Module 3

Portfolio Theory & Management

Portfolio Theory
 Harry Markowitz
• Harry Max Markowitz (born August 24, 1927)
is an American economist, recipient of the
1990 Nobel Memorial Prize in Economic
Sciences.
 Harry Markowitz Model

• Harry Markowitz put forward this model in 1952. It

assists in the selection of the most efficient by analyzing
various possible portfolios of the given securities.
• By choosing securities that do not 'move' exactly
together, the HM model shows investors how to reduce
their risk.
• The HM model is also called Mean-Variance Model due
to the fact that it is based on expected returns (mean)
and the standard deviation (variance) of the various
portfolios.
 Harry Markowitz made the following assumptions while developing the HM mode

1. Risk of a portfolio is based on the variability of returns from the said portfolio.
2. An investor is risk averse( avoid).
3. An investor prefers to increase consumption.
4. The investor's utility function is concave and increasing, due to his risk aversion
and consumption preference.
5. Analysis is based on single period model of investment.
6. An investor either maximizes his portfolio return for a given level of risk or
maximizes his return for the minimum risk.
7. An investor is rational in nature.

To choose the best portfolio from a number of possible portfolios, each with
different return and risk, two separate decisions are to be made:
1. Determination of a set of efficient portfolios.
2. Selection of the best portfolio out of the efficient set.
 Investor preference
a) From the portfolios that have the same
return, the investor will prefer the portfolio
with lower risk

(b) From the portfolios that have the same risk

level, an investor will prefer the portfolio with
higher rate of return.
 Determining the Efficient Set

(
• As the investor is rational, they would like to have higher return. And as he is risk averse, he
wants to have lower risk.

• [In Figure 1, the shaded area PVWP includes all the possible securities an investor can invest in.
• The efficient portfolios are the ones that lie on the boundary of PQVW. For example, at risk
level x2, there are three portfolios S, T, U.

• But portfolio S is called the efficient portfolio as it has the highest return, y 2, compared to T
and U. All the portfolios that lie on the boundary of PQVW are efficient portfolios for a given
risk level.

• The boundary PQVW is called the Efficient Frontier.

• All portfolios that lie below the Efficient Frontier are not good enough because the return
would be lower for the given risk. Portfolios that lie to the right of the Efficient Frontier would
not be good enough, as there is higher risk for a given rate of return.

• The Efficient Frontier is the same for all investors, as all investors want maximum return with
the lowest possible risk and they are risk averse.
 Achievable Set of Portfolio Combinations
Getting to the ‘n’ Asset Case

• In a real world investment universe with all of the investment

alternatives (stocks, bonds, money market securities, hybrid
instruments, gold real estate, etc.) it is possible to construct
many different alternative portfolios out of risky securities.
• Each portfolio will have its own unique expected return and
risk.
• Whenever you construct a portfolio, you can measure two
fundamental characteristics of the portfolio:
– Portfolio expected return (ERp)
– Portfolio risk (σp)

– The Capital Asset Pricing Model (CAPM) 9-9

The Achievable Set of Portfolio Combinations

• You could start by randomly assembling ten

risky portfolios.
• The results (in terms of ER p and σp )might
look like the graph on the following page:

– The Capital Asset Pricing Model (CAPM) 9 - 10

 Achievable Portfolio Combinations
The Two-Asset Case

• It is possible to construct a series of portfolios with different

risk/return characteristics just by varying the weights of the two
assets in the portfolio.
• Assets A and B are assumed to have a correlation coefficient of
-0.379 and the following individual return/risk characteristics

Expected Return Standard Deviation

Asset A 8% 8.72%
Asset B 10% 22.69%

The following table shows the portfolio characteristics for 100 different
weighting schemes for just these two securities:

– The Capital Asset Pricing Model (CAPM) 9 - 11

 Example of Portfolio Combinations and
Correlation
You repeat this
procedure down Expected Standard Correlation
until you have Asset Return Deviation Coefficient
determine the
A 8.0% 8.7% -0.379
portfolio
B 10.0% 22.7%
characteristics for
The first
all 100
Theportfolios.
second Portfolio Components Portfolio Characteristics
combination
portfolio assumes Expected Standard
99% simply
Nextin plot
A andthe1% Weight of A Weight of B Return Deviation
inreturns
assumes
B. Noticeonyou
a
the 100% 0% 8.00% 8.7%
graph (see
increase the
in return 99% 1% 8.02% 8.5%
invest
andnext
solely
slide)
the decrease 98% 2% 8.04% 8.4%
inin Assetrisk!
portfolio A 97% 3% 8.06% 8.2%
96% 4% 8.08% 8.1%
95% 5% 8.10% 7.9%
94% 6% 8.12% 7.8%
93% 7% 8.14% 7.7%
92% 8% 8.16% 7.5%
91% 9% 8.18% 7.4%
90% 10% 8.20% 7.3%
89% 11% 8.22% 7.2%

