Foundations of Finance II: Asset

Pricing, Market Efficiency,

and Agency Relationships
Chapter 2
Chapter overview
1. CAPM
2. EMH
3. Agency theory
CAPM
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.
• Expected values → distributional averages
• Using mean return and risk, the investor can make risk-return trade-
off comparisons.
RISK AND RETURN FOR INDIVIDUAL ASSETS
• Mean returns

• Sample variance

• Sample standard deviation

RISK AND RETURN FOR PORTFOLIOS OF
ASSETS
• Smart investors understand that the risk of a portfolio is not simply
the average risk of the assets in the portfolio.
• “don’t put all your eggs in one basket.” (Diversification)
• Statistical measures of how random variables are related are
covariance and correlation.
RISK AND RETURN FOR PORTFOLIOS OF
ASSETS
• Covariance

• Correlation
RISK AND RETURN FOR PORTFOLIOS OF
ASSETS
• Portfolio mean returns

• Portfolio variance
THE OPTIMAL PORTFOLIO
THE OPTIMAL PORTFOLIO
• 40% High Tech & 60% Low Tech

• Standard deviation 12.88%

Systematic versus Unsystematic risk
CAPM
• 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 gauge of risk because it measures total risk, including
both diversifiable, firm-specific risk, and systematic, market risk.
• beta(β), takes into account an asset’s sensitivity to the market and,
thus, only measures systematic, nondiversifiable risk.
CAPM
Market Efficiency
EMH
• A better working definition of the EMH is that prices reflect all
information such that the marginal benefit of acting on the
information does not exceed the marginal cost of acquiring the
information. In other words, no investor can consistently generate
excess returns
• In finance, when we say “information,” we mean items that are truly
unanticipated.
JOINT HYPOTHESIS PROBLEM
• 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. This is innocuous if we know with certainty what the
correct risk-adjustment model is, but unfortunately we do not.
• For example: Value premium
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 the principal’s 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.
• Agency costs that arise from principal-agent problems are both direct and
indirect.
• Much finance theory has focused on how to design an optimal
compensation contract to align the interests of shareholders and
managers.
• To motivate agents, principals include rewards and penalties in
compensation contracts, which are referred to as “carrots and sticks.”