SAPM - Module 2 - Efficient Market and Capital Market Theory

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SAPM – Module 2
Efficient Market and Capital

Market Theory
05-10-2020 Prof. Naveen 1

Surprise Discovery – Random Walk
• In 1953, Maurice Kendal presented a paper
• He examined the behavior of
• Stock prices
• Commodity Prices
• In search of regular cycles
• He could not find any regular cycles
• Prices appeared to follow a random walk
2
• In 1959, Harry Robert
• Resemblance between Time series and Stock Prices
• Osborne
• Stock price movements are similar to
Random walk
The movement of very small particles suspended in the

liquid medium
3
Many Researchers were inspired
They employed indigenous methods
To test the randomness of stock price behavior
4
Random Walk Model
One of the simple models, yet the random walk model is widely used in
the area of finance.
A common and serious departure from random behavior is called a
random walk.
By definition, a series is said to follow a random walk if the first
differences are random.
What is meant by first differences is the difference from one
observation to the next.
5
Random Walk Model
Think about the process of walking to class.
You have a set goal, you are achieving an objective.
However, while walking you use a sequence of stumbling,

unpredictable steps, the difference between each step has no
“rhyme or reason.”
6
Random Walk Model
In a random walk model, the series itself is not random.
However, its differences—the changes from one period to the next—

are random.
This type of behavior is typical of stock price data.
7
Random Walk Theory
• The movement of stock prices from day to day DO NOT reflect any
pattern.
• Statistically speaking, the movement of stock prices is random (skewed

positive over the long term).
8
Random Walk Theory
9
What is Efficient Market?
Market in which the market price of a security is an
unbiased estimate of its intrinsic value.
The price can deviate from intrinsic value.
But deviations are random and uncorrelated
10
Definition of 'Intrinsic Value'
The actual value of a company or an asset
Based on an underlying perception of its true value including all

aspects of the business
In terms of both tangible and intangible factors.
This value may or may not be the same as the current market
value.
11
Definition of 'Intrinsic Value'
Value investors use a variety of analytical techniques
In order to estimate the intrinsic value of securities in

hopes of finding investments
where the true value of the investment exceeds its

current market value.
12
What is Efficient Market?
Efficient Market is one in which security prices adjust
rapidly to the arrival of new information.
Therefore the current price of the security reflects all

information about the security
13
“Noise”
• An Article published in journal of finance
• Fischer Black
• “Efficient market is one in which the price is more than half of value
and less than two times the value.”
14
Conditions leading to Market Efficiency
1. Investor Rationality
Investors are rational – Stock prices adjust rationally
Dr Reddy’s stock price
-Announces an acquisition
15
2. Independent Deviation from rationality
If announcement was not understood
Optimistic
Pessimistic
As long as Deviations from rationality are independent

Errors tend to cancel out
16
3. Effective Arbitrage
Types of market participants
1. Irrational Amateur
▪Driven by emotions
✓Become overjoyed
✓Become depressed
2. Rational Professionals
▪Methodical and Thorough
▪Assess objectively
17
Example: Tata Motors and Maruti Suzuki
Tata Motors is overpriced

and Maruti Suzuki is underpriced
What would you do?
Sell Tata Motors and Buy Maruti Suzuki
18
Profound Impact of a simple idea
Financial theory development
Practical Developments
Empirical Evidence
19
Financial theory development
1. Financial theory development
1. Modigliani-Miller theories
2. CAPM
3. Black-Scholes Option pricing model
20
Practical Developments
2. Practical Developments are based on well functioning of
security markets
1. Disclosure of earnings
2. Index
3. Performance measurement
21
Empirical Evidence
3. Empirical Evidence
❖ Paved the way for Liberalization
❖ Academic attitude shifted
✓From suspicion
✓To respect/worship
22
Efficient Market Theory
Fama Divided it into three hypothesis
They are known as three components
Weak Form EMH
Semi strong-Form EMH
Strong-Form EMH
23
Weak Form EMH
Current market prices fully reflect all private

