1. The Inefficient Stock Market Chapter 2: Estimating Expected Return with the Theories of Modern Finance

2. Asset Pricing Theories  Estimating expected return with the Asset Pricing Models of Modern Finance  CAPM: strong assumption -- strong prediction.

3. Expected Return Risk (Return Variability) Market Index on Efficient Set Market Index A B C Market Beta Expected Return Corresponding Security Market Line x x x x x x x x x x x x x x x x x x x x x x x x

4. Market Index Expected Return Risk (Return Variability) Market Index Inside Efficient Set Corresponding Security Market Cloud Expected Return Market Beta

5. Asset Pricing Theories  Estimating expected return with the Asset Pricing Models of Modern Finance  CAPM: strong assumption -- strong prediction.  APT: weak assumption -- weak prediction.

6. The Arbitrage Pricing Theory  Estimating the macro-economic betas.  Obtain a characteristic line for each risk factor  Regress return on stock against risk factor

7. Relationship Between Return to General Electric and Changes in Interest Rates -25% -20% -15% -10% -5% 0% 5% 10% 15% 20% 25% Return to G.E. -10%-5%0%5%10% Percentage Change in Yield on Long-term Govt. Bond Line of Best Fit April, 1987

8. The Arbitrage Pricing Theory  Estimating the macro-economic betas.  No-arbitrage condition for asset pricing.  If risk-return relationship is non-linear, you can arbitrage.

9. Curved Relationship Between Expected Return and Interest Rate Beta -15% -5% 5% 15% 25% 35% Expected Return -313 Interest Rate Beta A B C D E F

10. The Arbitrage Pricing Theory  Two stocks:  A: E(r) = 4%; Interest-rate beta = -2.20  B: E(r) = 26%; Interest-rate beta = 1.83  Invest 54.54% in E and 45.46% in A.  Portfolio E(r) =.5454 * 26% +.4546 * 4% = 16%  Portfolio beta =.5454 * 1.83 +.4546 * -2.20 = 0  With many combinations like this, you can create a risk-free portfolio with a 16% expected return.

11. The Arbitrage Pricing Theory  Two different stocks:  C: E(r) = 15%; Interest-rate beta = -1.00  D: E(r) = 25%; Interest-rate beta = 1.00  Invest 50.00% in E and 50.00% in A.  Portfolio E(r) =.5000 * 25% +.4546 * 15% = 20%  Portfolio beta =.5000 * 1.00 +.5000 * -1.00 = 0  With many combinations like this, you can create a risk-free portfolio with a 20% expected return. Then sell-short the 16% and invest the proceeds in the 20% to arbitrage.

12. The Arbitrage Pricing Theory  No-arbitrage condition for asset pricing.  If risk-return relationship is non-linear, you can arbitrage.  Attempts to arbitrage will force linearity in relationship between risk and return.

13. APT Relationship Between Expected Return and Interest Rate Beta -15% -5% 5% 15% 25% 35% Expected Return -313 Interest Rate Beta A B C D E F

14. The Arbitrage Pricing Theory  But, in the real world …  Finite samples and fat-tailed distributions preclude the formation of the riskless hedges that are necessary to ensure that the theory holds  E.g., LTCM

15. Future topics Chapter 7 Importance of Efficient Capital Markets Alternative Efficient Market Hypotheses Efficient Markets and –Technical Analysis –Fundamental Analysis –Portfolio Management “Shift Happens” - Mauboussin “The Wrong 20-Yard Line” - Haugen