FINA 3010: FINANCIAL MARKETS

Wenxi JIANG
(Fall 2015)

Lecture Note 7:
Efficient Market Hypothesis

© Wenxi Jiang

1
Outline

1. Rational, frictionless framework

2. Efficient market hypothesis

3. Predictability of asset returns

4. Capital asset pricing model (CAPM)

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Overview

How should we understand asset prices?

Roadmap
1. Framework: traditional vs. behavioral/institutional
2. Stylized facts
3. Possible explanations

Course content
Part I: Financial Assets and Instruments
- Debt
- Stock
- Insurance, futures, and options
Part II: Investor in Financial Markets
- Individual investors
- Institutional investors
Part III: Prices of Financial Assets
- Efficient market hypothesis (EMH)
- Departure from EMH
- Aggregate asset market return
- The cross-section of asset return
- Bubble and crash

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Rational, frictionless framework
This is the “traditional” framework dominated finance thinking from the
start of the modern research era, the 1950s, until the early 1990s
• Assumes that everyone in the economy is fully rational
• Ignores most frictions, or institutional details
- e.g., short-sale constraints, delegated asset management,
transaction cost

Implication to asset prices

• Efficient Market Hypothesis (EMH)
• Capital Asset Pricing Model (CAPM)

Efficient market hypothesis

The efficient markets hypothesis is the hypothesis that the prices of all
financial asset are “right”
• They properly reflect all available (public) information
• They equal the asset’s fundamental value

In an efficient market
• New information is immediately impounded into asset prices
• No investment strategy can “beat the market”, on average

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“No arbitrage”
As soon as the price deviates from the asset’s fundamental value,
• Rational investors will take the opportunity and trade against the
mispricing, quickly correcting it (“arbitrage”)
• Thus, irrational investors cannot have a substantial impact on asset
prices

In a rational, frictionless economy, the EMH will hold

• Prices are right

Predictability of asset returns

In an economy with rational investors (and no frictions), the only reason
asset A would earn higher long-term average return than asset B is if it is
riskier
• e.g., in the bond market, bonds with higher default risk should earn
higher yield

Intuitively, a natural measure of risk is volatility of returns

• Supporting evidence: stocks appear to have higher volatility than
government bonds and also have average returns
- E.g. from 1928 to 2014, average annual return of the stock
market is 11.53%, and volatility is 19%

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 trailing total volatility or trailing beta—thus of $10.12 in real terms. Contrast this perfo
a going back to January 1963—and tracked with that of the highest-volatility portfolio.
ns on these portfolios. We also restricted the invested there was worth 58 cents at the
universe to the top 1,000 stocks by market December 2008, assuming no transactio
- Thethe
ation. Figure 1 shows average return of treasureGiven
results. bills is 3.53%
the and volatility
declining is dollar, the re
value of the
ardless of whether we define risk as volatil- of the high-volatility portfolio declined to l
3.0%.
a or whether we consider all stocks or only 10 cents—a 90 percent decline in real terms! R
s, low risk consistently outperformed
• Contradicting evidence: high ably,
stocks with highanvolatility
investortend
whotoaggressively
have low pursue
the period. Panel A shows that a dollar volatility stocks over the last four decade
returns
in the lowest-volatility portfolio in January have borne almost a total loss in real terms.
- Maybe volatility not a right measure of risk?
Figure 1. Returns by Volatility and Beta Quintile, January 1968–
December 2008
Downward Sloping
Cumulative returns Security
of stock Market
portfolios based onLine
A. All Stocks, Volatility Quintiles
(SML)
past volatility
Value of $1 Invested in 1968
100

Bottom Quintile

10

Top Quintile

0.1
68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

B. Top 1,000 Stocks, Volatility Quintiles

Value of $1 Invested in 1968
100

Bottom Quintile
6
10
Capital asset pricing model
• In the CAPM, risk of stock return is measured by beta, !
- Beta is the covariance of the stock returns with the market
returns, or with the macro economy
• According to CAPM
- Stocks with higher betas should have higher average returns
- Beta should be the only stock characteristics that predicts the
relative performance of stocks
$%&((" , (* )
!" =
&,-((* )

What is the intuition of CAPM?

Both of these predictions, however, are empirically false!

• Beta has no predictive power of future returns
• Lots of other stock characteristics do

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 The Capital Asset Pricing Model: Theory and Evidence 33

Figure 2
Average Annualized Monthly Return versus Beta for Value Weight Portfolios
Formed on Prior Beta, 1928 –2003
18
Average annualized monthly return (%)

16

14

12

10
Average returns
8 predicted by the
CAPM
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0.5 0.7 0.9 1.1 1.3 1.5 1.7 1.9

Source: Fama and French (2004)

line, with an intercept equal to the risk-free rate, R f , and a slope equal to the
expected excess return on the market, E(R M ) ! R f . We use the average one-month
Treasury bill rate and the average excess CRSP market return for 1928 –2003 to
estimate the predicted line in Figure 2. Confirming earlier evidence, the relation
Suggested readings
between beta and average return for the ten portfolios is much flatter than the
Sharpe-Lintner CAPM predicts. The returns on the low beta portfolios are too high,
andFabozzi,
the returns on the
Modigliani, andhigh
Jonesbeta portfolios
(2010): Chapter are
12 too low. For example, the predicted
return on the portfolio with the lowest beta is 8.3 percent per year; the actual return
is 11.1 percent. The predicted return on the portfolio with the highest beta is
Fama, Eugene F., and Kenneth R. French. "The capital asset pricing model: Theory and evidence."
16.8 percent per year; the actual is 13.7 percent.
Journal of Economic Perspectives 18 (2004): 25-46.
Although the observed premium per unit of beta is lower than the Sharpe-
Lintner model predicts, the relation between average return and beta in Figure 2
is roughly linear. This is consistent with the Black version of the CAPM, which
Reference
predicts only that the beta premium is positive. Even this less restrictive model,
however, eventually succumbs to the data.
Fama, Eugene F., and Kenneth R. French. "The capital asset pricing model: Theory and evidence."
Testing Whether
Journal Market
of Economic Betas 18
Perspectives Explain
(2004):Expected
25-46. Returns
The Sharpe-Lintner and Black versions of the CAPM share the prediction that
the market portfolio is mean-variance-efficient. This implies that differences in
expected return across securities and portfolios are entirely explained by differ-
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ences in market beta; other variables should add nothing to the explanation of
expected return. This prediction plays a prominent role in tests of the CAPM. In