information
• Historic sequence of prices

• Rate of return
• Trading volume data
• Other Market data
24
Weak Form EMH
Future prices – unpredictable
Excess returns cannot be earned in the long
Technical analysis techniques and excess returns
Do share prices exhibit serial dependencies?
25
Weak Form EMH
Prices must follow a random walk
This 'soft' EMH does not require that prices remain at or

near equilibrium,
but only that market participants not be able to

systematically profit from market 'inefficiencies'
26
It asserts that security prices adjust rapidly to the

release of all public information
It includes both market and non market information
➢Earnings
➢Dividends
➢P/E ratio
➢EPS
27
Share prices adjust to publicly available
New information very rapidly and in an unbiased fashion,

such that:-
- no excess returns can be earned by trading on
that information.
It implies that neither fundamental analysis nor technical
analysis techniques can produce excess returns.
28
Strong-Form EMH
• It contends that stock prices fully reflect all

information from Public and private sources.
• No monopolistic access to the information
• No group can consistently derive above average rate

of return
29
Strong-Form EMH
• Weak Form and Semi Strong form
• All information is available and they are cost free
• Share prices reflect all information

• No one can earn excess returns.
• If there are legal barriers to private information becoming
public, as with insider trading laws, -
• strong-form efficiency is impossible,
• except in the case where the laws are universally
ignored.
30
• Weak Form Efficiency
• Market prices reflect all private information
• Semi-Strong Form Efficiency
• Market prices reflect all publicly available information
• Strong Form Efficiency
• Market prices reflect all information, both public and private
31
➢Fundamental Analysts
– Research the value of stocks using NPV and other
measurements of cash flow
32
➢Technical Analysts
– Forecast stock prices based on the watching the
fluctuations in historical prices (thus “wiggle
watchers”)
Wiggle: Move or cause to move up and down or from side to side with small
rapid movements
33
The key links in the argument
• Information is freely and instantaneously available
• Prices reflect intrinsic values
• Prices change only in response to new information
• As new information can’t be predicted, price

changes can’t be forecast
• No one is in a position to influence the market
34
An Example of an Efficient Market
While there are investors who believe in both sides of the EMH, there
is real-world proof that wider dissemination of financial information
affects securities prices and makes a market more efficient.
For example, the passing of the Sarbanes-Oxley Act of 2002, which

required greater financial transparency for publicly traded
companies, saw a decline in equity market volatility after a company
released a quarterly report. It was found that financial statements
were deemed to be more credible, thus making the information
more reliable and generating more confidence in the stated price of a
security. There are fewer surprises, so the reactions to earnings
reports are smaller. This change in volatility pattern shows that the
passing of the Sarbanes-Oxley Act and its information requirements
made the market more efficient. This can be considered a
confirmation of the EMH in that increasing the quality and reliability
of financial statements is a way of lowering transaction costs.
35
Criticism of EMH and behavioural finance
Investors and researchers disputed the EMH.
Behavioral economists attribute the imperfections in

financial markets to a combination of cognitive biases:-
overconfidence,
overreaction,
representative bias,
information bias, and
various others predictable human errors –
- in reasoning and information processing.
36
Late 2000s financial crisis
The financial crisis of 2007–08 - “The EMH is responsible
for the current financial crisis”
Asset bubbles breaking.
A financial journalist blasted the theory
37
Tests and Results of Efficient Market
Hypothesis
Weak-Form Hypothesis
Now let us check does data support the Hypothesis.
Statistical tests of independence between rates of return
Tests of Trading rules.
38
Statistical tests of independence between rates of
return
1. Correlation tests
Does the rate of return on t correlate with rate

of return on day t-1, t-2, or t-3
Result: Insignificant Correlation
39
Statistical tests of independence between rates of
return
2. Runs test
Price changes are a set as pluses and minuses
Example: +++-+--++--++
A run occurs when two consecutive changes are same
Runs start and end
Studies confirmed the independence of stock price

changes
40
Tests of Trading rules.
Test through simulation
No profit based on past market information
Three Major pitfalls
1. Use only private data

