Chapter 2: Foundations of Finance II:

Asset Pricing, Market Efficiency and

Agency Relationships

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Capital asset pricing model (CAPM)

• CAPM is an equilibrium model: it brings all
investors together.
• According to CAPM only risk related to market
movements is priced by market.
• This is because all other risk can be diversified
away.
• Beta is measure of nondiversifiable risk for a
security.

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CAPM equation
CAPM equation:
E(Ri) = Rf + i * [E(Rm) – Rf]

Notes: E(Rm) – Rf is market risk premium

i = (Ri , Rm)/ 2(Rm)

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 CAPM assumptions
• Rational investors
• Investor beliefs are identical
• Investors have the same efficient frontier, hold
the same portfolio of risky assets, the market
portfolio

(Look at the example using US data)

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Market efficiency
• A market in which prices always “fully reflect”
available information is called “efficient.”
• What is relationship between value and price
if markets are efficient?
– Older version of market efficiency says value and price are
always identical.
– More subtle and realistic version says they can sometimes differ
a little.

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 Market efficiency and available
information
• Weak form: historical prices and returns
• Semi-strong form: all public information
• Strong form: all information, including
private information

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Operational definition of market

efficiency
• Financial markets are efficient if no one can
consistently earn excess returns.
• Based on the assumption “the cost of
information acquisition and generation is
zero” → not reasonable !
→ Excess returns after all costs have been
considered
• What sort of costs?
– Transaction costs
– Analysis costs
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What should be true if markets are

efficient?
• Security prices should respond quickly and
accurately to new information.
• Professional investors should not outperform
net of all fees.
• Technical analysis based on charts of historical
data and fundamental analysis based on
publicly available financial information will not
successfully generate excess returns
• Support passive investment strategy

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 Joint hypothesis problem
• All tests of market efficiency have two
maintained hypotheses:
– Markets are efficient.
– A fair return on a security or portfolio is from a particular model
(in early tests this model was usually CAPM).
• Rejection means:
– Markets are not efficient.
– Method for calculating fair returns is faulty.
– Or both.
• But which? Joint hypothesis problem!

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Joint hypothesis problem

• The need to utilize a particular risk-
adjustment model to produce required
returns but, do not know with certainty what
the correct risk-adjustment model is
• If a test rejects the EMH, is it because the
EMH does not hold, or because we did not
properly measure excess returns?

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Agency relationship and agency

problem
• Agency relationship exists whenever someone (the
principal) contracts with someone else (the agent) to
take actions on behalf of the principal and represent
the principal’s interests.
• In an agency relationship, agent has authority to
make decisions for the principal.
• An agency problem arises when the agent’s and
principal’s incentives are not aligned.

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 Agency problem in firms
• Between owners/shareholders and managers
• In large corporation in U.S: separation of
ownership from the management of the firm
• Managers’ incentives are not consistent with
maximizing the value of the firm

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Agency costs
• Direct costs:
– Example: need to monitor managers, including cost of
hiring outside auditors
– Expenditures that benefit the manager but not the firm
• Indirect costs: are more difficult to measure and
results from lost opportunities
– Example: managers of a firm that is an acquisition target
may resist the takeover attempt because of concern about
keeping their jobs, even if the shareholders would benefit
from merger

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Optimal compensation contract

• Align the interests of shareholders and
managers
• Good corporate governance may include:
– The observed manager’s actions
– Degree of information asymmetry
– Adequacy of performance measures
– Rewards and penalties in compensation contracts

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 From rationality to psychology
• Conventional Finance with three leading
theories
• Behavioral finance is still a relatively new field
and often is criticized because it lacks a unified
framework
• Clearly the recognition that psychological
influences are important is not new in finance
or economics

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