An Alternative View of
Risk and Return The
Arbitrage Pricing Theory
Arbitrage Pricing Theory

An asset’s return is related to common risk
factors
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Example: Fama French Model

Returns are a function of three risk factors
 Size

factor
Return on the averages small firm minus the average large firm
 Value

factor
Return on the average value firm minus the average growth
firm
 Market

Factor
Same as CAPM
R  βSML(SML)  βHML (HML)  βM (MKT )
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Multi-Factor Betas

Since we are allowing for multiple risk factors, how
will b change?
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Example

What is a stock’s expected return if its betas
are:
 SML:
0.5
 HML: 3.0
 Mkt: 2.0
 SML is 8%, HML is 5%, the market risk premium
is 4%, and the risk free rate is 3%
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Why We Care

Another investment rule
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Corporate Financing
Decisions and Efficient
Capital Markets
News and Returns

All news, and announcements contain anticipated
and unexpected components

The market prices assets based on the
anticipated component of the news
 This

is where expected return comes from
The surprise is what creates un-expected return
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Breaking Returns Down

A security’s actual return is comprised of:
1.
2.

The expected return
The un-expected return
Therefore, a stock’s return is:
R  R U
where
R is the expected part of the return
U is the unexpected part of the return
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Where does U come from?

Systematic Surprises:

Unique Surprises:
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Breaking Returns Down (2)
We defined returns as: R  R  U
 We can break U down further: R  R  m  
 m is the return earned because of unexpected
movements in systematic risk
  is the return from unique surprises

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Example

Lets use the Fama French factors:


SML, HML, and Mkt
Our model is:
R  R  βSML FSML  βHML FHML  βMkt FMkt  ε
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Surprises

Expected SML to be 3%, but it was 8%; surprise is?

Expected HML to be 4%, but it was 1%; surprise is?

Expected Mkt to be 10%, but it was stable; surprise is?

Finally, the firm attracted a “superstar” CEO, and this
unanticipated development contributes 1% to the
return.
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Example Betas


The stock’s betas are:
1. bSML = -2.30
2. bHML = 1.50
3. bMkt = 0.50
Remember the stock’s expected return was
8%
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Example’s Actual Return
R  R  βSML FSML  βHML FHML  βMkt FMkt  ε
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Underlying Assumption

The assumption we made, and that drove the
last example, is that the stock is priced in an
efficient market
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What is an efficient market?

A market is efficient when it uses all available
information to price assets.
 Information
is quickly incorporated into prices
Efficiency is the degree to which prices reflect
available information.
 Stock prices only respond to surprises, which
arrives randomly, so prices follow a random walk


Price tomorrow = today’s price + random (+/-)
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Price: Today and Tomorrow
Do you see a pattern
that you want to put
money on?
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Reactions to Beating Expectations
Over Reaction
Under Reaction
Efficient Response
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Reaction to Not Meeting Expectations
Under Reaction
Efficient Reaction
Over Reaction
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Potential Causes of Efficient
Markets

Investor Rationality
 Everyone
is rational → Everyone makes the right
decision

Independent Deviation from Rationality
 No
one is rational → Everyone makes the wrong
decision but each makes a different wrong decision


Average out the wrongness
Arbitrage
 Only
some people are rational → Smart money takes
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from less smart money
Types of Efficient Markets
Strong
Semi-Strong
Weak
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Weak Form Efficiency

Prices reflect all information contained in past
prices and volumes
 No
investor is able to form a trading strategy based
on historic prices and volumes and earn an excess
return
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Disbelievers

Chartists, or Technical Analysts
 Analyze

Chartist believe in identifiable and predictable
patterns in these characteristics
 Make

“charts” of a stock‘s Price and/or Volume
investment decisions based on these patterns
Brokerage firms tend to love chartists
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Head and Shoulders
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Stock Price
Why Technical Analysis Fails
Investors will eliminate any opportunities associated with
stock price patterns
If there is a profitable
pattern, everyone would do
it, and the profits would be
competed away.
Sell
Sell
Buy
Buy
Time
Semi-Strong Form Efficiency

