Financial Economics

Lecture-18

By
Arun

Department of Statistics,
University of Madras,
Chennai

December 28, 2021

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Contents

18.1 CAPM Implies An Equilibrium

18.2 Capital Market Equilibrium
18.3 Divorsified Portfolio Of Risky Assest
18.4 Efficiency Of Financial Markets
18.5 Efficient Market Hypothesis
18.6 Serial Randomness Of Price Changes

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18.1 CAPM Implies An Equilibrium

The Capital Assest Pricing Model(CAPM) is used to determine a

appropriate required rate of return of assest.

If that assest is to be added to an already well-diversified portfolio,

given that assest non-diversifiable risk.

It attempts to to measure the risk of a security in a portfolio sense.

The expected return an any simple risky assest ’i’ is (Ri-rf) and is
propotional through the β factor.

βi for assest i to be expected excess return on the market portfolio.

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Special Case 1

If βi=0 Cov(Ri,R M )-0 The Risky assest return Ri is uncompleted with

the return R M Of market portfolio

Ri = rf there is no expected return with risk free rate rf.

(Ri-rf) even if the investor of the risky assest bears some risk σp>o

Risky assests for which βi=0 is represented as points on horizontal

line.

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Special Case 2

When betai=1
M
CAPM: (Ri-rf)=βi(R -rf)

If βi=1 => Cov(Ri,R M )= Var(RM ) = Cov(RM ,R M )

CAPM= Ri=RM

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Special Case 3

When βi > 1

Cov (Ri, Rm)

βi = >1
Var (Rm)

(Ri − rf )
CAPM: βi = >1
(Rm − rf )

(Ri − rf ) > (Rm − rf ) = > Ri > R M

The risky assest ’i’ is aggresive assest.

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Special Case 3

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Capital Market Equilibrium And CAPM

The Risk of individual assest

Investor require componsation for taking risk SD of rate of return of

portfolio.

SD(Rp)=σp is a measure of risk for ones portfolio.

But on the other hand SD is not the best measure of risk for
individual assests when the investors hold diversified portfolio

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Divorsified Portfolio Of Risky assest

PD consists of assest from IT, Pharma, Network fields etc...

βi measure the sensitivity of risky assest is rate of return Ri

To the variation of the rate of return RM of market equilibrium.

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Measure the Beta(The Market Model)

P
Rit=αi + βi Rmt+ it => For risky assest i at time t

To run this linear regression panel data to find αi and βi

P P
Assume: Rmt is independent of it => Cov(Rmt, it)=0
z }| {
cov (Ri, R M
LSE OF βi =β̂i = z }| {
var (Rm)

βi measure the risk of individual assest (such as i) Instead of using σi

to measure risk of assest ’i’ we use βi to measure risk.

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Measure the Beta(The Market Model)

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Measure the Beta(The Market Model)
E[Ri]= rf + βi [E(Rm )-rt]

E[Ri]= Expected return of risky assest i

rf= Risk free rate

βi[E(Rm )-rt]= Market risk premium

SML describe CAPM relationship

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Example

Annual treasury bill return=1

β for reliance= 0.93 and

Historical market risk premium= 7.1. Find R reliance

=0.01+0.93(0.71)

=0.07603

=7.603

Note: R reliance=7.6% is the return predicted by CAPM and is the

risk adjusted retuen due to the pressure of β

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Market Model

P
Rit= α i + β i Rmt + it
P
Assume: Cov(Rmt, it)=0

Var(Rit)= βi2 Var(Rmt)+ Var(

P
it)

Var(Rit)= Total risk on assest

βi2 Var(Rmt)= Systematic market risk

P
Var( it)= Unique risk of assest i

this unique risk can be eliminated by diverification

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Market Model

R= one period rate of return for assest including dividents

(P1 − P0) + Di
R=
P0

Here P0 is known but D1 and R are not known and are random
variables’

E (P1) − P0 + E (D1)
E(R)=
Po

E (P1) + E (D1)
P0=
[1 + E (R)]

E (R1) + E (D1)
P0 =
[1 + β[E (R M ) − rf ]
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Efficiency Of Financial Markets
Efficiency Market Hypothesis(EMH): Financial market are efficiency if
current assest prices fully reflect all currently available relevant
information.

Implication Of EM: Efficient financial markets will respond for new

information immediately and completely.

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Efficiency Of Financial Markets

Financial markets may over react and then adjust gradually to the
efficient price path.

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Efficiency Of Financial Markets

Note: If FM are efficient then there is no best time to purchase an

assest.

Since the past price patterns are not predictive of the future assest of
the assests.

If markets are efficient then assest price changes are random cannot
predict future price of an assest based on obsending the history of
past prices of return.

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Special randomness of Price Change

A special case that the assest price change serially at random is the
random walk hypothesis

i.e the stock prices follow a random walk.

P
Pt + 1 = Pt + Expected Gain + t+1
P
∆ Pt+1= (Pt+1 - Pt)= Expected Gain + t+1

IID
t+1 ∼ (0,σ 2 )
P

P
E(∆ Pt+1)= Expected Gain+ E( t+1)-Expected Gain

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