Efficient Markets Hypothesis (EMH)

 

Efficient Markets Hypothesis (EMH)

 

Introduction

The Efficient Markets Hypothesis (EMH) is an investment theory.

By Eugene Fama’s research as detailed in his 1970 book, “Efficient Capital Markets: A Review of Theory and Empirical Work.”

Fama put forth the basic idea that it is virtually impossible to consistently “beat the market” – to make investment returns that outperform the overall market average as reflected by major stock indexes such as the S&P 500 Index.

 

Assumptions of the Efficient Markets Hypothesis

—  The assumptions include the one idea critical to the validity of the efficient markets hypothesis: the belief that all information relevant to stock prices is freely and widely available, “universally shared” among all investors.

—  As there are always a large number of both buyers and sellers in the market, price movements always occur efficiently (i.e., in a timely, up-to-date manner). Thus, stocks are always trading at their current fair market value.

—  The major conclusion of the theory is that since stocks always trade at their fair market value, then it is virtually impossible to either buy undervalued stocks at a bargain or sell overvalued stocks for extra profits. Neither expert stock analysis nor carefully implemented market timing strategies can hope to average doing any better than the performance of the overall market.

 

Variations of the Efficient Markets Hypothesis

—  There are three variations of the hypothesis – the weak, semi-strong, and strong forms – which represent three different assumed levels of market efficiency.

—  The weak form suggests today’s stock prices reflect all the data of past prices and that no form of technical analysis can aid investors. 

—  The semi-strong form submits that because public information is part of a stock's current price, investors cannot utilize either technical or fundamental analysis, though information not available to the public can help investors.

—  The strong form version states that all information, public and not public, is completely accounted for in current stock prices, and no type of information can give an investor an advantage on the market.

 

Capital Asset Pricing Model (CAPM)

 

Capital Asset Pricing Model (CAPM)

CAPM In Excel

Introduction

}  The capital asset pricing model was developed by the financial economist (and later, Nobel laureate in economics) William Sharpe, set out in his 1970 book Portfolio Theory and Capital Markets. His model starts with the idea that individual investment contains two types of risk:

}  Systematic Risk – These are market risks—that is, general perils of investing—that cannot be diversified away. Interest rates, recessions, and wars are examples of systematic risks.

}  Unsystematic Risk – Also known as "specific risk," this risk relates to individual stocks. In more technical terms, it represents the component of a stock's return that is not correlated with general market moves

}  No matter how much you diversify your investments, some level of risk will always exist. So investors naturally seek a rate of return that compensates for that risk. The capital asset pricing model (CAPM) helps to calculate investment risk and what return on investment an investor should expect.

The CAPM can be calculated with the CAPM formula as follows:

ERi = Rf + βi(ERm-Rf)

}  ERi = Expected return of investment

}  Rf = Risk-free rate

}  βi = Beta of the investment

}  ERm = Expected return of the market

}  (ERm – Rf) = The market risk premium, which is calculated by subtracting the risk-free rate from the expected return of the investment account. 

The benefits of CAPM include the following:

}  Ease of use and understanding

}  Accounts for systematic risk

The limitations of CAPM include the following:

}  Experts believe it is too simplistic because it does not cover all of the risks that are involved with investing 

}  It does not correctly evaluate reasonable returns

}  Assumes that you can lend and borrow at a risk-free rate

}  Returns that are calculated evaluate past returns and might not accurately reflect future returns

 

Arbitrage Pricing Theory

 Introduction

}  Arbitrage pricing theory (APT) is an alternative to the capital asset pricing model (CAPM) for explaining returns of assets or portfolios.

}  It was developed by economist Stephen Ross in the 1970s. The arbitrage pricing theory is a lot more difficult to apply in practice because it requires a lot of data and complex statistical analysis.

 What Is APT?

APT is a multi-factor technical model based on the relationship between a financial asset's expected return and its risk. The model is designed to capture the sensitivity of the asset's returns to changes in certain macroeconomic variables. Investors and financial analysts can use these results to price securities.

 Three Underlying Assumptions of APT

}  Asset returns are explained by systematic factors.

}  Investors can build a portfolio of assets where specific risk is eliminated through diversification.

}  No arbitrage opportunity exists among well-diversified portfolios. If any arbitrage opportunities do exist, they will be exploited away by investors. (This how the theory got its name.)

Formula of Expected Return of a diversified portfolio as per APT

}  For a well-diversified portfolio, a basic formula describing arbitrage pricing theory can be written as the following:

}  ​E(Rp​)=Rf​+β1​*RP1​+β2​* RP2​+…+βn​*RPn

 where:

}  E(Rp​)=Expected return

}  Rf​=Risk-free return

}  βn​= β is the sensitivity of the asset or portfolio in relation to the specified factor

}  fn​= RP is the risk premium of the specified factor.

Factors affecting expected return

}  Unlike in the capital asset pricing model, the arbitrage pricing theory does not specify the factors. However, according to the research of Stephen Ross and Richard Roll, the most important factors are the following:

}  Change in inflation

}  Change in the level of industrial production

}  Shifts in risk premiums

}  Change in the shape of the term structure of interest rates

  KEY TAKEAWAYS

}  The CAPM lets investors quantify the expected return on investment given the risk, risk-free rate of return, expected market return, and the beta of an asset or portfolio.

}  The arbitrage pricing theory is an alternative to the CAPM that uses fewer assumptions and can be harder to implement than the CAPM.

}  While both are useful, many investors prefer to use the CAPM, a one-factor model, over the more complicated APT, which requires users to quantify multiple factors.