Titel

1
C.E.E.B.S.
3 The Market for Capital Finance and the Price
of Risk
2
Three forms of the EMH
3
Stochastically generated share price chart (using
the NORMSINV function in Excel to create random
numbers ?)
4
Replication of the association of annual earnings
changes and abnormal returns from Ball and Brown
5
Hyper-rational MarketsRubinstein (2001)

• The market can be likened to an almost
  exhausted goldmine. A few nuggets remain and are
  occasionally found, which encourages further
  efforts by the over confident, but no miner can
  reasonably expect continued mining to be
  worthwhile. As a result, there is a sense that
  asset prices become hyper-rational that is, they
  reflect not only the information that was cost
  effective to learn and impound into prices but
  also information that was not worthwhile to
  gather and impound. Over spending on research is
  not in ones self interest, but it does create an
  externality for passive investors who now find
  that price embed more information and markets are
  deeper than they should be.

6
Risk and Return for the Two Security Portfolio

• (s) The standard deviation of each individual
  security's returns,
• (w) The weights by value of each individual
  security in the portfolio and,
• (sAB) The covariance term which measures the
  degree of interdependence between the two
  securities.
• (r) The return on the security or the portfolio.

7
Quarterly data for British Airways plc and
British Petroleum plc
8
Return and risk for combinationsBritish
Petroleum plc and British Airways plc
9
The risk return mapping for BA and BP assuming
different return correlations
10
Markowitz Efficient Set
11
The introduction of a risk free asset into the
Markowitz portfolio model
12
The Markowitz/Tobin assumptions

• Investors are risk averse single period, two
  parameter utility maximisers.
• Security markets are frictionless in that there
  are no transactions costs or taxes.
• There is a pure rate of interest reflecting the
  returns on risk free investment and investors
  have an unlimited borrowing or lending
  opportunity at this rate.
• All investors form common beliefs about the
  expected returns and risk from all securities.

13
The implications of the CAPM

• Investors are only rewarded in the pricing
  process for carrying market driven or
  systematic risk.
• The trade off between expected return and market
  risk is linear.

14
Risk reduction against portfolio size (number of
randomly drawn securities weighted by value)
15
The Capital Asset Pricing Model
16
Estimating the Risk Free Rate
Extract of UK interest rate data from the
Financial Times (17 February, 2005)
17
The steps towards the estimation of beta using
ordinary least squares regression
18
The Security Market Line
19
Arbitrage drivers and the linearity of the
security market line
20
The Arbitrage Pricing Model (two factor case)
21
3 The Market for Capital Finance and the Price
of Risk
22
LEARNING OUTCOMES

• Distinguish between the primary and secondary
  capital market.
• Characterise different types of equity finance
  and have an outline understanding of the
  mechanisms by which they are issued.
• Define what is meant by the Efficient Market
  Hypothesis and be able to describe the hypothesis
  in its three forms.
• Gain a good understanding of the theory of risk,
  the concept of mean-variance efficiency, the
  Markowitz/Tobin Separation Theorem and be able to
  make simple asset allocation decisions.
• Gain a good understanding of the Capital Asset
  Pricing Model and know how to source the
  necessary information for calculating the rate of
  return required by equity investors.
• An outline understanding of the Arbitrage Pricing
  Theory model and be able to identify its relative
  advantages to the Capital Asset Pricing Model.

23
The Three Components of the Capital Markets