2. Include all transaction costs
3. Adjust the results for risk
Result did not support the hypothesis
41
Hypothesis
Semi Strong - Form
1. Studies to predict future rates of return
2. Event studies to examine how fast stock prices adjust

to economic events
3. Results:
1. Limited success in Short horizons
2. Quite success in long horizons
42
Tests and Results of Efficient Market Hypothesis
Strong – Form
Analyzing four major groups of investors:-
1. Corporate insiders
2. Stock Exchange specialists
3. Security Analysts
4. Professional money managers

43
Hypothesis
Test Results of Strong form
1. Corporate insiders and stock exchange specialists

did not support the hypothesis
1. They have monopolistic access to the
information
2. Derive above-average returns
2. Performance by money managers provided mixed

response
44
Lessons of Market Efficiency
Markets have no memory
Trust market prices
Read the entrails
There are no financial illusions
The do it yourself alternative
Seen one stock, seen them all
45
Indian stock market – Moving towards
Efficiency
• Online Trading
• Depository System
• Changes in settlement system
• Ban on Badla
• Introduction of Derivatives
46
Indian stock market – Moving towards
Efficiency
• Transparency
• Check Insider trading
• Corporatization of stock exchanges
47
What is Badla?
Badla was an indigenous carry-forward system invented on the BSE
As a solution to the perpetual lack of liquidity in the secondary

market.
Badla was banned by SEBI in 1993
Badla was legalized again in 1996
Banned again on July 2, 2001, following the introduction of futures

contracts in 2000.
48
Misconceptions about the Efficient Market
Hypothesis
Misconception Answer
Market has perfect forecasting abilities Prices impound all available information
Prices do not reflect fair value as they Prices fluctuate to reflect the surprises
Fluctuate
Inability of Portfolio managers to achieve Market efficiency exists as Managers do

superior performance implies that they lack their job well
Competence.
The random movement of stock prices Randomness and irrationality are two
Suggest that the stock market is irrational different matters. If investors are rational
and competitive, price changes are bound
to be random
49
Partial Failure of the Efficient Market
Hypothesis in Enron Scandal
There was “partial failure” of the hypothesis.
The gradual fall in the stock price
Down, despite increased earnings
The market was in a period of correction.
Suggests a partial failure in the market efficiency.
50
CAPM
• Centre piece of modern financial economics
• Originator is William Sharpe
• Awarded the Nobel prize in Economics
51
William Forsyth Sharpe
The STANCO Professor of Finance
The winner of the 1990 Nobel Prize in Economic Sciences.
52
Capital Asset Pricing Model (CAPM)
The model was introduced by Jack Treynor, William Sharpe, John Lintner and Jan
Mossin independently.
Building on the earlier work of Harry Markowitz on diversification and modern

portfolio theory.
Sharpe, Markowitz and Merton Miller jointly received the Nobel Memorial Prize
in Economics for this contribution to the field of financial economics.
In finance, CAPM is used to determine a theoretically appropriate required rate

