Chapter 2: Foundations of Finance II:
Asset Pricing, Market Efficiency and
Agency Relationships
Powerpoint Slides to accompany Behavioral
Finance: Psychology, Decision-making and Markets
by Lucy F. Ackert & Richard Deaves
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posted to a publicly available website, in whole or in part.
Portfolio risk and return
• Return is a weighted average of returns of
individual securities.
• Risk is less than a weighted average of risks of
individual securities – provided correlations
are less than one.
• The lower are correlations the lower is the
risk of a portfolio.
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posted to a publicly available website, in whole or in part.
Two-security example
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posted to a publicly available website, in whole or in part.
Efficient set
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posted to a publicly available website, in whole or in part.
Two-fund separation
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posted to a publicly available website, in whole or in part.
Capital asset pricing model (CAPM)
• CAPM is an equilibrium model: it brings all
investors together.
• According to CAPM only risk related to market
movements is priced by market.
• This is because all other risk can be diversified
away.
• Beta is measure of nondiversifiable risk for a
security.
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posted to a publicly available website, in whole or in part.
CAPM relationship and beta
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posted to a publicly available website, in whole or in part.
CAPM equation
CAPM equation:
E(Ri) = Rf + i * [E(Rm) – Rf]
Notes: E(Rm) – Rf is market risk premium
i = (Ri , Rm)/ 2(Rm)
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posted to a publicly available website, in whole or in part.
Market efficiency
• Value is what a security should be worth
based on careful analysis.
• Price is what the market says it is worth.
• What is relationship between value and price
if markets are efficient?
– Older version of market efficiency says value and price are
always identical.
– More subtle and realistic version says they can sometimes differ
a little.
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posted to a publicly available website, in whole or in part.
Operational definition of market
efficiency
• Financial markets are efficient if no one can
consistently earn excess returns. Excess
means…
– After risk is factored in
– And after costs are factored in
• What sort of costs?
– Transaction costs
– Analysis costs
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posted to a publicly available website, in whole or in part.
What should be true if markets are
efficient?
• Security prices should respond quickly and
accurately to new information.
• Professional investors should not outperform
net of all fees.
• Simulated trading strategies should fail.
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posted to a publicly available website, in whole or in part.
Simulated trading strategies
• We can look at possible strategies using
historical data and see if they would have
earned excess returns.
• These strategies must be based on
information that was available.
• If a strategy succeeds in generating excess
returns, this is preliminary evidence against
market efficiency.
• But we need:
– Statistical significance.
– Consistency.
– Beware of data mining!
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posted to a publicly available website, in whole or in part.
Market efficiency and available
information
• Weak form: historical prices and returns
• Semi-strong form: all public information
• Strong form: all information, including
private information
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posted to a publicly available website, in whole or in part.
Joint hypothesis problem
• All tests of market efficiency have two
maintained hypotheses:
– Markets are efficient.
– A fair return on a security or portfolio is from a particular model
(in early tests this model was usually CAPM).
• Rejection means:
– Markets are not efficient.
– Method for calculating fair returns is faulty.
– Or both.
• But which? Joint hypothesis problem!
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posted to a publicly available website, in whole or in part.
Agency relationship and agency
problem
• Agency relationship exists whenever someone (the
principal) contracts with someone else (the agent) to
take actions on behalf of the principal and represent
the principal’s interests.
• In an agency relationship, agent has authority to
make decisions for the principal.
• An agency problem arises when the agent’s and
principal’s incentives are not aligned.
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posted to a publicly available website, in whole or in part.
Agency costs
• Agency costs are incurred because managers’
incentives are not consistent with maximizing value
of firm.
• Direct costs:
– Example: need to monitor managers, including cost of
hiring outside auditors
• Indirect costs:
– Example: managers of a firm that is an acquisition target
may resist the takeover attempt because of concern about
keeping their jobs, even if the shareholders would benefit
from merger
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posted to a publicly available website, in whole or in part.