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Ch02.pdf
1.
Chapter 2: Foundations
of Finance II: Asset Pricing, Market Efficiency and Agency Relationships Powerpoint Slides to accompany Behavioral Finance: Psychology, Decision-making and Markets by Lucy F. Ackert & Richard Deaves ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part. 1
2.
Portfolio risk and
return • Return is a weighted average of returns of individual securities. • Risk is less than a weighted average of risks of individual securities – provided correlations are less than one. • The lower are correlations the lower is the risk of a portfolio. 2 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
3.
Two-security example 3 ©2010
Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
4.
Efficient set 4 ©2010 Cengage
Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
5.
Two-fund separation 5 ©2010 Cengage
Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
6.
Capital asset pricing
model (CAPM) • CAPM is an equilibrium model: it brings all investors together. • According to CAPM only risk related to market movements is priced by market. • This is because all other risk can be diversified away. • Beta is measure of nondiversifiable risk for a security. 6 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
7.
CAPM relationship and
beta 7 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
8.
CAPM equation CAPM equation: E(Ri)
= Rf + i * [E(Rm) – Rf] Notes: E(Rm) – Rf is market risk premium i = (Ri , Rm)/ 2(Rm) 8 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
9.
Market efficiency • Value
is what a security should be worth based on careful analysis. • Price is what the market says it is worth. • What is relationship between value and price if markets are efficient? – Older version of market efficiency says value and price are always identical. – More subtle and realistic version says they can sometimes differ a little. 9 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
10.
Operational definition of
market efficiency • Financial markets are efficient if no one can consistently earn excess returns. Excess means… – After risk is factored in – And after costs are factored in • What sort of costs? – Transaction costs – Analysis costs 10 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
11.
What should be
true if markets are efficient? • Security prices should respond quickly and accurately to new information. • Professional investors should not outperform net of all fees. • Simulated trading strategies should fail. 11 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
12.
Simulated trading strategies •
We can look at possible strategies using historical data and see if they would have earned excess returns. • These strategies must be based on information that was available. • If a strategy succeeds in generating excess returns, this is preliminary evidence against market efficiency. • But we need: – Statistical significance. – Consistency. – Beware of data mining! 12 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
13.
Market efficiency and
available information • Weak form: historical prices and returns • Semi-strong form: all public information • Strong form: all information, including private information 13 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
14.
Joint hypothesis problem •
All tests of market efficiency have two maintained hypotheses: – Markets are efficient. – A fair return on a security or portfolio is from a particular model (in early tests this model was usually CAPM). • Rejection means: – Markets are not efficient. – Method for calculating fair returns is faulty. – Or both. • But which? Joint hypothesis problem! 14 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
15.
Agency relationship and
agency problem • 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, agent has authority to make decisions for the principal. • An agency problem arises when the agent’s and principal’s incentives are not aligned. 15 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
16.
Agency costs • Agency
costs are incurred because managers’ incentives are not consistent with maximizing value of firm. • Direct costs: – Example: need to monitor managers, including cost of hiring outside auditors • Indirect costs: – Example: managers of a firm that is an acquisition target may resist the takeover attempt because of concern about keeping their jobs, even if the shareholders would benefit from merger 16 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
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