Perfect capital market

Capital market is a financial market where agents make transactions, mostly stocks,
representing the companies financial assets.
A perfect market is a market in which there are never any arbitrage opportunities.
A Capital Market is perfect when any of the investors have enough power to change the
price of an asset and all of them have access to the same information. Also there are no
taxes, so we could say that a perfect capital market doesn't exist.
If a capital market has the following characteristics then it would be considered as a
perfect capital market. In perfect capital market case, assuming complete markets,
perfect rationality of agents and under full information, the equilibrium occurs where the
interest rates clear the market, with the supply of funds equal to the demand.

1. There is no transaction (brokerage) cost.

2. There are no taxes.
3. There are large numbers of buyers and sellers, so the actions of no one buyer or seller
affect the price of the traded security.
4. Both individuals and firms have equal access to the market.
5. There is no cost to obtain information, so everyone has the same information.
6. Everyone has the same (homogeneous) expectations.
7. There are no costs associated with financial distress.
8. Stock values adjust rapidly to new information.
9. Stock values should reveal all existing information.
10. Lot of investors examine and rate securities for income.
11. Fresh information come to the market independent from other news and in a
arbitrary way.

What Is the Capital Market Line (CML)?

The capital market line (CML) represents portfolios that optimally combine risk
and return. Capital asset pricing model (CAPM), depicts the trade-off between
risk and return for efficient portfolios. It is a theoretical concept that represents all
the portfolios that optimally combine the risk-free rate of return and the market
portfolio of risky assets. Under CAPM, all investors will choose a position on the
capital market line, in equilibrium, by borrowing or lending at the risk-free rate,
since this maximizes return for a given level of risk.

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The Capital Market Line (CML) formula can be written as follows:

where,

 Expected Return of Portfolio

 Risk-Free Rate
 Standard Deviation of Portfolio
 Expected Return of the Market
 Standard Deviation of Market

Assumptions of the CAPM

CAPM is founded on certain assumptions, most of which are constraining:

 Investors are risk-averse, utility-maximizing, rational individuals. It means

that investors prefer less risk over more and more wealth over less. It
doesn’t mean that all investors must reach the same conclusion but that
they all process information rationally. Recent research calls into question
the assumption of rationality.
 Markets are frictionless which means that (a) all sorts of trades including
short-selling is allowed, (b) lending and borrowing at the risk-free rate is
possible, (c) there are no transaction costs and (d) there are no taxes.

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 While these assumptions may not be met in all situations, they do not
affect the general conclusions of CAPM. However, a restriction on short-
selling may create an upward bias on prices.
 Investors plan for same single holding period. Even though this
assumption does not reflect investor learning or that an investor might be
willing to sustain a loss in the short-run to gain in the long-run, this
assumption does not severely limit applicability of CAPM.
Investors have homogeneous expectations or beliefs: This means that all
investors use the same inputs in their decisions, the same decision-making
processes and reach the same conclusions. However, CAPM still works if
this assumption is relaxed.
 All investments are infinitely divisible. This allows the model to employ
continuous functions. It has an inconsequential impact on the conclusions
of the model.
 Investors are price takers. It assumes that since there are many investors
and no investor is large enough, security prices would not be affected by
investor trades.
Despite these assumptions, the CAPM provides a reasonable benchmark for
initial return estimates.

The security market line

The security market line (SML) is a graph of the CAPM which plots the expected
return on y-axis and systematic risk (represented by beta) on the x-axis. Its y-
intercept equals the risk-free rate and its slope equals the market risk premium.

While the capital market line (CML) applies only to portfolios on the efficient
frontier, the SML applies to all assets. SML can be used to work out the expected
return on an asset.

When we have a portfolio of securities, its beta equals the weighted average of
the individual betas and the expected return can be calculated by using the
portfolio beta in the CAPM equation.

CAPM can be used to estimate expected return for capital budgeting, determine
benchmark return for performance appraisal, security selection, etc. For
example, CAPM can be used to work out the hurdle rate for capital budgeting
projects. Such an application uses a measure of project risk.

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Limitations of the CAPM
The CAPM is subject to theoretical and practical limitations.