– The Capital Asset Pricing Model (CAPM) 9 - 12

Achievable Portfolio Combinations
The First Ten Combinations Created

ERp

10 Achievable Risky
Portfolio
Combinations

Portfolio Risk (σp)

– The Capital Asset Pricing Model (CAPM) 9 - 13

 Achievable Set of Portfolio Combinations
All Securities – Many Hundreds of Different Combinations

• When you construct many hundreds of

different portfolios naively varying the weight
of the individual assets and the number of
types of assets themselves, you get a set of
achievable portfolio combinations as indicated
on the following slide:

– The Capital Asset Pricing Model (CAPM) 9 - 14

The Achievable Set of Portfolio Combinations

• You could continue randomly assembling

more portfolios.
• Thirty risky portfolios might look like the graph
on the following slide:

– The Capital Asset Pricing Model (CAPM) 9 - 15

Achievable Portfolio Combinations
Thirty Combinations Naively Created

ERp

30 Risky Portfolio
Combinations

Portfolio Risk (σp)

– The Capital Asset Pricing Model (CAPM) 9 - 16

Achievable Portfolio Combinations
More Possible Combinations Created

The highlighted
portfolios are
ERp ‘efficient’ in that they
offer the highest rate
of return for a given
E is the level of risk.
minimum Rationale investors
variance will choose only from
portfolio Achievable Set of Risky this efficient set.
Portfolio Combinations

Portfolio Risk (σp)

– The Capital Asset Pricing Model (CAPM) 9 - 17

Achievable Portfolio Combinations
Efficient Frontier (Set)

Efficient
ERp frontier is the
set of
achievable
portfolio
combinations
Achievable Set of Risky that offer the
Portfolio Combinations
highest rate of
return for a
given level of
E
risk.

Portfolio Risk (σp)

– The Capital Asset Pricing Model (CAPM) 9 - 18

The Capital Asset Pricing Model

The Hypothesized Relationship

between Risk and Return
 Capital Asset Pricing Model - CAPM

• The model was introduced by William Sharpe, John Lintner and Jan Mossin
independently, building on the earlier work of Harry Markowitz on
diversification and modern portfolio theory.

“ A model that describes the relationship

between risk and expected return and that is
used in the pricing of risky securities. ”
 CAPM
1. The general idea behind CAPM is that investors need to be compensated in two
ways: time value of money and risk.

2. The time value of money is represented by the risk-free (rf) rate in the formula
and compensates the investors for placing money in any investment over a period
of time

3. The other half of the formula represents risk and calculates the amount of
compensation the investor needs for taking on additional risk.

4. This is calculated by taking a risk measure (beta) that compares the returns of the
asset to the market over a period of time and to the market premium (Rm-rf).

5. The CAPM says that the expected return of a security or a portfolio equals the
rate on a risk-free security plus a risk premium.

6. If this expected return does not meet or beat the required return, then the
investment should not be undertaken.
 CAPM is based on the following assumptions:
1. All investors have identical expectations about expected returns,
standard deviations, and correlation coefficients for all securities.
2. All investors have the same one-period investment time horizon.
3. All investors can borrow or lend money at the risk-free rate of
return (RF).
4. There are no transaction costs.
5. There are no personal income taxes so that investors are
indifferent between capital gains an dividends.
6. There are many investors, and no single investor can affect the
price of a stock through his or her buying and selling decisions.
Therefore, investors are price-takers.
7. Capital markets are in equilibrium.(A stable situation in which
forces cancel one another)
 capital allocation line CAL
• Combining a risky portfolio with a risk-free asset is the
process that supports the two- fund separation theorem,
which states that all investors’ optimum portfolios will be
made up of some combination of an optimal portfolio of
risky assets and the risk-free asset.
• The line representing these possible combinations of risk-
free assets and the optimal risky asset portfolio is referred
to as the capital allocation line.
 Capital Market Line - CML
A line used in the capital asset pricing model 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. The CML is derived by drawing a tangent
line from the intercept point on the efficient frontier to the
point where the expected return equals the risk-free rate of
return.

