Capital Market

Topics: Capital asset pricing model, Modern portfolio theory, Investment Pages: 26 (7958 words) Published: August 25, 2013
International Business & Economics Research Journal – August 2012

Volume 11, Number 8

Capital Market Theories: Market Efficiency Versus Investor Prospects Kathleen Hodnett, PhD, University of the Western Cape, South Africa Heng-Hsing Hsieh, PhD, CFA, University of the Western Cape, South Africa

ABSTRACT This paper reviews the development of capital market theories based on the assumption of capital market efficiency, which includes the efficient market hypothesis (EMH), modern portfolio theory (MPT), the capital asset pricing model (CAPM), the implications of MPT in asset allocation decisions, criticisms regarding the market portfolio and the development of the arbitrage pricing theory (APT). An alternative school of thought proposes that investors are irrational and that their trading behaviors are driven by psychological biases such as greed and fear. Prospect theory and the role of behavioral finance that describe investment decisions in imperfect capital markets are presented to contrast the Utopian assumption of perfect market efficiency. The paper concludes with the argument of Hirshleifer (2001) that heuristics are shared by investors and asset prices may not reflect their long-term intrinsic values as indicated by efficient capital market theories. Keywords: Capital Market Theories; Markowitz Portfolio Theory; Capital Asset Pricing Model; Arbitrage Pricing Theory; Behavioral Finance; Prospect Theory; Efficient Market Hypothesis; Separation Theorem; Roll’s Critique; the Benchmark Error

INTRODUCTION

C

apital market theories provide the foundation for the development of financial asset pricing models. The mainstream view of capital markets adopt the perfect-world scenario where markets are perfectly efficient with regard to information in that asset prices quickly and accurately reflect new information as it arrives in the market. Under the assumption of efficient capital markets, all investors are risk-averse and completely rational in making their decisions. Theories developed based on the assumption of efficient capital markets include the efficient market hypothesis (EMH), Markowitz’s portfolio theory, the separation theorem, the capital asset pricing model (CAPM) and the arbitrage pricing theory (APT). The EMH is regarded as the fundamental theory underpinning all areas of finance. Modern Portfolio Theory (MPT), pioneered by Markowitz (1952) and the separation theorem of Tobin (1958) provide solutions for risk-averse investors to allocate assets in an efficient capital market. Under the assumptions of MPT, risk-averse investors have homogeneous expectations regarding the mean, variance, and covariance of asset returns, and aim at maximizing their expected utility when making investment decisions. The concept of risk aversion stems from the expected utility theory, which describes the decision making process of investors in the presence of risk and is based on investor rationality. As an extension to the existing framework of MPT, the capital asset pricing model (CAPM) is developed to price assets in an efficient capital market. The essence of MPT surrounds a completely diversified optimal risky portfolio called the market portfolio that all investors are assumed to hold, and the only source of risk in an investment is its sensitivity to movements in the market portfolio, since any firm-specific risk can be diversified away by holding the market portfolio. The concept of the market portfolio is criticized and a multifactor asset pricing model developed under the arbitrage pricing theory (APT) is viewed as an alternative to the CAPM in pricing assets in an efficient capital market. An alternative school of thought, behavioral finance, built on the likelihood of investor behaviors, or investor prospects, challenges the assumptions of market efficiency, particularly investor rationality. While traditional finance make suggestions regarding the manner in which assets should be priced in efficient...

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Volume 11, Number 8
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Volume 11, Number 8
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