Theoretical limitations

 It prices only systematic risk or beta risk which makes it restrictive and
inflexible.
 It does not consider multi-period implications. Hence, it cannot capture
factors that vary over time and span several periods.
Practical limitations

 CAPM defines a true market portfolio as including assets, financial and

nonfinancial. Since many assets are not investable, CAPM-defined market
portfolio cannot be created. This is why CAPM cannot be tested.
 Due to a lack of true market portfolio, different practitioners use different
proxies for the market portfolio which causes them to generate different
return estimates for the same asset, which is a violation of one of the
assumptions of CAPM.
 A long history of returns is needed to estimate beta but this might not be
an accurate representation of the current or future systematic risk of the
stock. Beta estimates also vary due to differences in return frequency (for
example, weekly versus monthly). Hence, different beta estimates may
result in different return estimates.
 Empirical studies suggest that the CAPM is a poor predictor of returns.

The assumption that there is homogeneity in investor expectations does not hold
in reality.

The Capital Market Line and the Security Market Line

The CML is sometimes confused with the security market line (SML). The SML is
derived from the CML. While the CML shows the rates of return for a specific
portfolio, the SML represents the market’s risk and return at a given time, and
shows the expected returns of individual assets. And while the measure of risk in
the CML is the standard deviation of returns (total risk), the risk measure in the
SML is systematic risk, or beta. Securities that are fairly priced will plot on the
CML and the SML. Securities that plot above the CML or the SML are generating
returns that are too high for the given risk and are underpriced. Securities that
plot below CML or the SML are generating returns that are too low for the given
risk and are overpriced.

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CML vs SML
CML stands for Capital Market Line, and SML stands for Security Market Line.

The CML is a line that is used to show the rates of return, which depends on risk-
free rates of return and levels of risk for a specific portfolio. SML, which is also
called a Characteristic Line, is a graphical representation of the market’s risk and
return at a given time.
One of the differences between CML and SML, is how the risk factors are measured.
While standard deviation is the measure of risk for CML, Beta coefficient
determines the risk factors of the SML.
The CML measures the risk through standard deviation, or through a total risk
factor. On the other hand, the SML measures the risk through beta, which helps to
find the security’s risk contribution for the portfolio.
While the Capital Market Line graphs define efficient portfolios, the Security
Market Line graphs define both efficient and non-efficient portfolios.

While calculating the returns, the expected return of the portfolio for CML is shown
along the Y- axis. On the contrary, for SML, the return of the securities is shown
along the Y-axis. The standard deviation of the portfolio is shown along the X-axis
for CML, whereas, the Beta of security is shown along the X-axis for SML.

Where the market portfolio and risk free assets are determined by the CML, all
security factors are determined by the SML.
Unlike the Capital Market Line, the Security Market Line shows the expected
returns of individual assets. The CML determines the risk or return for efficient
portfolios, and the SML demonstrates the risk or return for individual stocks.

Well, the Capital Market Line is considered to be superior when measuring the risk
factors.

Summary:

1. The CML is a line that is used to show the rates of return, which depends on risk-
free rates of return and levels of risk for a specific portfolio. SML, which is also
called a Characteristic Line, is a graphical representation of the market’s risk and
return at a given time.

2. While standard deviation is the measure of risk in CML, Beta coefficient

determines the risk factors of the SML.
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3. While the Capital Market Line graphs define efficient portfolios, the Security
Market Line graphs define both efficient and non-efficient portfolios.

4. The Capital Market Line is considered to be superior when measuring the risk
factors.

5. Where the market portfolio and risk free assets are determined by the CML, all
security factors are determined by the SML.

What Is APT?
Arbitrage pricing theory (APT) is an alternative to the capital asset pricing model
(CAPM) for explaining returns of assets or portfolios. It was developed by
economist Stephen Ross in the 1970s. Over the years, arbitrage pricing theory
has grown in popularity for its relatively simpler assumptions. However, arbitrage
pricing theory is a lot more difficult to apply in practice because it requires a lot of
data and complex statistical analysis.

APT is a multi-factor technical model based on the relationship between a

financial asset's expected return and its risk. The model is designed to capture
the sensitivity of the asset's returns to changes in
certain macroeconomic variables. Investors and financial analysts can use these
results to help price securities.

Inherent to the arbitrage pricing theory is the belief that mispriced securities can
represent short-term, risk-free profit opportunities. APT differs from the more
conventional CAPM, which uses only a single factor. Like CAPM, however, the
APT assumes that a factor model can effectively describe the correlation
between risk and return.

Three Underlying Assumptions of APT

Unlike the capital asset pricing model, arbitrage pricing theory does not assume
that investors hold efficient portfolios.

The theory does, however, follow three underlying assumptions:

 Asset returns are explained by systematic factors.