The CML is considered to be superior to the efficient frontier

since it takes into account the inclusion of a risk-free asset in
the portfolio.

The capital asset pricing model (CAPM) demonstrates that the

market portfolio is essentially the efficient frontier.
 Drawing the Capital Market Line

Step 1. Plot each portfolio onto

the Risk/Return Chart

R
e
t
u
r
n

Rp

Risk  p
 Drawing the Capital Market Line

Step 2. Freehand draw the efficiency frontier by joining the

outermost points to form a smooth curve

R
e
t
u
r
n

Rp

Risk  p
 Drawing the Capital Market Line

Step 3. Plot the risk free CML

P interest rate
o
r
t And then draw the capital
f market line from the risk free
ol point at a tangent (just
io nicking) to the efficiency
frontier
R
e
t
u
r
n

Rp
Risk  p
P CML
Super-efficient
o portfolio
r
t Efficient Portfolios
f Optimal
ol Portfolio
io Efficiency Frontier

R
e
t
u
r
n All portfolios below
efficiency frontier are
inefficient portfolios

Rp
Risk  p
– The slope of the CML is the incremental
expected return divided by the incremental
risk.
ER-RF
[9-4] Slope
ofthe
CML M

M

– This is called the market price for risk or the

equilibrium price of risk in the capital market.
– Solving for the expected return on a portfolio in the
presence of a RF asset and given the market price for
risk :

ER 
M - RF
[9-5] E
(RP) RF
 
 P
 σM 

– Where:
• ERM = expected return on the market portfolio M
• σM = the standard deviation of returns on the market portfolio
• σP = the standard deviation of returns on the efficient
portfolio being considered
 Security Market Line
• Unlike CML which Considers the Total risk as
measure of variability of returns SML takes
into account only systematic risk
• 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".
 Portfolio Risk
Portfolio risk is the weighted average of systematic
risk (beta) of the portfolio constituent securities.

Portfolio Beta $ Invested Weights

IBM 1.00 $2,500 0.125
GE 1.33 $5,000 0.25
Sears 0.67 $2,500 0.125
Pfizer 1.67 $10,000 0.5

ß P = (0.125)(1.00) + (0.25)(1.33) + (0.125)(0.67)

+ (0.50)(1.67) = 1.38
But portfolio volatility is not the same as the
weighted average of all portfolio security volatilities
 The Security Market Line
E(RP)
A - Undervalued SML
•

Slope = E(Rm) - RF =
RM • • Market Risk Premium

RF
• B - Overvalued
•
 =1.0 i
 SML
• The SML essentially graphs the results from the capital asset pricing model
(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. 
The security market line is a useful tool in determining whether an asset
being considered for a portfolio offers a reasonable expected return for
risk.

• Individual securities are plotted on the SML graph. If the security's risk

versus expected return is plotted above the SML, it is undervalued
 because the investor can expect a greater return for the inherent risk. 

• A security plotted below the SML is overvalued because the investor

would be accepting less return for the amount of risk assumed
 The Security Market Line
Plots relationship between expected return and
betas
• In equilibrium, all assets lie on this line.
• If individual stock or portfolio lies above the line:
• Expected return is too high.
• Investors bid up price until expected return falls.
• If individual stock or portfolio lies below SML:
• Expected return is too low.
• Investors sell stock driving down price until expected
return rises.
 SLM

Ra=Rf+ba(Rm-Rf)
The Capital Asset Pricing Model
 Application of CAPM

• Find the required return on a stock given that the risk-free rate is
8%, the expected return on the market portfolio is 12%, and the
beta of the stock is 2.
Ra=Rf+ba(Rm-Rf)
• Ra= 8% + 2(12% - 8%)
• Ra = 16%

• Note that you can then compare the required rate of return
to the expected rate of return. You would only invest in
stocks where the expected rate of return exceeded the
required rate of return.
40
 Application of CAPM

• Find the required return on a stock given that the risk-free rate is
10%, the expected return on the market portfolio is 14%, and the
beta of the stock is 1.5.

41
 Another CAPM Example

• Find the beta on a stock given that its expected return is 12%,
the risk-free rate is 4%, and the expected return on the market
portfolio is 10%.

