FINANC 3000 1st Edition Lecture 16 Outline of Last Lecture I. Forming PortfoliosII. Modern Portfolio TheoryIII. DiversificationIV. Expected ReturnV. Expected Return and CorrelationOutline of Current Lecture I. Measuring Market RiskII. Risk and ReturnIII. Security Market LineIV. CAPMV. Portfolio BetaVI. Capital Market EfficiencyCurrent LectureMarket Risk Premium- Market risk premium – investors are rewarded for taking risko Only rewarded for taking market risk, not firm specific risko Firm specific risk can be diversified away, so reward for mistakes or ignoranceo Risk premium between well diversified portfolio and risk free security(T-bills)- How to determine how much of standard deviation for a stock is for firm specific risk, how much is for market risk?o Answer allows us to figure out our required return for stockThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.Measuring Market Risk- β (Beta) the summary financial risk factor- Beta coefficient – the amount of systematic (nondiversifable) risk present in a particular risky asset relative to that of an market portfolio. Measures co-movement between a stock and the market portfolio- Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock marketindex, such as the S&P 500, is used to represent the market.- β <1.0 = Defensive stocks Beta of Caterpillar vs. Ameren- Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta (β ) of the security.(remember benefit of diversification)- Beta measures the responsiveness of a security to movements in the market portfolio.oRisk and Return- Expected Return on the Market:o Rm=Rf + market risk premium- Market Risk Premium - Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills. The reward for bearing as much risk as the market. o Historically, this has been about 8%.Risk and Return: Market Risk Premium- Expected return on an individual securityo E(r)= RF+Bi x (Rm-RF)- Beta compensates for relative market risk. The rest is firm for firm specific events- Higher risk companies have higher beta and require higher returnso This applies to individual securities when held within well-diversified portfoliosSecurity Market Line- The higher the beta -> the higher the risk premium the investors will demand for that security- Security market line – illustrates how return relates to risk at any particular time- To quantify the relationship, we can use the equation for the line:o y = b +mxCAPMβi=Cov( Ri ,RM)σ2( RM)- This formula is called the Capital Asset Pricing Model (CAPM)o E(r)= RF+Bi x (Rm-RF)- Assume βi = 0, then the expected return is RF.- Assume βi = 1, then- Defensive beta < 1. Exxon beta = 0.6Portfolio Beta- Portfolio’s Beta is the weighted average of the portfolio stocks’ beta.o- Using this formula will allow you to determine how adding new stock will affect the risk of the portfolio- Adding higher risk beta than beta of portfolio will increase risk, adding lower beta stock will lower riskConcerns with Beta- Using different time periods , will result in different beta(and different expected return)- Using different benchmarks as market rate will return in different beta- Beta measures historical return, does it apply to the future if the company’s operations change?- Best to add additional factors to the predictive model in addition to betaCapital Market Efficiency- Risk and return relationship relies on assumptions that stock prices are generally “correct”- Undervalued stocks would be bought, increasing price to reflect correct value(expected value for the risk)- Overpriced stocks would be sold to decrease price to reflect correct value(expected value for the risk)- Conditions necessary for efficient markets: o Many buyers and sellerso No high barriers to entryo Free and available information o Low trading or transaction costs- U.S. Stock market meets these conditionso Millions of stock investors trade everydayo Low trading fees through discount brokerso High availability of informationEfficient Market Hypothesis- Efficient Market Hypothesis states that security prices fully reflect all available informationo Security prices change as new information becomes availableo Can’t predict if new information is going to be good or bad hence can’t predict stock prices- What information is embedded in stock prices?- Three basic levels of market efficiency:o Weak formo Semi-strong formo Strong formWeak Form Efficiency- Current prices reflect all information derived from tradingo Includes current and past stock prices and trading volume- Segment of investment industry uses prices and volume charts to make investment timing decisions – technical analysiso If market is at least weak form efficient then this information is already reflected in pricesSemi-strong Form Efficiency- Current prices reflect all available public informationo Includes weak form as subseto Includes information like financial statements, news, analysts’ opinionso In this case security analysis using publically available information is useless because that information is already reflected in stock priceo Prices will react only to new(private) informationStrong Form Efficiency- Current prices reflect all informationo Public and private informationo Executive management usually knows information that hasn’t been released to publico If they trade on this information prices would change to reflect this private informationo Firm’s managers, accountants and auditors know private information days in advanceo If private information is incorporated, price wouldn’t change with announcementIs Market Strong Form Efficient?- Probably not, insider trading is illegal- There is some evidence that market is semistrong form efficient or weak-form efficient- There is also evidence that stock market is not efficient at allBehavioral Finance- People behave in “irrational” wayso Both optimism and pessimism can be extremeo Overconfidence is tendency to overestimate knowledge and underestimate risk o Overconfidence creates stock market bubbleso Pessimism tends to exacerbate the market crashes- Housing market bubble, tech stocks bubbleConstant Growth Model- CAPM and Constant Growth Models