 Investors can build a portfolio of assets where specific risk is eliminated
through diversification.
 No arbitrage opportunity exists among well-diversified portfolios. If any
arbitrage opportunities do exist, they will be exploited away by investors.
(This how the theory got its name.)
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Mathematical Model of the APT

The Arbitrage Pricing Theory can be expressed as a mathematical model:

Where:

 ER(x) – Expected return on asset

 Rf – Riskless rate of return
 βn (Beta) – The asset’s price sensitivity to factor
 RPn – The risk premium associated with factor

What Is the Fama and French Three Factor Model?

The Fama and French Three-Factor Model (or the Fama French Model for short) is an asset
pricing model developed in 1992 that expands on the capital asset pricing model (CAPM) by
adding size risk and value risk factors to the market risk factor in CAPM. This model considers
the fact that value and small-cap stocks outperform markets on a regular basis. By including
these two additional factors, the model adjusts for this outperforming tendency, which is thought
to make it a better tool for evaluating manager performance.

The Fama-French Three-factor Model is an extension of the Capital Asset Pricing

Model (CAPM). The Fama-French model aims to describe stock returns through
three factors: (1) market risk, (2) the outperformance of small-cap
companies relative to large-cap companies, and (3) the outperformance of high
book-to-market value companies versus low book-to-market value
companies. The rationale behind the model is that high value and small-cap
companies tend to regularly outperform the overall market.

The Fama-French three-factor model was developed by University of Chicago

professors Eugene Fama and Kenneth French.

KEY TAKEAWAYS

 The Fama French 3-factor model is an asset pricing model that expands on the capital
asset pricing model by adding size risk and value risk factors to the market risk factors.

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  The model was developed by Nobel laureates Eugene Fama and his colleague Kenneth
French in the 1990s.
 The model is essentially the result of an econometric regression of historical stock prices.

The Fama-French Three-Factor Model Formula

The mathematical representation of the Fama-French three-factor model is:

Where:

 r = Expected rate of return

 rf = Risk-free rate
 ß = Factor’s coefficient (sensitivity)
 (rm – rf) = Market risk premium
 SMB (Small Minus Big) = Historic excess returns of small-cap
companies over large-cap companies
 HML (High Minus Low) = Historic excess returns of value stocks (high
book-to-price ratio) over growth stocks (low book-to-price ratio)
 ↋ = Risk

#1 Market Risk Premium

Market risk premium is the difference between the expected return of the
market and the risk-free rate. It provides an investor with an excess return as
compensation for the additional volatility of returns over and above the risk-
free rate.

#2 SMB (Small Minus Big)

Small Minus Big (SMB) is a size effect based on the market capitalization of a
company. SMB measures the historic excess of small-cap companies over big-
cap companies. Once SMB is identified, its beta coefficient (β) can be
determined via linear regression. A beta coefficient can take positive values, as
well as negative ones.

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The main rationale behind this factor is that, in the long-term, small-cap
companies tend to see higher returns than large-cap companies.

#3 HML (High Minus Low)

High Minus Low (HML) is a value premium. It represents the spread in returns
between companies with a high book-to-market value ratio (value companies)
and companies with a low book-to-market value ratio. Like the SMB factor,
once the HML factor is determined, its beta coefficient can be found by linear
regression. The HML beta coefficient can also take positive or negative values.

The HML factor reveals that, in the long-term, value stocks (high book-to-
market ratio) enjoy higher returns than growth stocks (low book-to-market
ratio).

What Is the Efficient Market Hypothesis (EMH)?

The efficient market hypothesis (EMH), alternatively known as the efficient
market theory, is a hypothesis that states that share prices reflect all information
and consistent alpha generation is impossible.

According to the EMH, stocks always trade at their fair value on exchanges,
making it impossible for investors to purchase undervalued stocks or sell stocks
for inflated prices. Therefore, it should be impossible to outperform the overall
market through expert stock selection or market timing, and the only way an
investor can obtain higher returns is by purchasing riskier investments.

KEY TAKEAWAYS

 The efficient market hypothesis (EMH) or theory states that share prices
reflect all information.
 The EMH hypothesizes that stocks trade at their fair market value on
exchanges.
 Proponents of EMH posit that investors benefit from investing in a low-
cost, passive portfolio.
 Opponents of EMH believe that it is possible to beat the market and that
stocks can deviate from their fair market values.

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What Are the Weak, Strong, and Semi-Strong Efficient
Market Hypotheses?
Though the efficient market hypothesis as a whole theorizes that the market is
generally efficient, the theory is offered in three different versions: weak, semi-
strong, and strong.