42
• Ra=Rf+ba(Rm-Rf)
• 12% = 4% + bi(10% - 4%)
• bi = 12% - 4%
10% - 4%
• bi = 1.33

• Note that beta measures the stock’s volatility

(or risk) relative to the market.
 Limitations of the CAPM

1. The model makes unrealistic assumptions

2. The parameters of the model cannot be estimated precisely

- Definition of a market index
- Firm may have changed during the 'estimation' period'
3. The model does not work well
- If the model is right, there should be
– a linear relationship between returns and betas
• – the only variable that should explain returns is betas

- The reality is that

• the relationship between betas and returns is weak
• Other variables (size, price/book value) seem to explain differences in
returns better.
 Challenges to CAPM
• Empirical tests suggest:
– CAPM does not hold well in practice:
• Ex post SML is an upward sloping line
• Ex ante y (vertical) – intercept is higher that RF
• Slope is less than what is predicted by theory
– Beta possesses no explanatory power for predicting stock returns
(Fama and French, 1992)
• CAPM remains in widespread use despite the foregoing.
– Advantages include – relative simplicity and intuitive logic.
• Because of the problems with CAPM, other models have been
developed including:
– Fama-French (FF) Model
– Abitrage Pricing Theory (APT)

– The Capital Asset Pricing Model (CAPM) 9 - 45

The Process of Portfolio Management

46
Purpose of Portfolio Management
Portfolio management primarily involves
reducing risk rather than increasing return

Consider two Rs 10,000 investments:

1) Earns 10% per year for each of ten years (low risk)
2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, -12%,
and 10% in the ten years, respectively (high risk)

47
Low Risk vs. High Risk Investments

30,000.00

25,937
23,642
20,000.00

Low Risk

10,000.00 High Risk

10,000

0.00
200 200 200 200 200 200 200 200 200 200 200
2 2 2 2 2 2 2 2 2 2 2

48
Low Risk vs. High Risk Investments (cont’d)

1) Earns 10% per year for each of ten years (low risk)
– Terminal value is Rs25,937

2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, -

12%, and 10% in the ten years, respectively (high
risk)
– Terminal value is Rs 23,642

• The lower the dispersion of returns, the greater the

terminal value of equal investments

49
Portfolio Management Process
Determine the Investment Objectives
Choice asset mix
Formulation of portfolio strategy
Selection of securities
Portfolio execution
Portfolio revision
Performance evaluation
Quantifying
Expected
Capital Market Expectations
Return

Standar
d
Deviati
on
Correlation
with Other
Asset Classes
 Strategic Asset Allocation (SAA)
Strategic asset allocation (SAA) is a means to providing the
investor with exposure to the systematic risks of asset classes in
proportions consistent with the IPS.
Cash

Equities

Bonds

Real Estate
Alternative
Investments
Defining an Asset Class
Are all of these
specificationsBondsnecessary?
Government

Domestic

Foreign

Corporate

Investment Grade

High Yield
 EXAMPLE 7-9 Specifying Asset Classes
Asset class correlation matrix:
A B C D E F G H I J K L
A. MSCI Europe 1.00 0.77 0.95 0.97 0.88 0.20 0.59 –0.08 –0.35 0.10 –0.29 0.01
B. MSCI Emerging Markets 0.77 1.00 0.82 0.83 0.76 0.35 0.63 0.18 –0.25 0.22 –0.20 0.11
C. MSCI World 0.95 0.82 1.00 0.96 0.97 0.25 0.69 0.00 –0.31 0.18 –0.27 0.06
D. MSCI EAFE 0.97 0.83 0.96 1.00 0.88 0.27 0.65 –0.01 –0.34 0.15 –0.29 0.05
E. MSCI U.S. 0.88 0.76 0.97 0.88 1.00 0.20 0.70 –0.01 –0.27 0.18 –0.24 0.06
F. Commodities 0.20 0.35 0.25 0.27 0.20 1.00 0.27 0.25 –0.04 0.14 –0.07 0.14
G. Real Estate 0.59 0.63 0.69 0.65 0.70 0.27 1.00 0.18 –0.01 0.40 0.02 0.32
H. Gold –0.08 0.18 0.00 –0.01 –0.01 0.25 0.18 1.00 0.21 0.30 0.12 0.14
I. U.S. Treasuries –0.35 –0.25 –0.31 –0.34 –0.27 –0.04 –0.01 0.21 1.00 0.67 0.78 0.55
J. U.S. Investment Grade 0.10 0.22 0.18 0.15 0.18 0.14 0.40 0.30 0.67 1.00 0.61 0.79
K. European Government Bonds –0.29 –0.20 –0.27 –0.29 –0.24 –0.07 0.02 0.12 0.78 0.61 1.00 0.83
L. European Investment-Grade Corporates 0.01 0.11 0.06 0.05 0.06 0.14 0.32 0.14 0.55 0.79 0.83 1.00
Annualized Volatility 16.6% 20.7% 15.0% 15.4% 15.7% 25.4% 18.9% 16.6% 5.0% 6.0% 3.1% 3.2%

