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Economics 434 Theory of Financial Markets

Economics 434 Theory of Financial Markets. Professor Edwin T Burton Economics Department The University of Virginia. Capital Asset Pricing Model. Makes all the same assumptions as Tobin model But Tobin’s model is about “one person”

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Economics 434 Theory of Financial Markets

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  1. Economics 434Theory of Financial Markets Professor Edwin T Burton Economics Department The University of Virginia

  2. Capital Asset Pricing Model • Makes all the same assumptions as Tobin model • But Tobin’s model is about “one person” • CAPM puts Tobin’s model in equilibrium, by assuming that everyone faces the same portfolio choice problem as in Tobin’s problem • Only difference between people in CAPM is that each has their own preferences (utility function)

  3. CAPM – two conclusions

  4. Capital Market Line Mean M What is M ? Answer: contains all “positively” priced assets, weighted by their “market” values. Rf STDD

  5. Security Market Line i = Rf + i [M – Rf] Mean i M Rf Security Market Line Beta 1

  6. Roll’s Criticism • Erich Roll – UCLA, 1982 • Not a testable theory • Can’t find market basket • Without true market basket, can reach wrong conclusion • Is Beta dead?

  7. Fama-French • 1982 by Eugene Fama and Kenneth French • Research designed to test whether or not CAPM is true • Findings • Beta is largely irrelevant • Book/Market positively related to future performance • Size negatively related to future performance

  8. Performance Evaluation • Absolute Return Doesn’t Tell You Much • Need to Know What Risk Was Taken • Beta is the normal measure of risk • “Risk Adjusted” Performance is now the norm

  9. Roll’s Criticism Applies Here • Data might show superior performance • When performance is actually inferior • Data might show inferior performance • When performance is actually superior

  10. Two Things Keep Beta Going • The Limit Theorem • Ease of Computation

  11. Efficient Market Hypothesis Current Price is “best estimate” of value…..based upon all relevant information Can’t beat the market is one clear implication Probably “EMH” is false….volatility of market prices much greater than following of expectations of future earnings, dividends, and expectations of future interest rates

  12. Anomalies • People remember what price they paid for a stock and that influences their decisions • January effect • Small stock effect • Mean-reversion • Loss aversion

  13. Other Topics • Stocks for the long run? • Value versus Growth? • Corporate Governance

  14. The End

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