Investments MBA 536

1. InvestmentsMBA 536 Dr. David P Echevarria Cameron School of Business University of North Carolina Wilmington

2. Unit 3: Asset Pricing, Efficient Markets, Technical Analysis • In Unit 3 we get to the most important ideas in asset valuation theory. The simplest definition of “price” is the present value of future benefits to be received. The difficulty in this process is determining a suitable discount rate. Earlier we were exposed to the notion that return is tied to risk. The expected rate of return is fixed by the level of risk. • In MPT, there were two sources of risk; variance and covariance. Sharpe (64) (and later Lintner (65) and Mossin(66)) would reduce the variance-covariance matrix to a scalar (or column) of relative risk measures he called “beta - b”. The riskiness of securities would henceforth be characterized by their relation to the market’s riskiness (the market’s b = 1). The pricing of equities would be based on the Capital Asset Pricing Model (CAPM). • The CAPM breakthrough would soon be followed by Fama’s Efficient Market Hypothesis (EMH). • Joint testing of the EMH and CAPM would embroil the finance profession in heated debate about both concepts for the next 25 or 30 years. • The technicians would view this debate with little interest. The essential philosophical position of the technicians is that most of what the academic theorists believed was irrelevant in a market largely moved by greed and fear.

3. Chapter 7: Capital Asset Pricing model • Student Learning Objectives • Capital Asset Pricing Model (CAPM) • Assumptions of the CAPM • Investing in the CAPM world • Estimating Beta • Beta - good news and bad news

4. Chapter 7: Capital Asset Pricing model • Capital Asset Pricing Model (CAPM) • Asset Pricing Theory seeks to explain why certain assets have higher expected returns than other assets and why expected returns vary over time. Expected returns are those returns when assets are priced in equilibrium: demand for assets = supply of assets.

5. Chapter 7: Capital Asset Pricing model • Assumptions of the CAPM • The capital markets are characterized by perfect competition. • All investors choose the portfolio according to mean and variance efficiency • All investors have homogeneous expectations regarding future returns • All investors can borrow or lend at the risk-free rate (rf) Implication of the CAPM assumptions: All investors face an identical efficient frontier

6. Chapter 7: Capital Asset Pricing model • CAPM has 2 elements: Risk-Free Asset and Risky [Mean & Variance Efficient] portfolio • Characteristics of the risk-free asset • Its variance is zero (otherwise it would not be risk-free) sr.= 0. • Its covariance with all risky assets is also zero (sr,a). • Characteristics of the Risky Asset Portfolio • Risky asset portfolio is located on the efficient frontier • Accordingly, the risky asset portfolio is mean and variance efficient • In the CAPM world, investments are comprised of combinations of Rf and Ra

7. Capital Market Line (CML) Risky Market Portfolio Risk-Free Asset Chapter 7: Capital Asset Pricing model • Investors can construct different combinations (weights) of the risk-free asset and risky market portfolio in order to achieve an acceptable level of risk. • The line running from the risk-free asset to and beyond the risky market portfolio defines the CML

8. Chapter 7: Capital Asset Pricing model • Efficient Frontier and the [Optimal] Risky Portfolio • All portfolios lying on the Efficient Frontier are mean and variance efficient. • Optimal Efficient Portfolios depend on individual preferences for risk and return • Investor’s utility function drive the choice of portfolio • The slope of the Capital Market Line is: [E (Ra) – rf] / sa • The CML is frequently referred to as the Investment Opportunity line.

9. Chapter 7: Capital Asset Pricing model • The expected return for any portfolio is defined as: Rp = w Rf + (1 – w)Ra Where: w = weight of wealth endowment invested in Rf (1 – w) = weight invested in Ra (risky asset) • The expected portfolio variance (risk) is defined as: s2p = w2s2rf + (1 – w)2s2a + 2 w (1-w) srf,a srf,a = covariance of rf and a Since the variance of the risk-free asset is assumed to be zero and its covariance with the risky portfolio is zero, then the riskiness of the portfolio reduces to: s2p = (1 – w)2s2a (Variance) And: sp = (1 – w) sa (Std Deviation)

10. Chapter 7: Capital Asset Pricing model • The Capital Market Line (CML) • The CML defines the locus all mean-variance efficient risky portfolios • The CML is composed of all possible combinations of the market portfolio (m) and the risk-free asset (rf). • Borrowing and Lending at the Risk-free rate • Combinations of risk-free asset and risky market portfolio can be used to create portfolios along the CML • Borrowing-lending line is the CML, divided where it intersects the efficient frontier (point M) with the lending line on the left and borrowing on the right • Investing Rf asset = lending (investing in bills) • Investing to right of M is borrowing (buying on margin)

11. Chapter 7: Capital Asset Pricing model • Market Portfolio • The Market Portfolio (point M) must be the only risky portfolio chosen by all risk-averse investors. Because it is demanded by all investors, it must contain all the securities and other traded assets • Portfolio M’s risk = Market risk

12. Chapter 7: Capital Asset Pricing model • Types of CAPM Risk • Systematic or non diversifiable risk (market risk) • Beta is the measure of systematic risk • Only systematic risk is priced in the CAPM • Non Systematic or diversifiable risk (non-market risk) • Risk due to firm specific attributes • Irrelevant in a well diversified portfolio • Not priced in the CAPM – it is diversified away.