of return of an asset.
53
CAPITAL ASSET PRICING MODEL (CAPM)
• The capital asset pricing model (CAPM) is a model that provides a framework to
determine the required rate of return on an asset and indicates the relationship
between return and risk of the asset.
• The required rate of return specified by CAPM helps in valuing an asset.
• One can also compare the expected (estimated) rate of return on an asset with its
required rate of return and determine whether the asset is fairly valued.
• Under CAPM, the security market line (SML) exemplifies the relationship between an
asset’s risk and its required rate of return.
54
Assumptions of CAPM
• Individuals are risk averse
• Investors make investment decisions based on expected return and the variances of
security returns, i.e. two-parameter utility function.
• All investments are perfectly divisible
• Individuals seek to maximize the expected utility of their portfolio
• Individuals have homogeneous expectations
• Borrow and lend freely at risk less rate
• There is no uncertainty about expected inflation
• There are no taxes or commissions involved with security transactions.
• The market is perfect
• No taxes
• No transaction cost
• Market is competitive
• The quantity of risky securities are given
55
Capital Asset Pricing Model
(CAPM)
If investors are mainly concerned with the risk of their portfolio rather than
the risk of the individual securities in the portfolio, how should the risk of an
individual stock be measured?
• An important tool is the CAPM.
• Relevant risk of an individual stock is its contribution to the risk of a well-

diversified portfolio.
• CAPM specifies a linear relationship between risk and required return.
56
Capital Asset Pricing Model (CAPM)
• The equation used for CAPM is as follows:
Ki = Krf + bi(Km – Krf)
Where:
• Ki = the required return for the individual security
• Krf = the risk-free rate of return
• bi = the beta of the individual security
• Km = the expected return on the market portfolio
• (Km - Krf) is called the market risk premium
• This equation can be used to find any of the variables listed

above, given the rest of the variables are known.
57
Beta
The Beta (β) of a stock or portfolio
A number
Correlated volatility of an asset
in relation to the volatility of the benchmark*
* This benchmark is generally the overall financial market and is often estimated via the
use of representative indices, such as the Sensex.
58
Interpretation of Beta
Value
of Interpretation Example
Beta
Asset generally moves in the Gold, which often moves

β < 0 opposite direction as opposite to the movements
compared to the index of the stock market
Fixed-yield asset, whose

Movement of the asset is
growth is unrelated to the
β = 0 uncorrelated with the
movement of the stock
movement of the benchmark
market
59
Interpretation of Beta
Value of
Interpretation Example
Beta
Stable, "staple" stock such as a
Movement of the asset is company that makes soap. Moves
generally in the same direction in the same direction as the
0<β<1
as, but less than the movement market at large, but less
of the benchmark susceptible to day-to-day
fluctuation.
Movement of the asset is

generally in the same direction A representative stock, or a stock
β=1 as, and about the same amount that is a strong contributor to the
as the movement of the index itself.
benchmark
Movement of the asset is Volatile stock, such as a tech

generally in the same direction stock, or stocks which are very
β>1
as, but more than the movement strongly influenced by day-to-day
of the benchmark market news.
60
How to calculate Beta?
Hands-on practice
ra - Return on the Stock

rb - Return on the Market
61
Beta Calculation – Some more tips
1) The function in Excel is Slope.
2) Y (the dependent variable) is the stock returns while X
(the independent variable) is the returns on the
Sensex.
3) It has been observed that some students directly use
the slope function on the absolute values.
4) This approach is incorrect. First as demonstrated
above we need to first calculate returns.
The slope function in Excel should be used on the
values of the returns to calculate the beta of the
share.
62
Correlation Vs Beta
Intuitively what it really means is Beta is distinct from correlation in
that correlation is more indicative of direction.
While beta is also incorporating magnitude. If we say a market is up

15% always and the stock is always up 30%, then the correlation will
be 1.
However as beta gives us both the direction and the magnitude we

would get a beta of 2.
63
What Does Beta Mean for Investors?
• A stock with a beta of zero indicates no correlation with the chosen

benchmark (e.g. cash or treasury bills)
• One indicates a stock has the same volatility as the market
• More than one indicates a stock that’s more volatile than its
benchmark
• Less than one is less volatile than its benchmark
• 1.3 is 30% more volatile than its benchmark
64
CAPM Equation
Ki = Krf + bi(Km - Krf)
An exercise in Excel
65
Required rate of return Vs Expected rate
of return
You would only invest in stocks where the
expected rate of return exceeded the required
rate of return.
Expected>Required, You invest

