Foundations of Classical Finance

Session 1

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 Lets’ Make Some Money
• Here is Rs. 100 on the auction block.
• Who wants to participate? Volunteers?

2
 Rules of Game
• Highest Bidder would take the currency note.

• Second Highest bidder also have to pay.

• Bid starts at Rs. 40, Bid can be increased by Rs.

5 each time.

3
 Some unanswered Questions in
Corporate Finance
1. Why are some countries rich and others
poor?
2. What is the social purpose of finance?
3. Does geography matter to finance?
4. Do politics matter to finance?
5. Why are there bubbles?
6. Are corporate takeovers good or bad for an
economy?
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7. What causes markets to crash?
8. Do firms really use NPVs to allocate capital?
9. Are there bubbles in research?
10. How complete is arbitrage?
11. How does private information become
public?
12. How important are noise traders?
13. What moves stock prices?
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14. Does stock price variation reflect the real
economy?
15. How much stability is best for an economy?
16. Does it matter who controls businesses?
17. Are controlling shareholders good for a firm?
18. Are family firms a good idea?
19. How did different countries get different
varieties or capitalism?
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20. Are there exogenous variables in finance?
21. Which allocates capital better: Banks or
stock markets?
22. Are agents ever too loyal to principals?
23. Who watches the watchers?
24. Is highly concentrated corporate control
good for a country?
25. Why do business groups persist?
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 Some concepts
• Prospect v/s Probability Distribution:
A prospect is a lottery or series of wealth outcomes,
each of which is associated with a probability,
whereas a probability distribution defines the
likelihood of possible outcomes.
• Risk v/s Uncertainty
Risk is measurable using probability, but uncertainty is
not. Uncertainty is when probabilities can’t be
assigned or the possible outcomes are unclear.

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 Some Concepts
• Risk aversion, risk seeking, and risk neutrality
Risk aversion describes someone who prefers the
expected value of a lottery to the lottery itself.
Risk seeking describes someone who prefers a lottery to
the expected value of a lottery.
Risk neutrality describes someone whose utility of the
expected value of a lottery is equal to the expected
utility of the lottery.

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 Neoclassical economics
1. People have rational preferences across
possible outcomes or states of nature.
2. People maximize utility and firms maximize
profits.
3. People make independent decisions based
on all relevant information.

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 Preferences and utility function
• Two key assumptions about preferences:
– Completeness (ordering)
– Transitivity
• Utility over goods:
u(2 bread, 1 water) > u(1 bread, 2 water)
• Utility over money:
u(w2) > u(w1) if w2 > w1

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 Utility
• Satisfaction derived from a particular
outcome(a bundle of goods).
• Utility function U(*) assigns numbers to
possible outcomes such that preferred choices
are assigned higher numbers.
• Mathematically utility function is taken as
Natural Log Function - ln.

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 Utility Function
Wealth(w) in Rupee 10,000 U(w)=ln(w)
1 0.0000
2 0.6931
5 1.6094
7 1.9459
10 2.3026
20 2.9957
30 3.4012
50 3.9120
100 4.6052
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 0.0000
1.0000
2.0000
3.0000
4.0000
5.0000
6.0000
1
6
11
16
21
26
31
36
41
46
51
56
61
66
71
76
81
86
91
96
101
106
111
116
121
126
over wealth

131
136
141
146
151
156
161
166
171
176
181
Utility function (u(w) = ln(w))

186
191
196
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Utility Function of a Risk- averse Individual
Utility Function of a Risk Seeker
 Expected utility theory
• Says that individuals should act when
confronted with decision-making under
uncertainty in a certain way.
• Theory is really set up to deal with risk, not
uncertainty:
– Risk is when you know what the outcomes could be,
and can assign probabilities
– Uncertainty is when you can’t assign probabilities; or
you can’t come up with a list of possible outcomes

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 Wealth outcomes
• Say there are two states of the world:
– State A.
– State B
• And individuals can assign probabilities to each of these
states:
– Probability of State A is 0.3 and that of State B is 0.7.
• Say income (or wealth) level can be assigned to each state of
world.
– State A: Rs. 10,00,000
– State B: Rs. 50,00,000

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 Prospects
• A prospect is defined as a series of wealth or
income levels and associated probabilities.
• Example:
– Rs. 10,00,000 with probability 0.3
– Rs. 50,00,000 with probability 0.7
– P1(.3, 1000000, 5000000)
• When 2nd option is zero, let’s write:
– P2(.3, 1000000)
• Expected utility theory comes from a series of
assumptions (axioms) on these prospects.

