefits from diversification have been attained.

• The curve in the figure is built by changing the weights

for each asset and recalculating the expected return and
standard deviation.

• The curvature of this relationship comes from the

correlation between the two securities: the lower the
correlation, the greater the curvature.
 VI. Asset Pricing and Market Efficiency

The Optimal Portfolio

• How much should we invest in each asset?

• Now notice in this figure, several individual investments (A-D) and several portfolios (E-G) are shown.

• If we combine individual investments on a pairwise basis, we achieve diversification as reflected in the

(interior) risk-return trade-off curves.
• By mixing together many assets, we always do better.

• When we move as far to the left as possible (as in

portfolios E-G), we have reached the wrap of the curve.

• Above and to the right of the minimum risk point (the

tip of the curve, which is portfolio G) is that portion of
the curve called the efficient frontier.
 VI. Asset Pricing and Market Efficiency

The Optimal Portfolio

• If we introduce a risk-free asset to the mix, only one portfolio of risky assets will be held by investors.

• Adding the risk-free asset is like adding an exchange mechanism that allows investors to borrow or lend all
they want at the risk-free rate and invest it in risky assets.

• Investors maximize utility by combining the risk-free asset with a fund of risky assets.
• Since the returns for the risk-free asset and those of the
other assets are uncorrelated, the return and risk for a
portfolio including the risk-free asset and any other risky
asset is a linear function of the returns and risks.

• The points on the lines can be obtained by changing the

weights in Rf and X., with the line beginning at a return
of Rf and zero risk (100% invested the in risk-free asset).
 VI. Asset Pricing and Market Efficiency

The Optimal Portfolio

• The tangency portfolio is the market portfolio which includes all risky assets weighted by their value because
this is the most diversified portfolio possible, and we denote it as M.

• The line joining Rf and M is called the capital market line (CML) and represents all combinations of the risk-
free asset and the market portfolio.

• The CML tells the investor how much more return can be earned for taking on additional risk.

The Capital Asset Pricing Model

• Up to here, we have assumed that beliefs are the same across individuals, which means that investors have the
same efficient frontier, implying that all investors hold the same portfolio of risky assets, the market portfolio.

• According to the CAPM, only risk related to market movements is priced in the market.

• The variance or standard deviation of returns for an asset is not the appropriate measure of risk because it
measures total risk, including both diversifiable, firm-specific risk, and systematic, market risk.
 VI. Asset Pricing and Market Efficiency

The Capital Asset Pricing Model

• The CAPM’s measure of risk, beta (β), takes into account an asset’s sensitivity to the market and, thus, only
measures systematic, non-diversifiable risk.

• It can be proved that under these conditions the expected return for asset i is given by:

where E(Rm) is the expected return for the market.

• The beta for stock i is calculated as: , the covariance of stock i’s returns with the market’s
returns, divided by the variance of the market return.

• With a positive beta, the expected return on an asset increases with increases in the market risk premium
(E(Rm) − Rf).

• The market risk premium (equity premium) is the expected return on the market in excess of the risk-free rate.

• The relationship between β and E(Ri) is depicted in next figure with a line called the Securities Market Line.
 VI. Asset Pricing and Market Efficiency

The Securities Market Line

• In the SML, at a zero βi the E(Ri) is equal to the Rf

and the higher the βi means a higher E(Ri).

• With a βi of 1 the E(Ri) is equal to the Rf plus the

market risk premium (E(Rm) − Rf), or just E(Rm).

• Thus, for βi above 1, the higher the market risk

premium (E(Rm) − Rf)

• The return for the market is often measured using a

broad-based stock index, such as the S&P500 index,
and the risk-free rate is often proxied by the rate on
short-term U.S. Treasury bills.
 VI. Asset Pricing and Market Efficiency

• In past studies, expected returns seemed to be positively correlated with beta, and beta appeared to do a good
job explaining how returns varied across firms.

• Researchers found that other factors, in addition to the excess return on the market, were helpful in explaining
variation in expected returns across stocks.

• Some concern surrounds assumptions of the CAPM, a key one being that investors all have the same
expectations about asset returns.

Market Efficiency

• An efficient market is often taken to imply that an asset’s price equals its expected fundamental value.