The basic efficient market hypothesis posits that the market cannot be beaten
because it incorporates all important determining information into current share
prices. Therefore, stocks trade at the fairest value, meaning that they can't be
purchased undervalued or sold overvalued.

The theory determines that the only opportunity investors have to gain higher
returns on their investments is through purely speculative investments that pose
a substantial risk.

KEY TAKEAWAYS

 The efficient market hypothesis posits that the market cannot be beaten
because it incorporates all important information into current share prices,
so stocks trade at the fairest value.
 Though the efficient market hypothesis theorizes the market is generally
efficient, the theory is offered in three different versions: weak, semi-
strong, and strong.
 The weak form suggests today’s stock prices reflect all the data of past
prices and that no form of technical analysis can aid investors.
 The semi-strong form submits that because public information is part of a
stock's current price, investors cannot utilize either technical or
fundamental analysis, though information not available to the public can
help investors.
 The strong form version states that all information, public and not public, is
completely accounted for in current stock prices, and no type of
information can give an investor an advantage on the market.

Understanding the Weak, Strong, and Semi-Strong

Efficient Market Hypotheses
Weak Form
The three versions of the efficient market hypothesis are varying degrees of the
same basic theory. The weak form suggests that today’s stock prices reflect all
the data of past prices and that no form of technical analysis can be effectively
utilized to aid investors in making trading decisions.

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Advocates for the weak form efficiency theory believe that if the fundamental
analysis is used, undervalued and overvalued stocks can be determined, and
investors can research companies' financial statements to increase their chances
of making higher-than-market-average profits.

Semi-Strong Form
The semi-strong form efficiency theory follows the belief that because all
information that is public is used in the calculation of a stock's current price,
investors cannot utilize either technical or fundamental analysis to gain higher
returns in the market.

Those who subscribe to this version of the theory believe that only information
that is not readily available to the public can help investors boost their returns to
a performance level above that of the general market.

Strong Form
The strong form version of the efficient market hypothesis states that all
information—both the information available to the public and any information not
publicly known—is completely accounted for in current stock prices, and there is
no type of information that can give an investor an advantage on the market.

Advocates for this degree of the theory suggest that investors cannot make
returns on investments that exceed normal market returns, regardless of
information retrieved or research conducted.

Arbitrage
Arbitrage involves the simultaneous buying and selling of an asset in order to
profit from small differences in price. Arbitrage is possible because of
inefficiencies in the market.

Arbitrageurs—those who use arbitrage as a strategy—often buy stock on one

market such as a financial market in the U.S. like the New York Stock Exchange
(NYSE) while simultaneously selling the same stock on a different market like the
London Stock Exchange (LSE). The stock would be traded in U.S. dollars in the
United States, while in London, the stock would be traded in pounds. This usually
happens very quickly, and once acted upon, the opportunity is gone.

As each market for the same stock moves, market inefficiencies, pricing
mismatches, and even dollar/pound exchange rates can affect the prices
temporarily. Arbitrage is not limited to identical instruments. Instead, arbitrageurs
can also take advantage of predictable relationships between similar financial
instruments, such as gold futures and the underlying price of physical gold.

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Since arbitrage involves the simultaneous buying and selling of an asset, it is
essentially a type of hedge and involves limited risk when executed properly.
Keep in mind, limited doesn't necessarily mean minor. While there is a chance of
losing out from small fluctuations in price, other risks can be much stronger such
as the devaluation of a currency. Because arbitrage isn't exactly risk-free, traders
need to tailor their situation so the odds of greater profitability increase.

Arbitrageurs typically enter large positions since they are attempting to profit from
very small price differences. Because of these large positions, individual
investors usually don't engage in arbitrage. Instead, this strategy is used primarily
by hedge funds and large, institutional investors.

Speculation
Speculation is a short-term buying and selling strategy. It involves a significant
amount of risk of loss or gains. The reward is the main driver, so if there wasn't
any expectation of gain, there would be no use for speculation. This strategy is
generally driven by assumptions or hunches on the part of the trader, who
attempts to profit from rising and falling prices.

Speculation is a very important part of the market. Without it, there would be no
liquidity. Participants would be limited to just those producers and companies.
This would widen the bid-ask spread, making it harder to find buyers and sellers
in the market.

Without speculation, there would be no liquidity in the markets, and market

participants would be limited.