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 Transitivity and completeness of
preferences over prospects
• Consider two prospects P3 and P4:
– P3(.7, 4000000, 2500000)
– P4(.5, 3000000, 2000000)
• An ordering of P1 vs. P3 and P1 vs. P4 could
be:
• P1 P3 and P4 P1
• Transitivity says: P4 P3

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 Expected utility
• Say one has to choose between two prospects.
• Based on assumptions such as ordering and
transitivity (and others), it can be shown that
when such choices over risky prospects are to be
made, people should act as if they are
maximizing expected utility:
U(P) = pr A * u(wA) + (1-pr A) * u(wB)

• Can generalize to more than two outcomes:

U(P) = pr A * u(wA) + pr B * u(wB) + pr C * u(wC)

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 Expected utility example
• u(w) = w.5
• Prospects:
– P5(.5, 1000, 500)
– P6(.6, 1200, 300)
• For P5: U(P5) = .5 * 1000.5 + .5 * 500.5 = 26.99
• For P6: U(P6) = .6 * 1200.5 + .4 * 300.5 = 27.71
• So P6 P5.

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 Properties of utility functions
• Certain properties of utility functions can be
demonstrated:
– Upward-sloping
– Unique up to a positive linear transformation
• Latter allows one to set u(lowest outcome)=0 and u(highest
outcome)=1, which can be useful for proving certain things
• Other properties such as differentiability
(implying continuity) are often assumed.

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 Risk aversion assumption
• This comes from frequent observation that
most people most of the time are not willing
to accept a fair gamble:
• Would you be willing to bet me Rs. 100 that
you can predict a coin flip?
– Most would say no.
– And if one of you says yes, I will say no, since I am
risk averse.
• Risk aversion implies concavity.
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 Expected utility of a prospect
• Consider prospect P7:
• P7(.4, 50,000, 1,000,000)
• Use expected utility formula:
U(P7) = 0.40u(50,000) + 0.60u(1,000,000)
• Using logarithmic utility function, we have:
U(P7) = 0.40(1.6094) + 0.60(4.6052) = 3.4069
• Graph also shows utility of exp. value of prospect:
u(E(w)) = ln(62) = 4.1271

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 Expected utility on graph
•

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 Certainty equivalents
• Certainty equivalent is defined as that wealth
level which leads decision-maker to be
indifferent between a particular prospect and
a certain wealth level.
• We need to solve for w below:
U(P7) = 3.4069 = u(w)
• Solution is w = 30.17

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 Problems with expected
utility theory
• A number of violations of expected utility
have been discovered.
• Most famous is Allais paradox.
• Alternative theories have been developed
which seek to account for these violations.
• Best-known is prospect theory of Daniel
Kahneman and Amos Tversky.

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 Allais Paradox
• Choose an alternative:

Prospect A Prospect A*

Payoff Probability Payoff Probability

$1m 100% 0 1%

$1m 89%

$5m 10%
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 Allais Paradox

Prospect B Prospect B*

Payoff Probability Payoff Probability

0 89% 0 90%

$1m 11% $5m 10%

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 Allais Paradox: Explanation
u(1m) > 0.10*u(5m) + 0.89*u(1m) + 0.01*u(0m)
Add 0.89*u(0m) - 0.89*u(1m) to both sides.

0.11*u(1m) + 0.89*u(0m) > 0.10*u(5m) +

0.90*u(0m)
Violates Expected Utility Theorem!
 MODERN PORTFOLIO THEORY

The expected utility theory :in the face of uncertainty

individuals maximise the utility expected across possible states
of the world.
For a financial asset, like an equity stock, that has innumerable
possible outcomes, it is not a manageable proposition.

However, if we assume that investors are risk averse and

investor preferences can be defined in terms of the mean and
variance of returns, it is possible to quantify the tradeoff
between risk and return.

This is what the modern portfolio theory and the capital asset
pricing model do.
Portfolio theory, originally proposed by Harry Markowitz in the
1950s, was the first formal attempt to quantify the risk of a
portfolio and develop a methodology for determining the
optimal portfolio.

Prior to the development of portfolio theory, investors dealt

with the concepts of returns and risk somewhat loosely.

Intuitively smart investors know the benefit of diversification

which is reflected in the traditional adage “Do not put all your
eggs in one basket”.

