Pricing Theories Flashcards
Capital Asset Pricing Model (CAPM)
The CAPM suggests that the sensitivity of an investment to the market that is the appropriate measure of risk.
The sensitivity of a security relative to the market is expressed in terms of its beta.
The market has a beta of one.
A beta of less that 1 means the investment is less volatile than the market.
A beta of more than 1 means the investment is more volatile than the market.
The CAPM equation is usually expressed as:
E(Ri) = Rf + Bi (Rm - Rf)
E(Ri) - Expected return on the risky investment
Rf - Rate of return on a Risk free asset
Rm - Expected return of the market
Bi - The measure of sensitivity of the investment to movements in the overall markets
Bi (Rm - Rf0 is the risk premium on the risky investment
Modern Portfolio Theory
Modern Portfolio Theory promotes the idea that portfolios should be built to maximise returns and minimise risks through diversification. The key concept of MPT is the ‘efficient frontier’, which describes the relationship between the return that can be expected from a portfolio and the risk of the portfolio as measured by the standard deviation.
Expected Return ^ Risk >
Multi Factor Models
The CAPM is a single factor model, it only takes into account an investment’s sensitivity to a market as measure by its beta.
Multi factor models allow for different sensitivities to different economic factors and the identification of each factors contribution to the securities return.
All multi factor models share two basic ideas - investors require extra reward for taking extra risk cannot be eliminated by diversification.
One of the best known multi asset pricing models is based on arbitrage pricing theory.
Arbitrage Pricing Theory (APT)
Arbitrage Pricing Theory suggests the performance of an asset can be determined by a number of factors rather than just one, including:
- Unanticipated inflation
- Changes in the expected levels of industrial production
- Changes in default risk premium on bonds
- Unanticipated changes in yield curves
The model produced gives the correct price for the investment. if the actual price of the investment is under this ‘correct price’, then the investor may wish to purchase it in a bid to make a ‘risk free’ profit.
APT means more beta calculations and there are no guarantees that all relevant factors will be identified. Despite its complexity it is used as a basis for many commercial risk systems employed by asset managers.
Efficient Market Hypothesis (EMH)
The EMH states that it is impossible to achieve returns in excess of average market returns consistently through stock selection or market timing as the prices of securities in the market are always correct and reflect their intrinsic value and information about them at any given time.
The only way an investor can achieve a higher return therefore is to purchase riskier investments and this is a game of chance rather than skill.
There are three levels of EMH based on the different information they consider:
Weak form:
Current security prices fully reflect all past prices and trading volume information. Future prices cannot be predicted from historical data.
Semi strong form:
Security prices adjust very quickly to all publicly available information. No excess returns can therefore be made based on information availability.
Strong form:
Security prices reflect all information that an investor can acquire, public or private.
Behavioural Finance
Behavioural finance argues that investors do not always act rationally in relation to investment decisions.
This is known as prospect theory.
People tend to play it safe when protecting gains, but when faced with potential losses, they take riskier decisions (i.e. not selling) and end up with even greater loss.
Contrarianism
The contrarian investment manager believes that the average opinion is usually wrong, and that high returns can be achieved by going against the trend.
Correctly judging the point where a trend has reached an extreme of optimism or pessimism is difficult and risky.
This style is found most often in hedge fund managers.
Momentum
Momentum is the strategy most widely adopted by middle-of-the-road fund managers.
Successful momentum investors have to use this type of analysis to be ahead of the latest swing in opinions.
‘Sector rotation’, where sectors are expected to perform well at particular points in the economic cycle, is one example of momentum investing.
GAARP
GAARP is based on finding companies with long-term sustainable advantages in terms of their business franchise, quality of management, technology or other specific factors.
Proponents argue that it is worth paying a premium price for a business with premium quality characteristics. Many of its proponents use screens to identify potential stocks.
The style is used mainly by active growth managers
Value
This is the oldest style, dating back to Warren Buffett’s 1930s mentor Benjamin Graham.
It’s core statement comes from Graham: ‘In the short run, the stock market is a voting machine; in the long run, it is a weighing machine.’ Votes are investor’s purchases and sales; what the machine weighs is profits, dividends and asset values.
The value investor believes that, using deep and rigorous analysis, they can identify businesses whose value is greater than the price placed on the by the market.
By buying and holding such shares, often holding for long periods, they can earn a higher return than the market average. Managers of ‘equity income’ or ‘income and growth’ funds often adopt this style, since ‘out of fashion’ stocks often have high dividend yields.
Pragmatic Approach
Pragmatists, the pre-runners to Modern Portfolio Theorists, use forward looking judgements of likely returns and volatility to determine portfolio weightings.
These judgements tend to assume that returns and volatility will come close to their historical averages over longer timescales.
Short term predictions are high risk as investments tend to be more volatile over shorter timeframes.
