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Ingenieria FinancieraEfficient Market Theory, Market Risk and CAPM

9/14/2013

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financial markets are "informationally efficient

=

price of stocks and financial assets already

reflect all known information, and instantly change

to reflect new information (equilibrium)

Efficient Market Theory

Arguments:

100,000 or so full-time, highly trained, professional analysts and traders in

the market

fewer than 3,000 major stocks

each analyst follows 30 stocks, on average 1,000 analysts following each stock

SEC disclosure requirements and electronic information networks get new

information to the 1,000 analysts to evaluate it at about the same time

Therefore, the price of a stock will adjust almost immediately to any new

development.

Two proposals:

1. that stocks are always in equilibrium and

2. that it is impossible for an investor to consistently beat the market.

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Levels of Market Efficiency

Any information that comes from past stock prices is rapidly

incorporated into the current stock price.

Current market prices reflect allpubliclyavailable information Information from annual reports and any good or bad news has been priced

in when it was first announced

However, people withprivate information can earnconsistently abnormal returns

Also, whenever new information is released, prices react if

the information is different from expectations

Current marketprices reflect all information, whether publicly

available or privately held

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Weak Form

Semi-

strong

Form

Strong

Form

Source: 5 Minute MBA, Corporate Finance

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Pre-Announcement Abnormal Volume (Target and Matching Firm)

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Source: Rumors and Pre-Announcement Trading: Why Sell Target Stocks before Acquisition Announcements? Yuan Gaoa, * and Derek Olerb

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The Capital Asset Pricing Model (CAPM)

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Cost of Equity (Ke)

=

Rate of return required of a specific Stock, given its

riskiness

Ke = Rf+ (RM Rf)

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Beta relevant risk of an individual stock

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Calculating Wal-Marts beta

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Market Risk and Diversifiable Risk

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Source: 5 Minute MBA, Corporate Finance

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Risk Free Rate must be matched to our cash-flow horizon

Typically, long term

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3.75% - 4.5%

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Disneys Beta

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Required Rate

of Return

(discount rate)

In this case, Ke

Long term

Treasury

BondsRisk Free Returns

(Rf)

Market

Risk

Premium(RM - Rf)

Calculating Disneys Ke through CAPM

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Beta = 1.10

Disneys Ke = 4.5% + 1.10 (8.5) = 13.9%

5.4% to 8.5%(US)

3.75% to 4.5%

(US, 10-30y)

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Risk

Risk can be defined as the chance that some unfavorable event will occur.

Riskier assets must have higher returns

An assets risk consists of

1. diversifiable risk, which can be eliminated by diversification, plus2. market risk, which cannot be eliminated by diversification.

A stocks beta coefficient,, is a measure of its market risk.

measures the extent to which the stocks returns move relative to the market.

A high-beta stock is more volatile than an average stock, while a low-beta stock is less volatile than an

average stock.

An average stock has = 1.0.

The beta of a portfolio is a weighted average of the betas of the individual securities in theportfolio.

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