Harry Markowitz was the first person to show quantitatively why

and how diversification reduces risk. In recognition of his
seminal contributions in this field he was awarded the Nobel
Prize in Economics in 1990.
Risk and Return for Individual Assets

Modern portfolio theory assumes that investors are risk averse

and preferences (utilities) are defined in terms of the mean and
variance of returns.
The return on a risky asset is considered as being a random
variable which is normally distributed. This means that the
return of an asset for the next period is determined by a
probability distribution that is described by two parameters, viz,
expected value and variance (or its square root; standard
deviation). Since these two parameters are nor observable, in
empirical finance it is a common practice to estimate them using
historical data. For this purpose, we often use a sample of data,
collected ex post.
With n observations of the historical return of asset i,
the mean return is computed as follows:

where Ri is the mean return on asset i, Ri,t is the

return on asset i during the t th period, and n is the
number of periods over which historical return data is
gathered.
The mean return is the best estimate of the expected
value of the true distribution.
The sample variance of returns; σi2 is computed as
follows:

And the sample standard deviation of returns is:

To illustrate, consider the returns from a stock over a 6 year
period:
R1 = 15%, R2 = 12%, R3 = 20%, R4 = -10%, R5 = 14%, and R6 = 9%
 For the sake of simplicity, suppose there are only two stocks, A and
B, and a risk – free asset (RF) in a market. The expected returns,
standard deviation of returns, and correlations of returns between
these assets are shown in Exhibit 2.7. Note that by definition the
risk- free asset (RF) has a zero standard deviation of returns and
zero correlation with other assets.
n
E(Rp)=∑wiE(Ri)
i=1

n n
σp2= ∑ ∑ wiwjσ(Ri,Rj)
i=1 j=1
Return Characteristics of Various Assets
State of Probability Return on Deviation of Return on Deviation of Product of the
nature asset 1 the return on asset 2 the return on deviations
asset 1 from its asset 2 from times
mean its mean probability
(1) (2) (3) (4) (5) (6) (2) x (4) x (6)

1 0.10 -10% -26% 5% -9% 23.4

2 0.30 15% -1% 12% -2% 0.6
3 0.30 18% 2% 19% 5% 3.0
4 0.20 22% 6% 15% 1% 1.2
5 0.10 27% 11% 12% -2% -2.2
Sum = 26.0

Thus the covariance between the returns on the two assets is 26.0.
 COEFFICIENT OF CORRELATION
Cov (Ri , Rj)
Cor (Ri , Rj) or rij =
sisj
sij
=
si sj
sij = rij . si . sj
where rij = correlation coefficient between the returns on
securities i and j
sij = covariance between the returns on securities
i and j
si , sj = standard deviation of the returns on securities
i and j
GRAPHICAL PORTRAYAL OF VARIOUS TYPES OF
CORRELATION RELATIONSHIPS
 Portfolio Risk : 2 – Security Case
sp = [w12 s12 + w22 s22 + 2w1w2 r12 s1 s2]½
Example : w1 = 0.6 , w2 = 0.4,

s1 = 10%, s2 = 16%
r12 = 0.5
sp = [0.62 x 102 + 0.42 x 162 +2 x 0.6 x 0.4 x 0.5 x 10 x 16]½
= 10.7%
 Portfolio Risk : n – Security Case
sp = [ å å wi wj rij si sj ] ½
Example : w1 = 0.5 , w2 = 0.3, and w3 = 0.2
s1 = 10%, s2 = 15%, s3 = 20%
r12 = 0.3, r13 = 0.5, r23 = 0.6
sp = [w12 s12 + w22 s22 + w32 s32 + 2 w1 w2 r12 s1 s2
+ 2w2 w3 r13 s1 s3 + 2w2 w3 r23s2 s3] ½
= [0.52 x 102 + 0.32 x 152 + 0.22 x 202
+ 2 x 0.5 x 0.3 x 0.3 x 10 x 15
+ 2 x 0.5 x 0.2 x 05 x 10 x 20
+ 2 x 0.3 x 0.2 x 0.6 x 15 x 20] ½
= 10.79%
 RISK OF AN N - ASSET PORTFOLIO
s2p = S S wi wj rij si sj
n x n MATRIX
1 2 3 … n

1 w12σ12 w1w2ρ12σ1σ2 w1w3ρ13σ1σ3 … w1wnρ1nσ1σn

2 w2w1ρ21σ2σ1 w22σ22 w2w3ρ23σ2σ3 … w2wnρ2nσ2σn

3 w3w1ρ31σ3σ1 w3w2ρ32σ3σ2 w32σ32 …

: : :

n wnw1ρn1σnσ1 wn2σn2
 DOMINANCE OF COVARIANCE

As the number of securities included in a portfolio

increases, the importance of the risk of each individual
security decreases whereas the significance of the
covariance relationship increases.
 Capital Asset Pricing Model (CAPM)

