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



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...

References: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30.
Volume 11, Number 8
Bodie Z, Kane A and Marcus A J (2008), Investments. 7th Edition, McGraw Hill Chen N, Roll R and Ross S A (1986), “Economic Forces and Stock Market”, Journal of Business, vol 59, no 3, 389-403 Daniel K, Hirshleifer D and Subrahmanyam A (1998), “Investor Psychology and Security Market Underand Overreactions”, Journal of Finance, vol 53, no 6, 1839-1885 Fama E F (1965), “The Behavior of Stock Market Prices”, Journal of Business, no 38, 34-105 Fama E F (1970), “Efficient Capital Markets: A Review of Theory and Empirical Work”, Journal of Finance, no 25, 383-417 Fama E F (1991), “Efficient Capital Markets: II”, Journal of Finance, vol 46, no 5, 1575-1617 Kahneman D and Tversky A (1979), “An Analysis of Decision Under Risk”, Econometrica, vol 47, no 2, 263-291 Kendall M and Hill A B (1953), “The Analysis of Economic Time Series – Part I: Prices”, Journal of the Royal Statistical Society, vol 116, no 1, 11-34 Fuller R J (1981), “Capital Asset Pricing Theories: Evolution and New Frontiers”, Financial Analysts Research Foundation Hirshleifer (2001), “Investor Psychology and Asset Pricing”, Journal of Finance, vol 56, no 4, 1533-1597. Lintner J (1965), “The Valuation of Risky Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets”, Review of Economics and Statistics, vol 47, no 1, 13-37 Markowitz H M (1952), "Portfolio Selection", Journal of Finance, vol 7, no 1, 77–91 Markowitz H M (1959), Portfolio Selection: Efficient Diversification of Investments, John Wiley & Sons, New York Markowitz H M (2005), "Market Efficiency: A Theoretical Distinction and So What?", Financial Analysts Journal, vol 61, no 5, 17-30 Modigliani F and Pogue G (1988), “Risk, Return and CAPM: Concepts and Evidence”, The Financial Analyst’s Handbook, 2nd Edition, edited by Levine S, Dow Jones Irwin, Homewood Mossin J (1966), “Equilibrium in a Capital Asset Market”, Econometrica, vol 34, no 4, 768-783 Nofsinger J R (2005), The Psychology of Investing, 3rd Edition, Prentice Hall Reilly F K and Brown K C (2003), Investment Analysis and Portfolio Management, 7th Edition, Thomson Learning Roll R (1977), “A Critique of the Asset Pricing Theory’s Tests Part I: On Past and Potential Testability of the Theory”, Journal of Financial Economics, vol 14, no 2, 129-176 Roll R (1978), “Ambiguity When Performance is Measured by the Security Market Line”, Journal of Finance, vol 33, no 4, 1051-1069 Roll R and Ross S A (1980), “An Empirical Investigation of the Arbitrage Pricing Theory”, Journal of Finance, vol 35, no 5, 121-130 Roll R and Ross S A (1984), “The Arbitrage Pricing Theory Approach to Strategic Portfolio Planning”, Financial Analysts Journal, vol 40, no 1, 14-26 Ross S A (1976), “The Arbitrage Theory of Capital Asset Pricing”, Journal of Economic Theory, vol 13, no 2, 341-360 Ross S A, Westerfield R W and Jaffe J F (1990), Corporate Finance, International Edition, Richard D. Irwin Samuelson P (Spring 1965), "Proof That Properly Anticipated Prices Fluctuate Randomly", Industrial Management Review, vol 6, no 2, 41–49 Sharpe W F (1964), “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk”, Journal of Finance, vol 19, no 3, 425-442 Shefrin H and Statman M (1985), “The Disposition to Sell Winners Too Early and Ride Losers too Long: Theory and Evidence”, Journal of Finance, vol 40, no 3, 777-782 Statman M (1999), “Behavioral Finance: Past Battles and Future Engagements”, Financial Analysts Journal, vol 55, no 6, 18-27 Thaler R (1985), “Mental Accounting and Consumer Choice”, Marketing Science, no 4, 199-214 Tobin J (February 1958), “Liquidity preference as behavior toward risk”, The Review of Economic Studies, no 25, 65-86 861
© 2012 The Clute Institute
International Business & Economics Research Journal – August 2012 NOTES
Volume 11, Number 8
862 © 2012 The Clute Institute
Copyright of International Business & Economics Research Journal is the property of Clute Institute and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder 's express written permission. However, users may print, download, or email articles for individual use.
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Free Market Essay
  • Trading Behavior and Investment Decision Making Process of General Investors in Capital Market of Bangladesh Essay
  • Regulation of the Stock Market in Spain Essay
  • Case 1-1 E-Centives, Inc.—Raising Capital in Switzerland Essay
  • Capital Market Reforms Essay
  • Capital markets regulation Essay
  • Reforms of Capital Market Essay

Become a StudyMode Member

Sign Up - It's Free