Sources: MSCI, NAREIT, Barclays Capital, Standard and Poor’s

• High-paired correlations between equity asset classes suggest

that defining equity asset classes narrowly has limited value.
• The case for treatment as a separate asset class can best be
made for emerging market stocks.
 Steps Toward an Actual Portfolio
Overall Portfolio Risk

Risk Budgeting

Strategic Asset Tactical Asset

Security Selection
Allocation Allocation
 Identifying the long term trends is the key

Past performance of various asset classes in the Indian context

1987-92 – Equities
51% (Avg yearly rolling return)

1992-96 – Real Estate

1996-98 – Fixed Income

11.4% ( Avg yearly rolling return FD

1998-00 – Technology Media Telecom

2000-03 – Fixed Income

22.6% (Avg yearly rolling return 10 yr G sec)

2003 - 2007 - Equities, Real Estate

40% (Avg yearly rolling return)

– Next 5 – 10 years - ?????

Returns for real estate are not provided due to difficulty in mapping returns across different regions of India
 Formulation of Portfolio Strategy

• Passive management Follows a predetermined investment

strategy that is invariant to market conditions

• Active management - Requires the periodic changing of the

portfolio components as the manager’s outlook for the market
changes
 Market Timing
 Sector Rotation
 Security Selection
 Use of Specialized Concept

• Core & Satellite Portfolio Management is an investment strategy

that incorporates traditional fixed-income and equity-based securities
(i.e. index funds, exchange-traded funds (ETFs), passive mutual
funds, etc.) known as the "core" portion of the portfolio, with a
percentage of selected individual securities in the fixed-income and
equity-based side of the portfolio known as the "satellite" portion.
58
Selection Of Securities

Selecting securities based on the Asset Circle

Bonds
Equity Shares Commodities
( Fixed Income )
30% 30%
40%

GovtBonds Common stock

Corporate Bonds
Gold
ADR’S
silver
FCCB’S GDR’S
59
 Performance evaluation

• Sharpe Ratio
• Treynor ratio
• Jensen Index (Alpha)
• Beta ( Refer Module 1 ppt)
 Sharpe Ratio

• Sharpe ratio which is used to measure risk-adjusted performance was

developed by Nobel laureate William F. Sharpe. The ratio is calculated by
subtracting the risk-free rate, (e.g., a 10-year U.S. Treasury bond), from
the expected rate of return for a portfolio and dividing the result by the
standard deviation of the portfolio returns.
• The Sharpe Ratio helps to identify that the returns on a particular
portfolio are on account of smart investment decisions or is just a result
of high risk. When one portfolio or fund generates returns higher than its
peers, it could be a result of a good investment decision only if those
higher returns do not carry too much additional risk.
• The greater a portfolio's Sharpe ratio, the better its risk-adjusted
performance has been. A negative Sharpe ratio indicates that an asset with
no risk would perform better than the security that is being analyzed.
• Suppose for a portfolio of steel stock, the
expected return is 17% and the standard
deviation of the portfolio is 5%. The risk-free
rate is 7%. Calculate the Sharpe ratio of the
portfolio.
 Treynor ratio