William Sharpe and others asked the follow-up question: If

rational investors follow the Markowitzian prescription,
what kind of relationship exists between risk and return?
Essentially, the capital asset pricing model (CAPM)
developed by them is an exercise in positive economics. It is
concerned with two key questions:

ØWhat is the relationship between risk and return for an

efficient portfolio?
ØWhat is the relationship between risk and return for an
individual security?
 Assumptions
The CAPM is based on the following assumptions:
Ø Investors are risk averse.
Ø Security returns are normally distributed.
Ø The utility function of investors is quadratic.
Ø Investors have homogeneous expectations – they have
identical subjective estimates of the means, variances, and co-
variances among returns.
Ø Investors can borrow and lend freely at a riskless rate of
interest.
Ø The market is perfect: there are not taxes; there are no
transactions costs; securities are completely divisible; the
market is competitive.
Ø The quantity of risky securities in the market is given.
Ø Looking at these assumptions, one may feel that CAPM is
unrealistic. However, the value of a model depends not on the
realism of its assumptions, but on the validity of its
conclusions. Extensive empirical analysis suggests that there is
a lot of merit in the CAPM.
 Capital Market Line
For efficient portfolios (which includes the market portfolio) the relationship
between risk and return is depicted by the straight line Rf MZ. The equation for
this line, called the capital market line (CML), is:

where E(Rj) is the expected return on portfolio j, Rf is the risk-free rate, l is the
slope of the capital market line, and sj is the standard deviation of portfolio j.
Given that the market portfolio has an expected return of E(RM) and standard
deviation of the CML the slope of the CML can be obtained as follows :
E(RM) - Rf
l =
sM
where ,l, the slope of the CML, may be regarded as the “price of risk” in the
market.
 Empirical Evidence on CAPM
According to the capital asset pricing model, the expected return on a security
is:
E (Ri) = Rf + bi [ E (RM ) - Rf ] (9.14)

The ideal way to test the CAPM would be to observe investors’ expectations
of betas and expected returns on individual securities and the market
portfolio and then compare the expected return on each security with its
return predicted by the CAPM. Unfortunately, this procedure is not
practical since information on investor expectations is very sketchy.
In practice, researchers have tested the CAPM using ex post data, rather
than ex ante data. They have examined the relationship between the
security beta and realised return.
Ri = no + n1bi + ei (9.15)
where Ri is the realised return on security i, no is the intercept, bI is the
estimated beta of security i, and n1 is the slope coefficient.
 EMPIRICAL EVIDENCE ON CAPM

If the CAPM holds:

Ø The relationship should be linear. This means that terms
like bi2, if substituted for bi should not yield better
explanatory power.
Ø no, the intercept, should not be significantly different from
the risk-free rate, Rf.
Ø n1, the slope coefficient, should not be significantly different
from RM - Rf .
Ø No other factors such as company size or total variance,
should affect Ri .
Ø The model should explain a significant portion of variation
in returns among securities.
Ø Numerous empirical studies have been conducted to test
the CAPM. Without going into the details of the individual
studies, let us note the following general conclusions that
emerge from these studies.
Ø The relation appears to be linear.
Ø In general no is greater than the risk-free rate and n1is less
than RM – Rf. This means that the actual relationship
between risk (as measured by beta) and return is flatter
than what the CAPM says.
Ø In addition to beta, some other factors, such as standard
deviation of returns, price- earnings multiple and company
size, too have a bearing on return.
Ø Beta does not explain a very high percentage of the variance
in return among securities.
 EMPIRICAL EVIDENCE ON CAPM

Notwithstanding the problems mentioned above, the CAPM

is the most widely used risk return model. Its popularity may
be attributed to the following factors:
Ø Some objective estimate of risk premium is better than a
completely
Ø subjective estimate or no estimate.
Ø CAPM is a simple and intuitively appealing risk-return model.
Its basic message that diversifiable risk does not matter is
accepted by nearly every one.
Ø While there are plausible alternative risk measures, no
consensus has emerged on what course to plot if beta is
abandoned. As Brealey and Myers say: “ So the capital
asset pricing model survives not from a lack of
competition but from a surfeit”.

