The capital market theory builds upon the Markowitz

portfolio model. The main assumptions of the capital

market theory are as follows:

1. All Investors are Efficient Investors -

Investors follow Markowitz idea of the
efficient frontier and choose to invest in
portfolios along the frontier.

2. Investors Borrow/Lend Money at the

Risk-Free Rate - This rate remains static
for any amount of money.

3. The Time Horizon is equal for All

Investors - When choosing investments,
investors have equal time horizons for the
choseninvestments.

4. All Assets are Infinitely Divisible - This indicates that fractional shares can be purchased and
the stocks can be infinitely divisible.

5. No Taxes and Transaction Costs -assume that investors' results are not affected by taxes and
transaction costs.

6. All Investors Have the Same Probability for Outcomes -When determining the expected
return, assume that all investors have the same probability for outcomes.

7. No Inflation Exists - Returns are not affected by the inflation rate in a capital market as none
exists in capital market theory.

8. There is No Mispricing Within the Capital Markets - Assume the markets are efficient and
that no mispricings within the markets exist.

What happens when a risk-free asset is added to a portfolio of risky assets?

To begin, the risk-free asset has a standard deviation/variance equal to zero for its given level of return,
hence the "risk-free" label.

• Expected Return - When the Risk-Free Asset is Added

Given its lower level of return and its lower level of risk, adding the risk-free asset to a portfolio
acts to reduce the overall return of the portfolio.

Example: Risk-Free Asset and Expected Return

Assume an investor's portfolio consists entirely of risky assets with an expected return of 16%
and a standard deviation of 0.10. The investor would like to reduce the level of risk in the
 portfolio and decides to transfer 10% of his existing portfolio into the risk-free rate with an
expected return of 4%. What is the expected return of the new portfolio and how was the
portfolio's expected return affected given the addition of the risk-free asset?

Answer:
The expected return of the new portfolio is: (0.9)(16%) + (0.1)(4%) = 14.4%

With the addition of the risk-free asset, the expected value of the investor's portfolio was
decreased to 14.4% from 16%.

• Standard Deviation - When the Risk-Free Asset is Added

As we have seen, the addition of the risk-free asset to the portfolio of risky assets reduces an
investor's expected return. Given there is no risk with a risk-free asset, the standard deviation of
a portfolio is altered when a risk-free asset is added.

Example: Risk-free Asset and Standard Deviation

Assume an investor's portfolio consists entirely of risky assets with an expected return of 16%
and a standard deviation of 0.10. The investor would like to reduce the level of risk in the
portfolio and decides to transfer 10% of his existing portfolio into the risk-free rate with an
expected return of 4%. What is the standard deviation of the new portfolio and how was the
portfolio's standard deviation affected given the addition of the risk-free asset?

Answer:
The standard deviation equation for a portfolio of two assets is rather long, however, given the
standard deviation of the risk-free asset is zero, the equation is simplified quite nicely. The
standard deviation of the two-asset portfolio with a risky asset is the weight of the risky assets in
the portfolio multiplied by the standard deviation of the portfolio.

Standard deviation of the portfolio is: (0.9)(0.1) = 0.09

Similar to the affect the risk-free asset had on the expected return, the risk-free asset also has
the affect of reducing standard deviation,
risk, in the portfolio.

17.10 - The Capital Market Line

As seen previously, adjusting for the risk of an asset
using the risk-free rate, an investor can easily alter
his risk profile. Keeping that in mind, in the context
of the capital market line (CML), the market
portfolio consists of the combination of all risky
assets and the risk-free asset, using market value of
the assets to determine the weights. The CML line
is derived by the CAPM, solving for expected return
at various levels of risk.

Markowitz' idea of the efficient frontier, however, did

not take into account the risk-free asset. The CML does and, as such, the frontier is extended to the risk-
free rate as illustrated below:

Systematic and Unsystematic Risk

Total risk to a stock not only is a function of the risk inherent within the stock itself, but is also a function of
the risk in the overall market. Systematic risk is the risk associated with the market. When analyzing the
risk of an investment, the systematic risk is the risk that cannot be diversified away.

Unsystematic riskis the risk inherent to a stock. This risk is the aspect of total risk that can be diversified
away when building a portfolio.

Formula 17.10

Total risk = Systematic risk + Unsystematic risk

When building a portfolio, a key concept is to gain

the greatest return with the least amount of
risk. However, it is important to note, that additional
return is not guaranteed for an increased level of
risk. With risk, reward can come, but losses can be
magnified as well.

17.11 - The Capital Asset Pricing Model

(CAPM)
The capital asset pricing model (CAPM) is a model
that calculates expected return based on expected
rate of return on the market, the risk-free rate and
the beta coefficient of the stock.
 Formula 17.11

E(R) = Rf + B(Rf - Rmarket)

Example: CAPM model

Determine the expected return on Newco's stock using the capital asset pricing model. Newco's beta is
1.2. Assume the expected return on the market is 12% and the risk-free rate is 4%.

