LO 62.6: Describe efficient market theory and explain how markets can be

LO 62.6: Describe efficient market theory and explain how markets can be inefficient.
The APT was one of the earliest forms of the efficient market theory. The APT is a multifactor model where market participantsincluding active managers and arbitrageursmove an assets expected return toward a value that represents an equilibrium risk-return tradeoff. The APT uses systematic factors that cannot be removed through arbitrage. As a result, investors demand to be compensated for this risk in the form of a risk premium.
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Topic 62 Cross Reference to GARP Assigned Reading – Ang, Chapter 6
.Another efficient market theory was developed by Sanford Grossman and Joseph Stiglitz (1980).1 In their theory, markets are near-efficient and information is costless. Market efficiency is in part caused by active managers searching for areas of inefficiency, making markets more efficient in the process. We can expect to find these areas of inefficiency in illiquid market segments where information does not move freely and where these inefficiencies make it difficult to earn large profits. Note, however, that the assumption of costless information creates a circular argument: if there is no cost to information and prices already reflect all information, there wouldnt be a need to collect information. However, if no one collects information, then it cannot be fully reflected in asset prices.
Market efficiency is also described in the efficient market hypothesis (EMH). The EMH implies that speculative trading is costly, and active managers cannot generally beat the market. The average investor, who holds the market portfolio, can beat the market simply by saving on transaction costs. Even if markets cannot be perfectly efficient, the EMH is still useful because it can help investors identify areas of market inefficiency that can be exploited through active management.
The EMH has been refined to improve upon the CAPMs shortcomings by allowing for imperfect information and various costs, including transaction, financing, and agency costs. Behavioral biases also represent inefficiencies, which have similar effects as frictions. Behavioral biases can be described either through a rational or behavioral explanation approach.
Under the rational explanation approach, losses during bad times are compensated by high returns. It is important to clearly define what bad times constitutes, and whether these bad times are actually bad for investors. For example, an investor who shorted the market would benefit, rather than incur losses, in a bad times scenario.
Under the behavioral explanation approach, it is agents reactions (under/overreaction) to news that generates high returns. Perfectly rational investors are not prone to these biases, and they provide their own capital to take advantage of mispricing caused by biases. However, the markets may have barriers to the entry of capital that make it difficult to take advantage of mispricings, including structural barriers (e.g., certain investors are unable to take advantage of an opportunity) and regulatory barriers (e.g., minimum credit rating requirement of asset holdings). Structural barriers allow for behavioral biases to persist for a long time.
Ultimately, it is not the type of bias that matters, but whether the investor is different from the average investor who is subject to both rational and behavioral constraints, and whether return opportunities are expected to persist. 1
1. Sanford J. Grossman and Joseph E. Stiglitz, On the Impossibility of Efficient Markets,
American Economic Review 70 (1980): 393-498.
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Topic 62 Cross Reference to GARP Assigned Reading – Ang, Chapter 6
Ke y Co n c e pt s
LO 62.1 Exposure to different factor risks earns risk premiums. Underlying factors may include the market, interest rates, investing styles, inflation, and economic growth. Factor risks represent exposures to bad times, and this exposure must be compensated for with risk premiums. There are three important principles of factor risk: 1.
It is not exposure to the specific asset that matters, rather the exposure to the underlying risk factors.
2. Assets represent bundles of factors, and assets risk premiums reflect these risk factors.
3.
Investors each have different optimal exposures to risk factors, including volatility.
LO 62.2 The capital asset pricing model (CAPM) is a single-factor model that describes how an asset behaves in relation to other assets and to the market. The CAPM incorporates an assets covariance with the market portfolio, measured by the assets beta. In the CAPM world, the only relevant factor is the market portfolio, and risk premiums are determined solely by beta. * 1
LO 62.3 The CAPM has six important lessons: 1. Hold the factor, not the individual asset.
2.
Investors have their own optimal factor risk exposures.
3. The average investor is fully invested in the market.
4. Exposure to factor risk must be rewarded.
3. Risk is measured as beta exposure.
6. Valuable assets have low risk premiums.
The CAPM has six main shortcomings (i.e., unrealistic simplifying assumptions): 1.
Investors only have financial wealth.
2.
Investors have mean-variance utility.
3.
Investors have a single period investment horizon.
4.
Investors have homogeneous (identical) expectations.
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Topic 62 Cross Reference to GARP Assigned Reading – Ang, Chapter 6
5. Markets are frictionless (no taxes or transaction costs).
6. All investors are price takers.
LO 62.4 There are six lessons from the multifactor models: 1. Diversification is beneficial.
2.
Investors have optimal exposures, to factor risks in multifactor models.
3. The average investor holds the market portfolio.
4. Exposure to factor risks must be rewarded through risk premiums.
3. Risk is measured by factor betas.
6. Valuable assets have low risk premiums.
LO 62.3 Multifactor models define bad times over multiple factors using a pricing kernel, also known as the stochastic discount factor (SDF). The SDF represents an index of bad times. The SDF is denoted as m in the multifactor model, representing a single variable that captures all bad times for any given a and b constants:
m = a + b x Rm
The SDF model can also be set up using multiple factor exposures where factors represent different bad times.