Ø The situation perhaps may change as additional evidence

is gathered in favour of arbitrage pricing model and
operational guidelines for applying that model are
developed further. As of now, however, the CAPM appears
to be the model of choice in practice.
 Efficient Markets Hypothesis
In the mid-1960s, Eugene Fama introduced the idea of an
“efficient” capital market to the literature of financial
economics. Put simply, the idea is that the intense
competition in the capital market leads to fair pricing of
debt and equity securities.
This is indeed a sweeping statement. No wonder it
continues to stimulate insight and controversy even today.
Benjamin Friedman refers to efficient markets hypothesis as
a “credo,” a statement of faith and not a scientific
proposition. Warren Buffett, perhaps the most successful
investor of our times, has characterised the market as “a
slough of fear and greed untethered to corporate realities.”
For most financial economists, however, the efficient
markets hypothesis is a central idea of modern finance that
has profound implications.

An understanding of the efficient markets hypothesis will

help you to ask the right questions and save you from a lot of
confusion that dominates popular thinking in finance.
 Random Walk and Search for Theory
In 1950s, pioneering work done by distinguished statisticians
and physicists Such as Maurice Kendall, Harry Roberts,
Osborne and others found that stock prices behaved like a
random walk.
A random walk means that successive stock prices are
independent and identically distributed. Therefore, strictly
speaking, the stock price behaviour should be
characterised as a submartingale, implying that the
expected change in price can be positive because investors
expect to be compensated for time and risk. Further, the
expected return may change over time in response to
change in risk.
Search for Theory
When the empirical evidence in favour of the random walk hypothesis seemed
overwhelming, the academic researchers asked the question: What is the
Economic process that produces a random walk? They concluded that the
randomness of stock prices was the result of an efficient market. Broadly, the
key links in the argument are as follows:

Ø Information is freely and instantaneously available to all the market

participants.
Ø Keen competition among market participants more or less ensures that
market prices will reflect intrinsic values. This means that they will fully
impound all available information.
Ø Prices change only in response to new information that, by definition, is
unrelated to previous information (otherwise it will not be new
information).
Ø Since new information cannot be predicted in advance, price changes too
cannot be forecast. Hence, prices behave like a random walk.
 What is an Efficient Market

An efficient market is one in which the market price of a

security is an unbiased estimate of its intrinsic value. Note
that market efficiency does not imply that the market price
equals intrinsic value at every point in time. All that it says
is that the errors in the market prices are unbiased. This
means that the price can deviate from the intrinsic value
but the deviations are random and uncorrelated with any
observable variable. If the deviations of market price from
intrinsic value are random, it is not possible to consistently
identify over or under-valued securities.
MISCONCEPTIONS ABOUT THE EFFICIENT
MARKETS HYPOTHEIS
The efficient markets hypothesis has often been
misunderstood. The common misconceptions about the
efficient markets hypothesis are stated below along
with the answers meant to dispel them.
Misconception The efficient markets hypothesis implies that the market has perfect
forecasting abilities.

Answer The efficient markets hypothesis merely implies that prices impound all available
information. This does not mean that the market possesses perfect forecasting
abilities.

Misconception As prices tend to fluctuate, they would not reflect fair value.

Answer Unless prices fluctuate, they would not reflect fair value. Since the future is
uncertain, the market is continually surprised. As prices reflect these surprises they
fluctuate.
Misconception Inability of institutional portfolio managers to achieve superior investment
performance implies that they lack competence.

Answer In an efficient market, it is ordinarily not possible to achieve superior investment

performance. Market efficiency exists because portfolio managers are doing their
job well in a competitive setting.

Misconception The random movement of stock prices suggests that the stock market is
irrational.

Answer Randomness and irrationality are two different matters. If investors are rational
and competitive, price changes are bound to be random.
 Agency Theory

While there are compelling reasons for separation of

ownership and management, a separated structure
leads to a possible conflict of interest between managers
(agents) and shareholders (principals). Though
managers are the agents of shareholders they are likely
to act in ways that may not maximise the welfare of
shareholders.
The lack of perfect alignment between the interests of
managers and shareholders results in agency costs which
may be defined as the difference between the value of an
actual firm and value of a hypothetical firm in which
management and shareholder interests are perfectly
aligned.
To mitigate the agency problem, effective monitoring has to
be done and appropriate incentives have to be offered.
Monitoring may be done by bonding managers, by auditing
financial statements, by limiting managerial discretion in
certain areas, by reviewing the actions and performance of
managers periodically, and so on.
Incentives may be offered in the form of cash bonuses
and perquisites that are linked to certain performance
targets, stock options that grant managers the right to
purchase equity shares at a certain price thereby giving
them a stake in ownership, performance shares given
when certain goals are achieved, and so on.