4.4 Market Efficiency

The CAPM theory assumes the financial market is efficiency. In fact, throughout these chapters we have implicitly considered the efficiency of financial market, in the sense that share prices reflect all available information about the economy, about financial markets, and about the specific company involved.

4.4.1 Efficient Market Hypothesis（EMH）

有效市场假说

The extent to which asset prices reflect available information has been widely tested. These tests examine the efficient market hypothesis（EMH）. The implication of EMH is that market price of individual securities adjust very rapidly to new information. As a result, security prices are said to fluctuate randomly about their intrinsic values. In an effi cient market, no one can earn superior return, at least not for long term.

The capital market efficiency assumes that：

·Axes or transaction costs are low.

·Few barriers to entry and exit the market.

·Many buyers and sellers, so that no one can dominate the market.

·Products and services are homogeneous.

·Information is costless and freely available.

·Investors act rationally.

There are three levels of market efficiency：

·Weak-form efficiency:current price fully reflect the historical sequence of prices. In short, studying past price pattern like the way technical traders（chartists）do will not help you to predict future prices.

·Semi-strong-form efficiency:both that price reflects all publicly available information and that price instantly change to reflect new public information（accounting data, announcement of important events of the company, etc.）. One implication of semi-strong-form efficiency is that, fundamental analysis is waste of time.

·Strong-form efficiency:current prices instantly reflect all information, even hidden“insider”information, and no one can earn excess returns.

4.4.2 Market Anomalies

市场异象

Dose EMH always hold? We noticed that although market efficiency is a good explainer of market behavior most of the time and securities seem to be efficiently priced relative to each other, there are exceptions. Investors, including the likes of Warren Buffett, who once said“I'd be a bum on the street with a tin cup if the markets were always efficient”, and researchers have disputed the efficient market hypothesis both empirically and theoretically. Sudden market crash down, calendar effect, P/E ratio effect, all such market anomalies cast doubts on EMH. Moreover, certain emerging markets such as China are not empirically efficient;that the Shanghai and Shenzhen markets, exhibit considerable serial correlation（price trends）, non-random walk, and evidence of manipulation.

Some argued that these anomalies might be explained by investor irrational behavior rather than assuming rational investors in capital market as EMH states. Still, the concept of market efficiency provides the foundation where a great deal of research on the market behavior set foot on.

Summary

·The expected return is simply a weighted average of the possible returns, with the weights being the probabilities of occurrence.

·The risk of a security can be viewed as the variability of returns from those that are expected. The measure of variability around the expected return is the standard deviation, σ, or σ2, known as the variance.

·Investors are, by and large, risk averse. This implies that they demand a higher expected return for a given level of risk, lower risk for a given level of return.

·The expected return from a portfolio is simply a weighted average of the expected return of the securities comprising that portfolio.

·The risk（standard deviation）of a portfolio, depend primarily on the covariance among securities.

·Diversification can reduce risk as long as securities combined are not perfectly, positively correlated.

·Total risk of portfolio can be divided into systematic risk and unsystematic risk.

·Unsystematic risk can be eliminated through diversification; hence investors won't be compensated for bearing this risk.

·Systematic risk is undiversifiable, any risky securities is supposed to provide an expected return commensurate with its system risk, which is represented by beta（β）.

·CAPM describes the relationship between risk（beta, β）and expected return. The required return is the risk-free rate plus a market risk premium for systematic risk that is proportional to beta.

·Financial markets are said to be efficient when security prices fully reflect all available information. According to the degree of efficiency, there are three forms of market efficiency, strong, semi-strong/semi-weak and weak form.

Questions

1．True or false？

（a）Where two shares are perfectly positive correlated, there is no deduction in systematic risk through diversification.

（b）Investors prefer diversified companies because they are less risky.

（c）Diversification over a large number of securities completely eliminates risk.

（d）Diversification works only when assets are uncorrelated.