The SDF model can be used to predict an assets price, where SDF is the relevant factor m:
The assets risk premium can be modeled using beta.
The risk premium equation can be set up using multiple factor exposures where factors represent different macroeconomic factors, including inflation, economic growth, the market portfolio, or investment strategy.
LO 62.6 Arbitrage pricing theory (APT) uses systematic factors that cannot be removed through arbitrage, and for which investors must be compensated for through risk premiums.
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Topic 62 Cross Reference to GARP Assigned Reading – Ang, Chapter 6
Another efficient market theory developed suggests that markets are near-efficient and information is costless. Active managers search for areas of inefficiency in illiquid market segments, making markets more efficient in the process.
The efficient market hypothesis (EMH) states that speculative trading is expensive, and active managers cannot beat the market on average. The EMH is useful because it helps investors identify areas of market inefficiency that active management can exploit. The EMH has been refined to allow for imperfect information, various costs (transaction, financing, and agency), and behavioral biases.
Under the rational explanation of behavioral biases, losses during bad times are compensated for by high returns. Under the behavioral explanation, it is agents under- or overreactions to news that generates high returns. Market barriers may make it difficult to take advantage of mispricings.
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Topic 62 Cross Reference to GARP Assigned Reading – Ang, Chapter 6
Co n c e pt Ch e c k e r s
1.
2.
3.
4.
3.
Which of the following concepts would least likely meet the definition of a factor? A. Market. B. Volatility. C. Hedge funds. D. Momentum investing style.
Infinitely risk-tolerant investors. According to the capital asset pricing model (CAPM), in equilibrium, all investors hold the mean-variance efficient portfolio. Which of the following investor types is an exception to this assumption? A. Infinitely risk-averse investors. B. C. Investors who hold some of the risk-free asset. D. Investors who hold the market portfolio. Assets that have losses during periods of low market returns have: low betas and low risk premiums. A. B. high betas and low risk premiums. C. low betas and high risk premiums. D. high betas and high risk premiums.
Which of the following statements best describes the relationship between asset payoffs and bad times events (high inflation, low economic growth, or both)? A. The higher the expected payoff of an asset in bad times, the higher the assets
B. The higher the expected payoff of an asset in bad times, the lower the assets
expected return.
expected return.
C. The expected payoff of an asset in bad times is unrelated to the assets expected
return, because it depends on investor preferences.
D. The expected payoff of an asset in bad times is unrelated to the assets expected
return, because arbitrageurs eliminate any expected return potential.
Which of the following statements least likely represents a limitation of the capital asset pricing model (CAPM)? A. All investors are price takers. B. C. All investors have the same expectations. D. There are uniform taxes and transaction costs.
Information is costless to obtain.
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Topic 62 Cross Reference to GARP Assigned Reading – Ang, Chapter 6
Co n c e pt Ch e c k e r An s w e r s
1. C Assets, including corporate bonds, private equity, and hedge funds, are not considered factors themselves, but contain many factors, such as equity risk, interest rate risk, volatility risk, and default risk.
Some assets, like equities and government bonds, can be thought of as factors themselves. Factors may also include the market (a tradable investment factor), interest rates, or investing styles (including value/growth, low volatility, or momentum).
2. A According to the CAPM, all investors hold a combination of the risky mean-variance
efficient market portfolio and the risk-free asset. All investors hold the same market portfolio (therefore the mean-variance efficient portfolio is the market portfolio), and it is only the quantity of holdings that differs among investors. The only exception to this assumption is an infinitely risk-averse investor, who would only hold the risk-free asset.
3. D Assets that have losses during periods of low market returns have high betas (high sensitivity to market movements), which indicates they are risky and, therefore, should have high risk premiums. Low beta assets have positive payoffs when the market performs poorly, making them valuable to investors. As a result, investors do not require high risk premiums to hold these assets.
4. B The higher the expected payoff of an asset in bad times, the lower the assets expected return.
Assets that have a positive payoff in bad times are valuable to hold, leading to high prices and, therefore, low expected returns.
5. D The CAPM does not assume uniform taxes and transaction costs; it assumes there are no taxes or transaction costs (i.e., frictionless markets). The other limiting assumptions of the CAPM include:
1.
Investors only have financial wealth.
2.
3.
4.
Investors have mean-variance utility.
Investors have a single period investment horizon.
Investors have homogeneous (identical) expectations.
5. All investors are price takers.
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The following is a review of the Risk Management and Investment Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Fa c t o r s
Ex a m Fo c u s
Topic 63
Macroeconomic factors have been linked to asset returns. The most important macro factors that affect returns are economic growth, inflation, and volatility. Volatility risk can be mitigated by investing in low-volatility assets or buying volatility protection in the derivatives market (e.g., buying put options). The capital asset pricing model (CAPM) is a single-factor model that relates asset returns to market risk. The Fama-French model is a multifactor model that adds a size factor and a value factor to the original CAPM market factor to explain stock returns. A momentum factor can also help explain asset returns. The momentum strategy far outpaces the size and value-growth strategies in terms of returns. Ffowever, momentum strategies are prone to crashes. For the exam, understand the risk and return profiles of each factor. Also, be aware of rational and behavioral explanations for each factor.
Va l u e In v e s t in g

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