13. Chapter 9: Capital Asset Pricing model • Relative Risk • Relative risk contribution of security i • Total risk contribution of security i divided by Total risk of market portfolio, M • Known as beta, b , it measures security risk, or volatility relative to the market portfolio • Beta greater than 1.0 is riskier than the market • Beta less than 1.0 is less risky than the market • The value of beta implies something about returns relative to the market portfolio • The choice of a proxy affects beta.

14. Chapter 7: Capital Asset Pricing model • Security Market Line (SML) • The CML is for assets priced in equilibrium • The SML is for assets that may be mispriced • The SML is defined in same way as CML • E(Ri) = RF + (E(RM) - RF) bi • Expected ROR = Risk Free Rate + Risk Premium*b

15. Chapter 7: Capital Asset Pricing model • Differences between the CML and the SML • The CML measures risk by standard deviation, or total risk • The SML measures risk by beta; security’s risk contribution to portfolio • CML defines efficient portfolios • SML describes efficient and non efficient portfolios • CML eliminates diversifiable risk for portfolios • SML includes all portfolios that lie on or below the CML, • Firm specific risk is irrelevant to each, but for different reasons

16. BREAK TIME 15 MINUTES

17. Chapter 8: Efficient Market Hypothesis • Student Learning Objectives • What is the Efficient Markets Hypothesis? (EMH) • What are the implications of the EMH? • Are there different forms of the EMH? • How do we test for efficient markets? • What is the evidence for and against the EMH?

18. Chapter 8: Efficient Market Hypothesis • Efficient Market Hypothesis (EMH) • Prices fully reflect all available information • Prices adjust quickly to new information • Implications of the EMH • Information cannot be used to earn abnormal returns • Short-term price movements cannot be predicted - a random walk • Time series in which each change is independent from previous change. • Random series may appear to have patterns • Use of runs test for randomness

19. Chapter 8: Efficient Market Hypothesis • Technical analysis is of no value even under weak-form EMH which requires that either the patterns are mere illusions, or other investors would also recognize any patterns • Fundamental analysis is only of value if one has superior forecasting skills and can act before the market can react to new public information • Active portfolio management probably cannot outperform passive portfolio management • Portfolio selection will depend upon risk preferences, age, income, etc….

20. Chapter 8: Efficient Market Hypothesis • Sources of Market Efficiency • Competition for “best” investments • Large number of investors • Ongoing research and market analysis keeps prices moving toward intrinsic values

21. Chapter 8: Efficient Market Hypothesis • Forms of E M H • Weak-form market efficiency • Current prices reflect all historical information • Markets generally prove to be weak-form efficient • Semi-strong-form market efficiency • Prices fully reflect all public information • Market do not prove to be semi-strong form efficient • Anomalies literature • Strong-form market efficiency • Prices fully reflect all public and private information • Markets routinely outperformed by insiders.

22. Chapter 8: Efficient Market Hypothesis • Anomalies Evidence Against Semi-Strong Form Market Efficiency • Calendar anomalies • January effect • Weekend effect • Small-firm effect • Stocks of small firms outperform large firms (by MVE) • Risk measure may not be adequate • Institutional investors overlook small firms • Performance of Investment Professionals • Value Line rankings • Fund Manager performance

23. Chapter 8: Efficient Market Hypothesis • Are Markets Efficient? • Some Evidence supports the EMH • Cannot cover transaction expenses • Timing models inter-temporally unstable • More Evidence contradicts the EMH • Serial properties of economic data • Improvements in data mining • Better analytical techniques

24. Chapter 9: Behavioral Finance – Technical Analysis • Learning objectives • What do we mean by behavior? • Why are the technicians so numerous? • Is there any hope for Virginia?

25. Chapter 9: Behavioral Finance – Technical Analysis • Behavioral Critique • Investor Rationality • Does history repeat? Is history a problem? • How well do we analyze information? How do we know if we’re doing it right? • Why the divergence of opinions given the same facts? • Do experts really exist? • Why are we slow to react? • Is arbitrage possible? • Why do bubbles occur?

26. Chapter 9: Behavioral Finance – Technical Analysis • Technical Analysis • Figuring out which way the herd is moving – the trend • How many theories are there? • Dow Theory • Elliott Wave Principle (Robt Prechter) • Moving Averages (Simple, MACD) • Momentum • Sentiment Indicators • Confidence Indicators • Put/Call and Other Ratios • Kondratiev Waves (50 to 60 year cycles)

27. Chapter 9: Behavioral Finance – Technical Analysis • Yes Virginia, there is hope • Fundamentalists vs. Technicians • The truth is out there. • Fundamental analysis can be used to reveal value • Technical analysis can be used to time