Financial News Discussion
BabyTazz21
CF5e_PPT_Ch06-Part2.pptx1
Ehrhardt & Brigham
Corporate Finance:
A Focused Approach 5e
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CHAPTER 6
Capital Asset Pricing Model
Efficient Market Hypothesis
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Market Risk Due to an Individual Stock
How do you measure the amount of market risk that an individual stock brings to a well-diversified portfolio?
William Sharpe developed the Capital Asset Pricing Model (CAPM) to answer this question.
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Market Risk and Beta
Beta is a measure of the volatility–or systematic risk–of a security or portfolio compared to the market as a whole.
Beta is used in the capital asset pricing model (CAPM), which describes the relationship between systematic risk and expected return for assets (usually stocks).
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Required Return and Risk: General Concept
Investors require a return for time (for tying their funds up in the investment).
rRF, the risk-free rate (e.g. T-Bills)
Investors require a return for risk, which is the extra return above the risk-free rate that investors require to induce them to invest in Stock i.
RPi, the risk premium of Stock i.
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Required Return and Risk: The CAPM
RPM is the market risk premium. It is the extra return above the risk-free rate that that investors require to invest in the stock market:
RPM = rM − rRF.
The CAPM defines the risk premium for Stock i as:
RPi = bi (RPM)
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The Security Market Line: Relating Risk and Required Return
Risk depends on beta: bi
Required return (ri) depends on beta:
CAPM Formula:
ri = rRF + bi (RPM)
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Beta for Blandy
Use the previously calculated standard deviations for Blandy and the market to estimate Blandy’s beta:
0.60
The average beta is equal to 1.0, so Blandy’s stock contributes less risk to a well-diversified portfolio than does the average stock.
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Required Return for Blandy
Inputs:
rRF = 4% (given)
RPM = 5% (given)
b = 0.60 (given – however estimated with a regression model)
CAPM: ri = rRF + bi (RPM)
ri = 4% + 0.60(5%) = 7%
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Web Sites for Beta
Enter the ticker symbol for a “Stock Quote”, such as IBM or Dell, then click GO.
When the quote comes up, select Key Statistics from panel on left.
Enter a ticker symbol at the top of the page.
Most stocks have betas in the range of 0.5 to 1.5.
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Efficient Market Hypothesis (EMH): It’s all about the info.
The EMH asserts that when new information arrives, prices move to the new equilibrium price very, very quickly because:
There are many really smart analysts looking for mispriced securities.
New information is available to most professional traders almost instantly.
When mispricing occurs (due to new info or inefficient markets), analysts have billions of dollars to use in taking advantage of the mispricing– which then quickly eliminates the mispricing.
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Implications of Efficient Market Hypothesis (EMH)
Stocks are normally in equilibrium.
One cannot “beat the market” by consistently earning a return higher than is justified by a stock’s risk.
There are thee form of Market Efficiency mentioned in the book. This is theoretical so read about it. However, this is high theoretical material so it is not used in the real world.
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Market Bubbles and Market Efficiency
Market bubbles:
Prices climb rapidly to heights that would have been considered extremely unlikely before the run-up.
Trading volume is unusually high.
Many new investors (or speculators?) eagerly enter the market.
Prices suddenly fall precipitously.
What does this imply about the EMH?
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Bubbles are hard to puncture.
If there is a bubble, why don’t traders take positions that make big profits when the bubble bursts?
It is hard to recognize a bubble until after it bursts—then it seems obvious!
Trading strategies expose traders to possible big negative cash flows if the bubble is slow to burst.
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Market Efficiency: The Bottom Line
For most stocks, for most of the time, it is generally safe to assume that the market is reasonably efficient.
Many investors have given up trying to beat the market, which helps explain the popularity of index funds.
However, bubbles do occur infrequently. Not true.
Bubbles happen every 10 years based on historical data
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