Expected=Required, Indifferent
Expected<Required, Never invest
66
Efficient frontier
• A concept in modern portfolio theory
• When is a portfolio referred to as "efficient“
• A hyperbola, is then called the "efficient frontier".
67
Efficient frontier
• The CAPM assumes that the risk-return profile of a
portfolio can be optimized—
• an optimal portfolio displays the lowest possible level of risk
for its level of return.
• Additionally, since each additional asset introduced into a
portfolio further diversifies the portfolio, the optimal portfolio
must comprise every asset,
• All such optimal portfolios, i.e., one for each level of return,
comprise the efficient frontier.
• Because the unsystematic risk is diversifiable,
• The total risk of a portfolio can be viewed as beta.
68
Efficient frontier
69
Market portfolio
• An investor might choose
• Risky assets and Cash
• or borrow money to fund his purchase of risky assets
• a negative cash weighting.
• The ratio of risky assets to risk-free asset does not
determine overall return—
• this relationship is clearly linear.
70
Market portfolio
Possible to achieve a particular return in two ways:
• Risky portfolio
or
• Invest a proportion in a risky portfolio and the remainder

in cash.
71
Benefits of CAPM
• Worth of Investments can be evaluated in view of
expected returns
• Suggests diversification
• An appropriate return is determined
• Used to price initial public offerings
• Used to identify over and under valued securities
• Used to measure the riskiness of securities/companies
• Used to measure the company’s cost of capital
• Guides managerial decisions.
72
Limitations of CAPM
• Assumptions don’t hold good:-
• Difficult to estimate the rates
• It is single period model and more difficult to adjust
• Risk is not variance in itself, rather it is the probability of

losing.
73
Limitations of CAPM
• The model does not appear to adequately explain the
variation in stock returns.
• It does not allow for active and potential shareholders
who will accept lower returns for higher risk. Casino gamblers pay to take on
more risk, and it is possible that some stock traders will pay for risk as well.
• Works of art, real estate, human capital

• The model considers just two dates
• Multiple portfolios - see behavioral portfolio theory
• Empirical tests show market anomalies like the size and
value effect.
74
Extreme and interesting cases
• Beta has no upper or lower bound, and betas as large as
3 or 4 will occur with highly volatile stocks.
• Beta can be zero.
• Some zero-beta assets are risk-free, such as treasury bonds
and cash.
• However, simply because a beta is zero does not mean that it
is risk-free.
• A beta can be zero simply because the correlation between
that item's returns and the market's returns is zero.
• An example would be betting on horse racing. The correlation
with the market will be zero, but it is certainly not a risk-free
endeavour.
75
• What does a negative beta simply mean?
• Answer?
• A negative beta - even when benchmark index and
the stock have positive returns.
• Lower positive returns of the index coincide with higher

positive returns of the stock, or vice versa.
• The negative slope of the regression line
76
• If beta is a result of regression of one stock against
the market where it is quoted, betas from different
countries are not comparable.
• Staple stocks are thought to be less affected by cycles
and usually have lower beta.
• Procter & Gamble, which makes soap, is a classic example.
• Other similar ones are Philip Morris (tobacco) and Johnson
& Johnson (Health & Consumer Goods).
• 'Tech' stocks typically have higher beta.
• An example is the dot-com bubble.
• Although tech did very well in the late 1990s, it also fell
sharply in the early 2000s, much worse than the decline of
the overall market.
77
• Foreign stocks may provide some diversification.

• World benchmarks such as S&P Global 100 have slightly
lower betas than comparable India-only benchmarks
such as Sensex.
• However, this effect is not as good as it used to be.
• The various markets are now fairly correlated, especially the
US and Western Europe.
78
Capital Market Line - CML
• A line used in CAPM to illustrate the rates of return for efficient

portfolios depending on the risk-free rate of return and the level of
risk (standard deviation) for a particular portfolio.
79
Security Market Line - SML
• A line that graphs the systematic, or market, risk versus return of the whole
market at a certain time and shows all risky marketable securities.
Also referred to as the "characteristic line".
• The SML essentially graphs the results from CAPM formula.