Security prices reflect all publicly available
information.
 Encompasses

weak form efficiency
Publicly available information includes:
 Historical price
 Published
and volume information
accounting statements
 Information
found in the WSJ
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Disbelievers

Fundamental Analysts
 Use
revenues, earnings, future growth forecasts,
return on equity, profit margins, and other data to
determine a company's underlying value and
potential for future growth (Financial Statements)

These guys make more sense than technical
analysts. Why?
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Strong Form Efficiency

Strong form efficiency says that anything
pertinent to the stock price and known to at
least one investor is already incorporated in the
security’s price.
 Public
& Private
 Implies:

Insider trading will not earn excess return
Strong form efficiency incorporates weak and
semi-strong form efficiency.
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Disbelievers
Pretty much everyone
 Insiders trading is generally profitable

 Martha
Stewart
 Galleon
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What EMH Does and Does NOT Say

Investors can throw darts to select stocks.
 Kind

of: We still need to consider risk
Prices are random or uncaused.
 Prices
reflect information.
 Price CHANGES are driven by new information,
which by definition is random
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Implications of Efficient Markets
Purchase or sale of any security can never be a
positive NPV transaction.
 Trust market prices
 Stocks with similar risk are substitutes
 Mutual fund managers cannot systematically
outperform the market

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The Evidence

The record on the EMH is extensive,
and generally supportive of the market
being semi-strong form efficient
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Event Studies
 Event
Studies examine returns around
information release dates
 EX:
Earnings, Dividend announcements
 A test of semi-strong form efficiency
 Look
at how quickly prices adjust to the
information
 Looking
for under-reaction, over-reaction, early
reaction, or delayed reaction around the event.
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Event Study Results
The studies generally support the view that the
market is semi-strong form efficient.
 Studies suggest that markets may even have
some foresight into the future, i.e., news tends
to leak out in advance of public
announcements.

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Cumulative abnormal returns
(%)
Event Studies: Dividend Omissions
Cumulative Abnormal Returns for Companies Announcing
Dividend Omissions
1
0.146 0.108
-8
-6
0.032
-4
-0.72
0
-0.244
-2 -0.483 0
-1
2
-2
-3
-3.619
-4
-5
4
6
8
Efficient market
response to “bad news”
-4.563-4.747-4.685-4.49
-4.898
-5.015
-5.183
-5.411
-6
Days relative to announcement of dividend omission
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The Record of Mutual Funds
If the market is semi-strong form efficient,
then mutual fund managers, should not be able
to consistently beat the average market return
 When we compare the record of mutual fund
performance to a market index, we see that
mutual funds are not able to
CONSISTENTLY beat the market.

 Consistent
with the market being semi-strong form
efficient
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Mutual Fund Performance
All funds
Smallcompany
growth
Otheraggressive
growth
-2.13%
Growth
Income
-0.39%
-2.17%
Growth and
Maximum
income
capital gains
Sector
-1.06%
-0.51%
-2.29%
-5.41%
-8.45%
Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and
Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).
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Insider trading
 Strong
form market efficiency implies
that even insiders trading on private
information cannot earn excess return
 A number of studies find that insiders are
able to earn abnormal profits
 Violation
of Strong form efficiency
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Verdict on Market Efficiency
Market is pretty efficient
 Opportunities for easy profits are rare.
 Financial managers should assume, at least as
a starting point, that security prices are fair and
that it is difficult to outguess the market.
 New information is rapidly incorporated into
the prices.

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EMH Exercises

Indicate whether or not the EMH is contradicted,
if so which form of EMH is contradicted
 An
investor consistently earn an abnormal return over
that expected by the market by examining charts of
historical prices
 The acquisition of the latest annual report of a company
enables an investor to earn an abnormal return.
 A stock which has been fluctuating between $25 and
$27 in the last three months suddenly rises to $40 per
share right after management announces a new project
that has a promising impact on the firm's expected
future cash inflows.
 By subscribing to the Value Line Investment Survey, an
investor can earn at least 5% over that earned by the
market on comparable risk investments.
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Why We Care

Offering several points of view on how the
market works, and the evidence for and against
 Using
this you can form your own opinion about
how the market works and invest accordingly
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