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RSM332H1 Study Guide - Final Guide: Efficient-Market Hypothesis, Growth Stock, Capital Asset Pricing Model


Department
Rotman Commerce
Course Code
RSM332H1
Professor
William Huggins
Study Guide
Final

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APT
Arbitrage Pricing Theory (APT) is a factor-based model of expected returns,
much like the CAPM but with fewer restrictions.
No need to talk about investor utility or risk aversion
No need to find a proxy for the “market portfolio”, nor is everyone
predicted to own it
CAPM can be considered a special case of APT.
What makes good risk factors?
Its variations should affect a large amount (if not all) of the stocks under
consideration.
Its impact on prices should come from its unpredictable changes
The risks should be un-diversifiable (generally they will be macroeconomic
variables)
Accurate and timely information must be available (or you won’t be able
to test the relationship)
Conditions to meet efficient market:
A large number of rational, profit-maximizing investors exist, who actively
participate in the market by analyzing, valuing, and trading securities. The markets
must be competitive, meaning no one investor can significantly affect the price of
the security through their own buying or selling.
Info is costless and widely available to market participants at the same time.
Information arrives randomly(unpredictably) and therefore announcements over
time are not serially connected.
Investors react quickly and fully (and reasonably accurately) to the new
information, which is reflected in stock prices.
Efficient Market Hypothesis
An efficient market is a market that reacts quickly and relatively accurately to
new public information, which results in prices that are, on average, correct.
The efficient market hypothesis is the theory that markets are efficient and
therefore, in its strictest sense, implies that prices accurately reflect all available
information at any given time
Weak form EMH
Weak form EMH is the theory that security prices reflect all market data, referring
to all past price and volume trading information
If weak form efficient, historical trading data will already be reflected (discounted)
in current prices and should be of no value in predicting future price changes
The Random Walk Hypothesis states prices follow a random walk with
price changes over time being independent of one another
Tests: Serial correlation tests, Sign tests
Anomalies
o Evidence of momentum
o Seasonal pattern (January effect)
o Cancelled by transaction costs, ad risky because they do not
occur all the time
Semi- Strong EMH
Semi-strong form EMH is the theory that all publicly known and available
information is reflected in security prices
Assumes the weak-form set of information as well as all public information
pertinent to the security such as: earnings, dividends, corporate investments,
management changes
If semi-strong efficient, it is futile to analyze public information such as earnings
projections and financial statements in an attempt to identify underpriced or
overpriced securities
Tests: Events studies, Examination of performance investors
Stock price actually go up before the announcement supports semi-
strong EMH, but not strong EMH
Anomalies and (counter arguments)
o Earning surprises, their substantial adjustment after the
announcement date contradicts semi-strong EMH
o Value vs. growth stocks (value could outperform growth stock)
o Size effect (performance fluctuates, and higher trading costs in
smaller caps)
o Survey by Value Line Inc. (trading costs, and market adjusts
quickly to new information)
Strong form EMH
Strong form EMH is the theory that stock prices fully reflect all information, which
includes both public and private information
Stock prices are fairly priced.
It is not possible to use public and insider information to identify over-
priced or under-priced stocks
Conclusion and Implications
Empirical Evidence suggests:
Markets generally react quickly and relatively accurately to new public
information
Market prices are thus correct on average
This implies that market prices can be “incorrect” and empirical evidence
suggests mispricing can last for a long time.
Importantly, these conclusions are based on the population mean, not every
observation.
The existence of investors with superior skills does not invalidate the
hypothesis as they are likely to be countered in the population by those
whose skills are below average.
Markets may not be perfectly efficient, but it can be said that they are
relatively efficient, and that efficiency increases with the number of active
investors and analysts covering a firm.
TVM
Mortgage compounded semi-annually.
Principal outstanding is the PV of all future payments after x years.
Bonds
Many bonds are paid semi-annually.
To adjust for semi-annual coupons, we must make three changes:
Size of the coupon payment (divide by 2)
Number of periods (multiply by 2)
Yield-to-maturity (divide by 2)
Clean Price & Dirty Price
The quoted (clean) price is the price reported by the media
The cash (dirty) price is the price paid by an investor
The cash price includes both the quoted price plus any interest that
has accrued since the last coupon payment date
Why do bonds have different yields?
Default risk the higher the default risk, the higher the required YTM
Liquidity the less liquid the bond, the higher the required YTM
Options and other embedded features increase or decrease the
required YTM, depending on who benefits from the clause.
Default Risk
The key concern of all bond investors is that the borrower will not
honour their re-payment obligations
If there is a default, the seniority of lenders becomes important
Those with the highest order claims are in a less risky position and
thus do not require as high a rate.
In general, bonds with lower seniority are paid higher
rates to compensate them for their “recovery” risk
Price Yield-relationship
It is important to remember that prices are set by supply and
demand and that it is YTM which is changing in response to changes
in price
As a result, bond prices fall as interest rates rise.
The coupon rate doesn’t change, so interest payments are
no longer sufficient to cover the risks and the price falls.
Interest Rate Risk & Price volatility
The sensitivity of bond prices to changes in interest rates is a
measure of the bond’s interest rate risk
A bond’s interest rate risk is affected by:
Yield to maturity (see graph on next slide)
Term to maturity
Size of coupon
Factors Affecting Bond Price Volatility
Time to maturity
Long bonds have greater price volatility than short bonds
The longer the bond, the longer the period for which the cash flows
are fixed
Size of coupon
Low coupon bonds have greater price volatility than high coupon bonds
High coupons act like a stabilizing device, since a greater proportion
of the bond’s total cash flows occur closer to today & are therefore
less affected by a change in YTM
Theories of Term Structure
Three theories are used to explain the shape of the term structure
Liquidity preference theory: Investors must be paid a “liquidity
premium” to hold less liquid, long-term debt
Expectations theory: The long rate is the average of expected future
short interest rates
Market segmentation theory: Distinct markets exist for securities of
different maturities
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