• Jack Treynor developed this ratio to measure the returns

that are earned in excess of that which could have been
earned on a riskless investment, per each unit of market
risk.
• In other words, the Treynor ratio is a risk-adjusted
measure of return based on systematic risk. It is quite
similar to the Sharpe ratio, with the only difference being
that the Treynor ratio measures volatility using beta.
• Suppose for a portfolio of power stock, the
expected return is 20% and the Beta of the
portfolio is 2. The risk-free rate is 10%.
Calculate the Treynor ratio of the portfolio.
 Jensen Index
• Jensen Index measures the risk-adjusted performance by
representing the average return on a portfolio, given the
portfolio's beta and the average market return. This is the
portfolio's alpha and hence this concept is sometimes
referred to as "Jensen's alpha."
• The average return of the portfolio that is measured in
Jensen’s index is over and above that predicted by the capital
asset pricing model (CAPM). The basic principle of Jenson’s
Index is to analyze the performance of the fund manager by
analyzing the overall return of a portfolio in conjunction with
the risk involved in that particular portfolio.
• rp = Expected portfolio return
• rf = Risk free rates
• βp = Beta of the portfolio
• rm = Expected market return
• If this value is positive, it implies that the
portfolio is earning excess returns for the risk
involved in a portfolio.
• Expected return and Beta of a portfolio of stocks
are 12% and 1.5 respectively. The expected
market return is 9% and risk free rate being 6%.
Calculate Jenson’s Index for the given portfolio.
• An asset pricing model based on the idea that an
asset's returns can be predicted using the
relationship between that same asset and many
common risk factors. Created in 1976 by Stephen
Ross, this theory predicts a relationship between
the returns of a portfolio and the returns of a single
asset through a linear combination of many
independent macro-economic variables.
• APT uses the risky asset's expected return and the risk
premium of a number of macro-economic factors.
Arbitrageurs use the APT model to profit by taking
advantage of mispriced securities. A mispriced security
will have a price that differs from the theoretical price
predicted by the model. By going short an over priced
security, while concurrently going long the portfolio the
APT calculations were based on, the arbitrageur is in a
position to make a theoretically risk-free profit.
THE EFFICIENT MARKET
HYPOTHESIS (EMH)
 Random Walk & Efficient Market
Hypothesis (EMH)

“Random walk refers to the notion that

stock price changes are random and
unpredictable.”

“ EMH – the hypothesis that prices of

securities fully reflect available information
about securities.”
 Assumptions Of Random Walk
• Markets are supreme and no individuals investor group can
influence it
• stock price discount all information quickly
• Markets are efficient and the flow of information is free and
unbiased
• All investors have free access to the same information and
nobody has superior knowledge or expertise
• Market quickly adjust itself to any deviation from the
equilibrium level due to the operation of free forces of
demand and supply
• Market prices change only on the information relating to the
fundamentals when equilibrium level may shift
• These prices move in the independent fashion without undue
pressures or the manipulation
• No insider information
• Investor behave in rational manner and demand and supply
forces are the result of rational investment decisions
• Institutional investors or any major fund managers have to
follow the market and markets cannot be influence by them
• A large number of buyers and sellers and perfect market
conditions of competition will prevail
 Efficient Stock Market

Efficient Stock market is one in which current market

prices of shares reflect available information such
that it is impossible to outperform the market.

• Arrival of new information leads to price

changes
• The measure of efficiency is seen in the
extent and speed with which the market
reflects new information in the share price.
 Issues in Market Efficiency
• Equivalent securities must be traded at the same
price. This is the Law of One Price.

• This law assumes that no Arbitrage

Opportunities exist i.e. simultaneously and
buying and selling of the same security thereby
making profit and incurring no risk.

• In an efficient market, arbitrage activities will

continue until the price differential that gives rise
to the arbitrage profit is eliminated.
 Information and Market Efficiency

Information can be classified into three:

(i) Historical information: past movements and trends in share prices as an

indicator of the performance of companies

(ii) Current information: current movements and trends in share prices as

well as in the performance of companies

(iii) Forecast information: information about future movements and trends in

share prices as and in the performance of
companies
 The Efficient Market Hypothesis

This is the hypothesis that stock prices fully

reflect available information.

Three levels of Efficient Market Hypothesis:

• (i) The Weak Form Efficient
• (i) The Semi-strong Form Efficient
• (i) The Strong Form Efficient
 Weak Form Efficient

• Current share prices fully reflect all

information contained in past price
movements.
• It is a waste of time trying to predict future
price movements by analyzing trends in past
price movements i.e. trend analysis is
fruitless
• Prices fluctuate randomly or follow
randomwalk.
 Semi-Strong Form Efficient

Current market prices reflect both past price

movements and publicly available information.

• No profit analyzing existing information provided in

published financial statements.
• It is a waste of time analyzing dividend and profits
announcements, appointment of new chief executives
or product breakthrough, other new discoveries, etc.
since the market have already capture these.
 Strong Form Efficient

• Current market price reflects all relevant

information even if privately held.

• The current market price reflects the intrinsic

value of the shares based on the underlying
future cash flows.

• By implication: no one can consistently beat the

market by earning abnormal returns.