（e）A security with a high standard deviation may contribute less to portfolio risk than a security with a lower standard deviation.

（f）The expected return on an investment with a beta of 2.0 is twice as high as the expected return on the market.

（g）If a stock lies below the security market line, it is undervalued.

（h）The CAPM predicts that a security with a beta of 0 will offer a zero expected return.

（i）Investors who puts $1000 in treasury bills and $2000 in the market portfolio will have a beta of 2.0.

2．Calculate the expected return from a portfolio consisting of three securities with the following expected returns and weights（　）.

A. 0.114%

B. 12%

C. 11.75%

D. 15%

3．From the following information, calculate the expected return and standard deviation of a portfolio that consists of 60% of Security A（expected return of 0.10 and standard deviation of 0.03）and 40% of Security B（expected return of 0.20 and standard deviation of 0.05）, assuming correlation coefficient between A and B is-0.8（　）.

A. E（R）=0.152, σ=0.161

B. E（R）=0.138, σ=0.012

C. E（R）=0.14, σ=0.085

D. E（R）=0.14, σ=0.012

4．Which type of risk is unique to a firm and may be eliminated by diversification?（　）.

A. Macro risk

B. Unsystematic risk

C. Systematic risk

D. Total risk

5．For a two-stock portfolio, the maximum reduction in risk occurs when the correlation coefficient between the two stocks is（　）.

A.+1

B. -0.5

C. -1

D. 0

6．Which of the following is not an example of unsystematic risk?（　）.

A. Changes in the level of interest rates

B. The chief executive officer resigns

C. A legal suit against a company for environmental pollution

D. The development of a new product line

7．Suppose you invest equal amounts in a portfolio with an expected return of 16% and a standard deviation of returns of 20% and a risk-free asset with an interest rate of 4%; the rate of return and the standard deviation of the returns on the resulting portfolio are respec-tively：

A. 4%,8%

B. 10%,10%

C. 12%,20%

D. 10%,8%

8．Which statement best describes the market portfolio?（　）.

A. Portfolio of all traded assets in the universe

B. Portfolio of all assets weighted according to their marketcapitalisation

C. Portfolio of all risky assets weighted according to their value

D. Portfolio of all risky assets weighted according to their marketcapitalisation

9．Which of the following statements is true?（　）.

A. Two assets that are perfectly negatively correlated can produce a portfolio with zero vari-ance

B. Adding an asset to a portfolio by random selection will reduce the risk of a portfolio

C. Adding a riskless security to a portfolio will increase its overall risk

D. The amount of risk reduction that can be achieved by adding a new security to an existing portfolio increases as the correlation between the expected returns of the new security and the expected returns on the existing portfolio increases

10．An“efficient”portfolio is one that（　）.

A. Combines assets whose returns are not perfectly correlated

B. Offers the highest expected return for a given level of risk

C. Holds a proportion of all possible assets

D. Combines many diverse assets

11．If the beta of Microsoft is 1.13, risk-free rate is 3% and the market risk premium is 8%, what return should investor expect from Microsoft?（　）.

A. 12.04%

B. 15.66%

C. 13.94%

D. 8.65%

12．Given the following data for a stock:beta=1.5; risk-free rate=4%; market rate of return=12%; and expected rate of return on the stock=15%. Then the stock is（　）.

A. Overpriced

B. Under priced

C. Correctly priced

D. Cannot be determined

13．On February 10th SBU plc shares were listed on the stock exchange at 120p. There were 25 million 25p shares in issue at that date.

On February 11th SBU announced to the press that it had unexpectedly discovered a new deposit of minerals with a net present value of £ 7.25 million.

On February 17th the company announced that it was intending to raise £ 4m to finance development of the deposit by means of a rights issue which was to be priced at 80p. Required：

（a）Assuming the market is semi-strong form efficient, calculate the market capitalisation on February 11th after the announcement to the press.

（b）Based on efficient market hypothesis, explain how the market and investor react to the announcement.