Unlike arbitrage, anyone can engage in speculation. You don't need to take large
positions in a trade in order to speculate, so anyone can speculate on their
trades, from individual investors to large, institutional ones.

There is usually a fine line between investing and speculating. For example,
someone may purchase a home as his dwelling. In this case, he may be
considered to be investing his money. But if that person purchases a property
with the express purpose of selling it quickly for a profit, he is engaging in
speculation.

Financial speculation is not limited in the types of securities involved. It can

involve the trading of instruments such as bonds, commodities, currencies, and
derivatives. It can even be used in the real estate market, as outlined in the
example above.

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A trader, for example, may open a long (buy) position in a stock index futures
contract with the expectation of profiting from rising prices. If the value of the
index rises, the trader may close the trade for a profit. Conversely, if the value of
the index falls, the trade might be closed for a loss.

Speculators may also attempt to profit from a falling market by shorting (selling
short or simply selling) the instrument. If prices drop, the position will be
profitable. If prices rise, however, the trade may be closed at a loss.

Hedging

Hedging is the simultaneous purchase and sale of two assets in the

expectation of a gain from different subsequent movements in the price of
those assets. Usually the two assets are equivalent in all respects except
maturity.

 Hedging is a risk management strategy employed to offset losses in

investments by taking an opposite position in a related asset.
 The reduction in risk provided by hedging also typically results in a
reduction in potential profits.
 Hedging strategies typically involve derivatives, such as options and
futures contracts.

What Is a Broker-Dealer?
A broker-dealer (B-D) is a person or firm in the business of buying and
selling securities for its own account or on behalf of its customers. The term
broker-dealer is used in U.S. securities regulation parlance to describe stock
brokerages because most of them act as both agents and principals.

A brokerage acts as a broker (or agent) when it executes orders on behalf of its
clients, whereas it acts as a dealer, or principal when it trades for its own
account.

KEY TAKEAWAYS

 A broker-dealer is a financial entity that is engaged with trading securities

on behalf of clients, but which may also trade for itself.
 A broker-dealer is acting as a broker or agent when it executes orders on
behalf of its clients, and as a dealer or principal when it trades for its own
account.

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  There are thousands of broker-dealers comprising two broad categories: a
wirehouse, which sells its own products, or an independent broker-dealer,
which sells products from outside sources

Understanding What a Broker-Dealer Is

Broker-dealers fulfill several important functions in the financial industry. These
include providing investment advice to customers, supplying liquidity through
market making activities, facilitating trading activities, publishing investment
research and raising capital for companies. Broker-dealers range in size from
small independent boutiques to large subsidiaries of giant commercial and
investment banks.

There are two types of broker-dealers:

1. a wirehouse, or a firm that sells its own products to customers; and

2. an independent broker-dealer, or a firm that sells products from outside
sources.

Key Difference: Brokers are the agents who play a role of inter-mediator between a
buyer and a seller for carrying out the transactions. On the other hand, dealers are the
market makers for the securities.
In layman’s terms, a broker is a person or a firm that conducts the transactions on
behalf of a client. The type of transactions may vary. Brokers play a vital role in financial
transaction in a stock market. They are paid commission fees in exchange of the
services provided by them. Generally, they handle two types of accounts, known as
advisory and discretionary accounts./

Dealer refers to a person or a company that trades securities on its own behalf.
Therefore, the dealer is a principal in a transaction. Unlike broker, he neither conducts
business on behalf of his clients, nor does he try to act as a catalyst for the transactions.

Some of the differences are listed below:-

Brokers Dealers

They are the agents who play a

role of inter-mediator between a They are the market makers for
Definition
buyer and a seller to carry out a the securities.
transaction.

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They charge commissions for
Main characteristic
their services.
Full-service brokers provides
execution and advice and charge
the highest fees.
Types
Discount brokers provides
execution only.
Securities are traded On buyer’s or seller’s behalf
Brokers have restricted freedom
Freedom
and rights.
Other names Agent
Represents investor (Represents
Relationship with investor the order, finding opposite sides
of the trade)
They maintain an inventory and
offers to buy at the bid price.
Later offers to sell at the asked
price.
Institutional market makers can
be banks or other large
corporations that usually offer a
bid/ask quote to other banks,
institutions.
Retail market makers are usually
companies dedicated to offer
retail trading services to
individual traders.
Dealers have all the rights and
freedom regarding the buying
and selling of securities
Comparatively more freedom
and rights.
Market-maker
Opponent of investor (They
benefit from a higher bid/ask
spread.)
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