Answer:
E(R) = 4% + 1.2(12% - 4%) = 13.6%.

Using the capital asset pricing model, the expected return on Newco's stock is 13.6%.

The Security Market Line (SML)

Similar to the CML, the SML is derived from the CAPM, solving for expected return. However, the level of
risk used is the Beta, the slope of the SML.

The SML is illustrated below:

Beta
Beta is the measure of a stock's sensitivity of returns to changes in the market. It is a measure of
systematic risk.

Formula 17.12

Beta = B = Covariance of stock to the market

Variance of the market
Example: Beta
Assume the covariance between Newco's stock and the market is 0.001 and the variance of the market is
0.0008. What is the beta of Newco's stock?

Answer:

BNewco = 0.001/0.0008 = 1.25

Newco's beta is 1.25.

Determing Whether a Security is Under-, Over- or Properly Valued

As discussed, the SML line can be derived using CAPM, solving for the expected return using beta as the
measure of risk. Given that interpretation and a beta value for a specific security, we can then determine
the expected return of the security with the CAPM. Then, using the expected return for a security derived
from the CAPM, an investor can determine whether a security is undervalued, overvalued or properly
valued.

Example:Calculate the expected return on a security and evaluate whether the security is
undervalued, overvalued or properly valued.
An investor anticipates Newco's security will reach $30 by the end of one year. Newco's beta is
1.3. Assume the return on the market is expected to be 16% and the risk-free rate is 4%. Calculate the
expected return of Newco's stock in one year and determine whether the stock is undervalued,
overvalued or properly valued with a current value of $25.

Answer:

E(R)Newco = 4% + 1.3(16% - 4%) = 20%

Given the expected return of Newco's stock using CAPM is 20% and the investor anticipates a 20%
return, the security would be properly valued.

• If the expected return using the CAPM is higher than the investor's required return, the security
is undervalued and the investor should buy it.
• If the expected return using the CAPM is lower than the investor's required return, the security is
overvalued and should be sold.

The Characteristic Line

The characteristic line is line that occurs when an individual asset or portfolio is regressed to the
market. The beta is the slope coefficient for the characteristic line and is thus the measure of systematic
risk for the asset or portfolio. Recall, a beta is the measure of a stock's sensitivity of returns to changes in
the market. It is a measure of systematic risk.

12.12 - The Efficient Market Hypothesis

What is An Efficient Capital Market?
An efficient capital market is a market that reflects
all available news and information. An efficient
market is also quick to absorb new information and
adjust stock prices relative to that information. This
is known as an informationally efficient
market. Generally, efficient markets are expected to
reflect all available information. If that is not the
case, investors with the information may benefit
leading to abnormal returns.

The following are the main assumptions for a

market to be efficient:
• A large number of investors
analyze and value securities for
profit.
• New information comes to the
market independent from other
news and in a random fashion.
• Stock prices adjust quickly to new information.
• Stock prices should reflect all
available information.

To learn more about the Efficient Market

Hypothesis, please take a look the following
article: Working Through the Efficient Market
Hypothesis
12.13 - Weak, Semi-Strong and Strong EMH
The Three Basic Forms of the EMH

The efficient market hypothesis assumes that

markets are efficient. However, the efficient market
hypothesis (EMH) can be categorized into three
basic levels:

1.Weak-form EMH
2.Semi-strong form EMH
3.Strong-from EMH

1. Weak-Form EMH
The weak-form EMH implies that the market is efficient, reflecting all market information. This hypothesis
assumes that the rates of return on the market should be independent; past rates of return have no effect
on future rates. Given this assumption, rules, such as the ones traders use to buy or sell a stock, are
invalid.

2. Semi-Strong EMH
The semi-strong form EMH implies that the market is efficient, reflecting all publicly available
information. This hypothesis assumes that stocks adjust quickly to absorb new information. The semi-
strong form EMH also incorporates the weak-form hypothesis. Given the assumption that stock prices
reflect all new available information and investors purchase stocks after this information is released, an
investor cannot benefit over and above the market by trading on new information.
3. Strong-Form EMH
The strong-form EMH implies that the market is efficient: it reflects all information both public and
private, building and incorporating the weak-form EMH and the semi-strong form EMH. Given the
assumption that stock prices reflect all information (public as well as private) no investor would be able to
profit above the average investor even if he was given new information.

Weak Form Tests

The tests of the weak form of the EMH can be categorized as:

1.Statistical tests for independence

2. Trading tests

1. Statistical Tests for Independence

In our discussion on the weak-form EMH, we stated that the weak-form EMH assumes that the rates of
return on the market are independent. Given that assumption, the tests used to examine the weak form of
the EMH test for the independence assumption. Examples of these tests are the autocorrelation tests
(returns are not significantly correlated over time) and runs tests (stock price changes are independent
over time).