• The x-axis represents the risk (beta), and the y-axis represents the expected
return.
• The market risk premium is determined from the slope of the SML.
80
Security Market Line - SML
81
Arbitrage Pricing Theory
82
What is Arbitrage?
• Arbitrage is the practice of taking advantage of a price
difference between two or more markets.
• An arbitrage involves taking advantage of differences in

price of a single asset or identical cash-flows.
83
Arbitrage pricing theory
• It is a general theory of asset pricing
• That holds that the required return of a financial asset
can be modeled as a linear function of:-
• various macro-economic factors or
• theoretical market indices,
• Where sensitivity to changes in each factor is

represented by:-
• A factor-specific beta coefficient.
86
Arbitrage pricing theory
• The model-derived rate of return will then be used to price the asset
correctly
• The asset price should equal the required end of period price
discounted at the rate implied by the model.
• If the price diverges, arbitrage should bring it back into line.
• The theory was proposed by the economist Stephen Ross in 1976.
87
The APT model
Risky asset returns are said to follow a factor intensity structure if they can be expressed as:
where
is a constant for asset
is a systematic factor
is the sensitivity of the th asset to factor , also called factor loading,
and is the risky asset's idiosyncratic random shock with mean zero.
Idiosyncratic shocks are assumed to be uncorrelated across assets and

uncorrelated with the factors.
Idiosyncratic - Unique
88

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1-84>

Efficient Market and Capital

05-10-2020 Prof. Naveen 1

The movement of very small particles suspended in the

They employed indigenous methods

To test the randomness of stock price behavior

However, while walking you use a sequence of stumbling,

However, its differences—the changes from one period to the next—

This type of behavior is typical of stock price data.

• Statistically speaking, the movement of stock prices is random (skewed

The price can deviate from intrinsic value.

But deviations are random and uncorrelated

Based on an underlying perception of its true value including all

In terms of both tangible and intangible factors.

In order to estimate the intrinsic value of securities in

where the true value of the investment exceeds its

Therefore the current price of the security reflects all

Investors are rational – Stock prices adjust rationally

Dr Reddy’s stock price

As long as Deviations from rationality are independent

Example: Tata Motors and Maruti Suzuki

Tata Motors is overpriced

What would you do?

Sell Tata Motors and Buy Maruti Suzuki

Financial theory development

3. Black-Scholes Option pricing model

❖ Paved the way for Liberalization

❖ Academic attitude shifted

Weak Form EMH

Semi strong-Form EMH

Current market prices fully reflect all private

• Historic sequence of prices

Future prices – unpredictable

Excess returns cannot be earned in the long

Technical analysis techniques and excess returns

Do share prices exhibit serial dependencies?

Prices must follow a random walk

This 'soft' EMH does not require that prices remain at or

but only that market participants not be able to

It asserts that security prices adjust rapidly to the

It includes both market and non market information

Share prices adjust to publicly available

New information very rapidly and in an unbiased fashion,

• It contends that stock prices fully reflect all

• No monopolistic access to the information

• No group can consistently derive above average rate

• Weak Form and Semi Strong form

• All information is available and they are cost free

• Share prices reflect all information

• Prices reflect intrinsic values

• Prices change only in response to new information

• As new information can’t be predicted, price

• No one is in a position to influence the market

For example, the passing of the Sarbanes-Oxley Act of 2002, which

Behavioral economists attribute the imperfections in

Asset bubbles breaking.

A financial journalist blasted the theory

Statistical tests of independence between rates of return

Tests of Trading rules.

Does the rate of return on t correlate with rate

Result: Insignificant Correlation

Price changes are a set as pluses and minuses

A run occurs when two consecutive changes are same

Runs start and end