Basis of EMH (7)
- price is always right
- no bargains to be had
- sufficient buyers and sellers in the market to ensure the price is correct
- fund manager can not add value
- EMH supports passive investment
- everybody knows all information / nobody knows anything that anybody else doesn’t know
- because information is priced into the market
Three types of believers of the EMH
1) weak form believer - no benefit to be had from technical analysis (charts)
2) semi strong believer - no benefit to be had from technical or fundamental analysis (co. acc’s)
3) no benefit to be had from technical or fundamental analysis OR any information you have (everyone knows everything)
CAPM
- says that because non systematic risk (investment specific) can be eliminated through diversification it is not rewarded
- it is the sensitivity of the security to the market that is the appropriate measure of risk (systematic/market risk)
- CAPM provides the relationship between a securities systematic risk and its expected return
- do that securities with higher leaflets of market risk/beta can be expected to have higher returns in a rising market
(CAPM) what is beta?
- market has a beta of 1
- beta of an individual security reflects the extent to which a securities returns move up and down with the market
According to CAPM:
- security with a beta of 1 will move up and down exactly with the market
- if beta is more than 1 the this exaggerates the market movement and is more volatile than the market
- if market goes up then security goes up by more
- if market goes down then security goes down by more
- know as aggressive securities
- if beta is less than 1 then the opposite will happen
- more stable than the market
- know as defensive securities
CAPM equation
Er = Rf + Bi(Rm-Rf)
Er = Expected return Rf = risk free rate of return Bi = beta of investment Rm = expected return is the market
Shows expected return for a security as a combination of the risk free rate of return and compensation for holding a risky asset I.e. risk premium
Assumptions for CAPM (7)
- investors are rational and risk averse, making decisions based on risk and return alone
- all investors have identical holding periods
- market comprises many buyers and sellers and no individual can affect market price
- no taxes or transaction costs
- information is free and simultaneously available to all investors
- all investors can borrow and lend money at the risk free rate
- quantity of securities in the market is fixed and are all fully marketable (so liquidity is ignored)
Limitations of CAPM (3)
Unrealistic assumptions:
- assumes all investors and borrow unlimited funds at risk free rate
- assumes no taxes or charges
- assumes investors are rational and risk averse
- assumes market is efficient
- assumes all investors have access to all information
- single factor model
- based on historic data
- difficultly identifying risk free rate
- doesn’t work in the real world
1) what to use as risk feee rate!
- Finding a totally risk free rate is difficult.
- common practice to use TBills
- 91 day money market instruments issues by UK government
- they are virtually default risk free and due to their short life, interest rate and inflation risks are minimal
2) what is the market portfolio
- in theory CAPM uses all risky investments worldwide but in reality it usually uses an index from a particular country’s market eg FTSE 100 or all share
- betas on each index are significantly different
- so questionable whether indices represent the true market
- if true market is not used then correct beta for the security can not be determined
3) suitably of beta
- for CAPM to be useful the beta must be stable
- beta is calculated based on historic data and do not seem to be stable
- so questions reliability as a guide to estimating future risk
- some studies particularly in US show CAPM to be incorrect
- some show securities with low beta to return more than CAPM predicts and those with high beta to return less
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Criticisms of CAPM (7)
- investors are rational and risk averse, making decisions based on risk and return alone
- all investors have identical holding periods
- market comprises many buyers and sellers and no individual can affect market price
- no taxes or transaction costs
- information is free and simultaneously available to all investors
- all investors can borrow and lend money at the risk free rate
- quantity of securities in the market is fixed and are all fully marketable (so liquidity is ignored)
ALSO:
- single factor model
- based on historic data
- difficult to identify risk free rate
- not a good indicator in practice / doesn’t work
Why are momentum, size and value used in multi factor models? (3)
- Momentum - shares of companies who have increased in price over the past 6-12 months tend to continue to outperform and this is not explained by CAPM
- Value - undervalued companies measured by price to book tend to outperform
- Size - small company shares tend to outperform larger companies
Multi factor models
CAPM is described as a single factor model as it is only concerned with one factor:
- the security’s sensitively to the market (as measured by beta)
Multi factor models attempt to describe security returns as a function of a number of factors.
Eg value, size, momentum
Multi factor models all differ but tend to share two main ideas:
- investors require extra risk for taking risk
- concerned with risk that can not be eliminated by diversification
Problems are-
- Different betas need to be calculated for each factor
- trouble identifying all the relevant factors
Multi factor models
CAPM is described as a single factor model as it is only concerned with one factor:
- the security’s sensitively to the market (as measured by beta)
Multi factor models attempt to describe security returns as a function of a number of factors.
Eg value, size, momentum
Multi factor models all differ but tend to share two main ideas:
- investors require extra risk for taking risk
- concerned with risk that can not be eliminated by diversification