2. Trading Tests
Another point we discussed regarding the weak-form EMH is that past returns are not indicative of future
results, therefore, the rules that traders follow are invalid. An example of a trading test would be the filter
rule, which shows that after transaction costs, an investor cannot earn an abnormal return.

Semi-strong Form Tests

Given that the semi-strong form implies that the market is reflective of all publicly available information,
the tests of the semi-strong form of the EMH are as follows:

1. Event Tests
The semi-strong form assumes that the market is reflective of all publicly available information. An event
test analyzes the security both before and after an event, such as earnings. The idea behind the event
test is that an investor will not be able to reap an above average return by trading on an event.

2. Regression/Time Series Tests

Remember that a time series forecasts returns based historical data. As a result, an investor should not
be able to achieve an abnormal return using this method.

Strong-Form Tests
Given that the strong-form implies that the market is reflective of all information, both public and private,
the tests for the strong-form center around groups of investors with excess information. These investors
are as follows:

1. Insiders
Insiders to a company, such as senior managers, have access to inside information. SEC regulations
forbid insiders for using this information to achieve abnormal returns.

2. Exchange Specialists
An exchange specialist recalls runs on the orders for a specific equity. It has been found however, that
exchange specialists can achieve above average returns with this specific order information.

3. Analysts
The equity analyst has been an interesting test. It analyzes whether an analyst's opinion can help an
investor achieve above average returns. Analysts do typically cause movements in the equities they focus
on.

4. Institutional money managers

Institutional money managers, working for mutual
funds, pensions and other types of institutional
accounts, have been found to have typically not
perform above the overall market benchmark on a
consistent basis.

12.14 - Market Anomalies

1.Earnings Reports

It has been shown that an investor can profit from

investing immediately when a company reports
because it takes time for the market to absorb the
new information. This goes against the EMH.

2.January Anomaly
The January effect goes against the
EMH. Essentially the January effect indicates that as a result of tax-related moves, investors have been
shown to profit by buying stocks in December as they are being sold for losses and then selling them
again in January.

3.Price-Earnings Ratio
Investing using the P/E ratio valuation metric has been an anomaly against the EMH. It has been shown
that investors can profit by investing in companies with a low P/E ratio.

4.Price-Earnings/Growth (PEG) Ratio

Investing using the PEG valuation metric has been anomaly against the EMH. It has been shown similar
to the P/E ratio that investors profit by investing in companies with low PEG ratios.

5.Size Effect
Going against EMH, it has been shown that smaller companies, on a risk-adjusted basis, have greater
returns their larger peers.

6.Neglected Firms
Neglected firms are firms that Wall Street analysts deem too small to cover. As a result, these firms tend
to generate larger levels of return, negating the EMH.

Overall Conclusions About Each Form of the EMH

• Weak-Form EMH
The weak-form EMH is supported by the tests and analysis done. Essentially, the weak-form
holds that abnormal returns are not achievable with the use of past-historical data as a means to
generate returns.
• Semi-strong Form EMH
The semi-strong form EMH, at times, is both supported and not supported by the tests and
analysis done. There has been some evidence that securities are not reflective of the semi-
strong form EMH.
 • Strong Form EMH
It appears from the tests and analysis performed, that the strong-form EMH does hold. While
insiders and specialists do have access to
private information, SEC regulations forbid
this information to be used.

12.15 - Implications of Efficient Markets

EMH and Technical Analysis

Technical analysis bases decisions on past

results. EMH, however, believes past results cannot
be used to outperform the market. As a result, EMH
negates the use of technical analysis as a means to
generate investment returns.

With respect to fundamental analysis, the EMH also

states that all publicly available information is
reflected in security prices and as such, abnormal returns are not achievable through the use of this
information. This negates the use of fundamental analysis as a means to generate investment returns.

EMH and the Portfolio Management Process

As we have discussed, the portfolio management process begins with an investment policy statement,
including an investor's objectives and constraints. Given EMH, the portfolio management process should
thus, not focus on achieving above-average returns for the investor. The portfolio management process
should focus purely on risks given that above average returns are not achievable.

A portfolio manager's goal is to outperform a specific benchmark with specific investment ideas. The EMH
implies that this goal is unachievable. A portfolio manager should not be able to achieve above average
returns.

Why Invest in Index Funds?

Given the discussion on the EMH, the overall assumption is that no investor is able to generate an
abnormal return in the market. If that is the case, an investor can expect to make a return equal to the
market return. An investor should thus focus on the minimizing his costs to invest. To achieve a market
rate of return, diversification in a numerous amounts of stocks is required, which may not be an option for
a smaller investor. As such, an index fund would be the most appropriate investment vehicle, allowing the
investor to achieve the market rate of return in a cost effective manner.

Conclusion
Within this section we have discussed the organization and function of securities markets, the
composition and characteristics of the various weighting schemes, and the various implications of the
efficient market hypothesis.