Ingenieria Financiera

Efficient Market Theory, Market Risk and CAPM

9/14/2013

Efficient Market Theory

Arguments: 100,000 or so full-time, highly trained, professional analysts and traders in the market fewer than 3,000 major stocks each analyst follows 30 stocks, on average 1,000 analysts following each stock SEC disclosure requirements and electronic information networks get new information to the 1,000 analysts to evaluate it at about the same time Therefore, the price of a stock will adjust almost immediately to any new development. Two proposals: 1. that stocks are always in equilibrium and 2. that it is impossible for an investor to consistently beat the market. financial markets are "informationally efficient = price of stocks and financial assets already reflect all known information, and instantly change to reflect new information (equilibrium)

9/14/2013

Ingenieria Financiera Primavera 2010

Levels of Market Efficiency

Weak Form

Any information that comes from past stock prices is rapidly incorporated into the current stock price.

Current market prices reflect all publicly available information

Information from annual reports and any good or bad news has been priced in when it was first announced

Semistrong Form

However, people with private information can earn consistently abnormal returns Also, whenever new information is released, prices react if the information is different from expectations

Strong Form

Current market prices reflect all information, whether publicly available or privately held

Source: 5 Minute MBA, Corporate Finance 9/14/2013 Ingenieria Financiera Primavera 2010 3

Pre-Announcement Abnormal Volume (Target and Matching Firm)

Source: Rumors and Pre-Announcement Trading: Why Sell Target Stocks before Acquisition Announcements? Yuan Gaoa, * and Derek Olerb 9/14/2013 Ingenieria Financiera Primavera 2010 4

The Capital Asset Pricing Model (CAPM) Cost of Equity (Ke) = Rate of return required of a specific Stock, given its riskiness

Ke = Rf + (RM Rf)

9/14/2013

Ingenieria Financiera Primavera 2010

Beta relevant risk of an individual stock

9/14/2013

Ingenieria Financiera Primavera 2010

Calculating Wal-Marts beta

9/14/2013

Ingenieria Financiera Primavera 2010

Market Risk and Diversifiable Risk

Source: 5 Minute MBA, Corporate Finance 9/14/2013 Ingenieria Financiera Primavera 2010 8

Risk Free Rate must be matched to our cash-flow horizon

Typically, long term

3.75% - 4.5%

9/14/2013

Ingenieria Financiera Primavera 2010

Disneys Beta

9/14/2013

Ingenieria Financiera Primavera 2010

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Calculating Disneys Ke through CAPM

Required Rate of Return (discount rate) In this case, Ke

5.4% to 8.5% (US)

Market Risk Premium (RM - Rf)

3.75% to 4.5% (US, 10-30y)

Long term Treasury Bonds

Risk Free Returns (Rf) Beta = 1.10

Disneys Ke = 4.5% + 1.10 (8.5) = 13.9%

9/14/2013 Ingenieria Financiera Primavera 2010 11

Risk
Risk can be defined as the chance that some unfavorable event will occur. Riskier assets must have higher returns An assets risk consists of
1. 2. diversifiable risk, which can be eliminated by diversification, plus market risk, which cannot be eliminated by diversification. measures the extent to which the stocks returns move relative to the market. A high-beta stock is more volatile than an average stock, while a low-beta stock is less volatile than an average stock. An average stock has = 1.0.

A stocks beta coefficient,, is a measure of its market risk.

The beta of a portfolio is a weighted average of the betas of the individual securities in the portfolio.

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Ingenieria Financiera Primavera 2010

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