CAPM and Market Efficiency

A summary

Individuals are greedy, form rational expectations, and maximize their expected utility.

Individuals are greedy, form rational expectations, and maximize their expected utility.

Individuals are greedy, form rational expectations, and maximize their expected utility.

Individuals are greedy, form rational expectations, and maximize their expected utility.

We care about E(R) and We always produce the best estimates of cash flows,

given the information available

Individuals are greedy, form rational expectations, and maximize their expected utility.

Individuals are greedy, form rational expectations, and maximize their expected utility.

We care about E(R) and

We hold only efficient portfolios, according to individual risk preferences.

The efficient set is a curved line.

We always produce the best estimates of cash flows,

given the information available

Individuals are greedy, form rational expectations, and maximize their expected utility.

Individuals are greedy, form rational expectations, and maximize their expected utility.

We care about E(R) and

We hold only efficient portfolios, according to individual risk preferences.

The efficient set is a curved line.

We hold a mix of cash and the (efficient) M.The efficient set is a straight line.M becomes the yardstick for risk.

Risk-free assetRisk-free asset

We always produce the best estimates of cash flows,

given the information available

Individuals are greedy, form rational expectations, and maximize their expected utility.

Individuals are greedy, form rational expectations, and maximize their expected utility.

We care about E(R) and

We hold only efficient portfolios, according to individual risk preferences.

The efficient set is a curved line.

We hold a mix of cash and the (efficient) M.The efficient set is a straight line.M becomes the yardstick for risk.

Risk-free assetRisk-free asset

is a measures the relative risk.Risk premia per unit of relative risk is constant:

(Ri - Rf)/ = RM - Rf

is a measures the relative risk.Risk premia per unit of relative risk is constant:

(Ri - Rf)/ = RM - Rf

We always produce the best estimates of cash flows,

given the information available

Individuals are greedy, form rational expectations, and maximize their expected utility.

Individuals are greedy, form rational expectations, and maximize their expected utility.

We care about E(R) and

We hold only efficient portfolios, according to individual risk preferences.

The efficient set is a curved line.

We hold a mix of cash and the (efficient) M.The efficient set is a straight line.M becomes the yardstick for risk.

Risk-free assetRisk-free asset

is a measures the relative risk.Risk premia per unit of relative risk is constant:

(Ri - Rf)/ = RM - Rf

is a measures the relative risk.Risk premia per unit of relative risk is constant:

(Ri - Rf)/ = RM - Rf

We always produce the best estimates of cash flows,

given the information available

We all use the same yardstick for risk to estimate stock prices:

CAPM

Individuals are greedy, form rational expectations, and maximize their expected utility.

Individuals are greedy, form rational expectations, and maximize their expected utility.

We care about E(R) and

We hold only efficient portfolios, according to individual risk preferences.

The efficient set is a curved line.

We hold a mix of cash and the (efficient) M.The efficient set is a straight line.M becomes the yardstick for risk.

Risk-free assetRisk-free asset

is a measures the relative risk.Risk premia per unit of relative risk is constant:

(Ri - Rf)/ = RM - Rf

is a measures the relative risk.Risk premia per unit of relative risk is constant:

(Ri - Rf)/ = RM - Rf

We always produce the best estimates of cash flows,

given the information available

We all use the same yardstick for risk to estimate stock prices:

CAPM

Individuals are greedy, form rational expectations, and maximize their expected utility.

Individuals are greedy, form rational expectations, and maximize their expected utility.

We care about E(R) and

We hold only efficient portfolios, according to individual risk preferences.

The efficient set is a curved line.

We hold a mix of cash and the (efficient) M.The efficient set is a straight line.M becomes the yardstick for risk.

Risk-free assetRisk-free asset

is a measures the relative risk.Risk premia per unit of relative risk is constant:

(Ri - Rf)/ = RM - Rf

is a measures the relative risk.Risk premia per unit of relative risk is constant:

(Ri - Rf)/ = RM - Rf

We always produce the best estimates of cash flows,

given the information available

We all use the same yardstick for risk to estimate stock prices:

CAPM

Individuals are greedy, form rational expectations, and maximize their expected utility.

Individuals are greedy, form rational expectations, and maximize their expected utility.

We care about E(R) and

We hold only efficient portfolios, according to individual risk preferences.

The efficient set is a curved line.

We hold a mix of cash and the (efficient) M.The efficient set is a straight line.M becomes the yardstick for risk.

Risk-free assetRisk-free asset

is a measures the relative risk.Risk premia per unit of relative risk is constant:

(Ri - Rf)/ = RM - Rf

is a measures the relative risk.Risk premia per unit of relative risk is constant:

(Ri - Rf)/ = RM - Rf

We always produce the best estimates of cash flows,

given the information available

We all use the same yardstick for risk to estimate stock prices:

CAPM

Stock prices always represent the best estimation of future

dividends and risk.

Stock prices always represent the best estimation of future

dividends and risk.

Market efficiency says that...

There is no point in buying individual stocks, searching for bargains. They’re all correctly priced.

Buy the market index and adjust your cash position for risk (borrowing & lending)

Don’t delay that bond issue if interest rates are too high. They are never too high. Interest rates are always fair because they reflect future inflation and risk.

It doesn’t matter if you issue bonds or stock. The market cares only about how you invest the money, not about how you raise money and distribute the results.

In other words...

Stock prices move at random. There are no patterns in their movements.

Although we produce the best estimates of stock prices (we know their probability distribution), we cannot forecast their movement from one period to another.

Hence, we cannot beat the market.

If we can’t beat it, we should join it. Buy the market portfolio.

Buy and hold is as good as any other strategy

Market efficiency depends on:

• The investment behavior of individuals

• The availability of information

What if individuals are not rational?

Overreaction and persistent stock price patterns.

One can fool (the same) investors all the time.

What if information is not available to everyone?

Different forms of market efficiency

Market Efficiency

• Weak

• Semi-strong

• Strong

Why is market efficiency important?

Market efficiency is needed to allocate resources to the most productive users