• For example, according to the present value model, a stock’s price equals the present value of expected future
dividends expressed as: where pt is the stock price today at time t, Et(dt+i) is the
expected value of the future dividend at time t+i using information available today, and δ is the discount rate,
which reflects the stock’s risk.
 VI. Asset Pricing and Market Efficiency

Market Efficiency

• Tests of the present value model must specify the information available to investors in forming their
expectations of future dividends.

• The present value model of stock prices suggests that in an efficient market a stock’s price is based on
reasonable expectations of its fundamental value.

• For most people information means knowledge, but in finance when we say “information” we mean items that
are truly unanticipated.

• If it is announced that the unemployment rate has risen to 6% and most people already expected the
unemployment rate to be 6%, this is not considered to be true information.

• Because information arrival is by definition unpredictable, stock price changes, if they are only driven by
information, must themselves be unpredictable.
 VI. Asset Pricing and Market Efficiency

Market Efficiency

• Proponents of the EMH argue that technical analysis based on charts of historical data and fundamental
analysis based on publicly available financial information will not successfully generate excess returns.

• Market efficiency does not suggest that individuals are ill-advised to invest in stocks, nor does it suggest that
all stocks have the same expected return.

• The EMH does not suggest that any stock or portfolio is as good as any other.

• While a manager cannot systematically generate returns above the expected, risk-adjusted return, stocks are
priced fairly in an efficient market.

• Because investors have different attitudes toward risk, they may have different portfolios.

• While the EMH suggests that excess return chances are unpredictable, it doesn’t suggest that price are random.

• Prices are fair valuations of the firm based on the information available to the market (incorporated in prices).
 VI. Asset Pricing and Market Efficiency

Joint Hypothesis Problem

• Because an excess return is defined in relation to a risk-adjusted return, the measurement of excess returns
requires a model of returns.

• For example, if the CAPM is the best model for predicting returns, stock i generates an excess return when:

• The Joint-Hypothesis Problem arises because of the need to utilize a particular risk-adjustment model to
produce required returns, that is, to risk-adjust.

• If a test rejects the EMH, is it because the EMH does not hold, or because we did not properly measure excess
returns by using the wrong model for that?

• Recent research has reported a series of anomalies, that is, findings that appear to be contrary to the EMH.

• If other factors may affect the excess returns, then by using the CAPM alone is not a good way to predict them.
 VI. Asset Pricing and Market Efficiency

Agency Theory

• An agency relationship exists whenever someone (the principal) contracts with someone else (the agent) to
take actions on behalf of the principal and represent his interests.

• In an agency relationship, the agent has authority to make decisions for the principal.

• An agency problem arises when the agent’s and principal’s incentives are not aligned.

• In firms, conflicts of interest often surface, particularly between owners and managers.

• In a large corporation, we usually observe separation of ownership from the management of the firm.

• Shareholders are the owners of the firms and they elect a board of directors who select the management team.

• Agency theory has important implications concerning the structure of a corporation because of principal-agent
problems between managers and stockholders.
 VI. Asset Pricing and Market Efficiency

Agency Theory

• Agency costs that arise from principal-agent problems are both direct and indirect.

• These costs arise because managers’ incentives are not consistent with maximizing the value of the firm.

• Direct costs are expenditures that benefit the manager but not the firm, such as purchasing a jet for travel.

• Other direct costs result from the need to monitor managers, including the cost of hiring outside auditors.

• Indirect costs are more difficult to measure and result from lost opportunities (e.g., managers of a firm that is
an acquisition target may resist the takeover attempt because of concern about keeping their jobs, even if the
shareholders would benefit from the merger).

• Finance theory has focused on how to design an optimal compensation contract to align the interests of
shareholders and managers.

• The best design of the contracts will depend on many factors…

 VI. Asset Pricing and Market Efficiency

Agency Theory

• The best design of the contract will depend on factors such as: whether the manager’s actions are observable,
the degree of information asymmetry between managers and shareholders, adequacy of performance measures,
and differing horizons of managers and shareholders.

• To motivate agents, principals include rewards and penalties in compensation contracts.

• Good corporate governance, including optimal incentive contract design, is critical to the maximization of the
value of a firm and the optimal allocation of capital in our economy.