Faculty

of Economics and Business

Department of Business
FINANCE I (102329) Groups 4 & 53 2013-14
Dr. Joan Montllor & Dr. Maria-Antonia Tarrazon

Wenwen Xi
Diego Ivan Barros
Marc Mataix Sanjuan

Assignment on Market Efficiency, Noise, and Behavioural Finance

Relate the assessment by Fisher Black

Noise makes it very difficult to test either practical or academic theories about the way
that financial or economic markets work. We are forced to act largely in the dark.
with the evaluation of the impact of efficient markets theory and behavioral finance made
by Robert J.Shiller.

Professor Black is a heavy supporter of the efficient markets theory. This theory states that
price in the stock market is set as a function of the information related with its true value.
Noise is defined as the irrelevant information that some investors include as relevant but is
unrelated with the true value of a given asset. Hence, trading this type of information
creates inefficiencies in the market. If there was no noise in the market, the market will not
exist. That is because if everyone has the same information, the will not be double
coincidence of wants. Noise crates high volatility in prices and because of that, Proferssor
Black states that Noise makes it very difficult to test either practical or academic theories
about the way that financial or economic markets work. We are forced to act largely in the
dark.
Traditional finance ignores the research for investors actual decision-making behavior. The
rise of behavioral finance theory break the fundamental assumption of traditional finance
theory, based on a psychology research, proceeding from actual decision-making
psychology of real investors. With the development of behavioral finance, behavioral
economists and experimental economists have proposed numerous paradoxes. The
traditional "rational man" assumption has been unable to explain the reality of economic
life and behavior.
It is consistence with the evidences to assume the general public to behaves totally rational.
Many investors often make trading decisions based on "noise" rather than the relevant
information. They are easily effected by suggestion from financial experts suggest and will
not divert investment, often traded with self-righteousness and transformed the portfolio in
the hands frequently. It is not as efficient market theory finds that, public trading passively
as they lack information. Behavioral finance believes that when arbitrageurs trade, they are
not only facing the risks of changes in underlying factors, but also the noise trading risk.
There are two theoretical basis of behavioral finance: one is limited arbitrage, the second is
investor psychology analysis.

Faculty of Economics and Business

Department of Business
FINANCE I (102329) Groups 4 & 53 2013-14
Dr. Joan Montllor & Dr. Maria-Antonia Tarrazon

From the first premise, traditional finance believes that arbitrage plays a key role in
achieving market efficiency. Even the irrationality of investors exists and stock prices deviate
from the basic value, there are still rational arbitrageurs, which eliminates the former
influence on prices. However, behavioral finance believes that, the perfect arbitrage is
actually quite limited due to the fact that the noise trader risks, etc. It weakened its
influence on market efficiency.
Viewed from the theory of the second base, although limited arbitrage explains why market
is inefficient with the interference of noise trader, it cannot tell us what specific form is
taken by this inefficiency. Due to this, we need the establishment the second theory. There
are two major reactions in the market, which are overreaction and under reaction. In
response to these two reactions, experts of behavioral finance proposed some models of
investors behavior based on psychology.
According to the behavioral theorists, we are not longer assuming that we act to dark but
rather to continue investigate investors, not assets, to turn the dark into bright color.

Assignment on the CAPM.

1. Explain the meaning of the market portfolio, its relationship with the separation
theorem and with market indices as well as how it influences investors decision making.
(No calculations are required to answer this part of the question). Why does the market
portfolio of Khalersburg yield an expected return of 14.1415% with an associated
variability of 11.8279%?
The market portfolio is a weighted average of the sum of all assets that exists in a market.
The separation theory, according to Tobin, states that if an investor can lend and borrow at
the same rate, the market portfolio will always be the same. In other words, if an investor
can lend and borrow at the same rate, they will choose the same proportion they invest in
the assets of the market in combination with the risk free asset.
The market portfolio of Khalersburg consists of four stocks, which own their own expected
return and associated risk. The total expected return will be the weighted average of the
expected rate of returns of all the assets in the Khalersburg market. That is,
= . , + 0, , + , , + , , = ,

The volatility of the market can be explained by the weighted average of the individual
volatilities plus the relationship among them. That is, the weighted average of the
volatilities plus the covariance between the stocks.

Faculty of Economics and Business

Department of Business
FINANCE I (102329) Groups 4 & 53 2013-14
Dr. Joan Montllor & Dr. Maria-Antonia Tarrazon

2.Calculate the coefficient beta of stock 3 using covariances. Explain the meaning of
coefficient beta and its significance in financial markets. Which is the correlation
coefficient between stock 3 and the market portfolio? What does it mean? Finally, relate
3 to M.

The beta of the security 3 is 2.18. That is, when the market changes 1 basic point, the
security changes 2.18 basic points. The correlation between the stock and the market is
0.049504618. This means that the stock is has a very light positive dependence with the
market. Hence, when beta m, which is nothing else than the market variance, changes the
stock reacts in the same way 2.18 times.

3.Why does stock 3 promises an expected return of 25%? Calculate the risk for which the
expected return on stock 3 offers a risk premium. In case that this risk premium does not
compensate for total risk, explain why.
We can calculate the require return of the stock that is part of M using the Security Market
Line:
= + = +
0.25 = 0.05 + 0.141415 0.05 2.187820434

If we assume that there is no diversification, we can calculate the required rate of return
using the Capital Market Line. That is:
0.141415 0.05
0,25 = 0.05 +
= 0,3038124
0.118279
For the same level of return of 25%, we can obtain a risk of 30% in the Capital Market Line.
The stock has a risk 50% that means that the risk premium is 20%. That is because in the
Capital Market Line we assume perfect diversification and hence, the specific risk of the
particular stock is eliminated.

Faculty of Economics and Business

Department of Business
FINANCE I (102329) Groups 4 & 53 2013-14
Dr. Joan Montllor & Dr. Maria-Antonia Tarrazon

4. Break down the risk of stock 3 justifying the relationship among the different types of
risk associated to it.
We can break down the risk as follows: The total risk is equal to the systematic risk plus the
specific risk. Everything has to be squared.
That is:
(! )! = (! ! )! + (()!
In the case of the stock 3, that is:
0,5! = (2.19 0.118270)! +
= 0.4276834653
This means that this stock has a risk of 6,7% due to the intrinsic risk of the market where it is
trade and a risk of 42% associated with the specific value of stock 3.

5. Mr. Pepet Canons decides to invest 10.000 assuming a total risk of 50%. Design an
efficient investment for him on the Kahlersburg stock exchange that copes with his
preference. Calculate the expected rate of return his investment portfolio, its composition
and the amount of Euros that Mr.Canons invests in stock 3 efficiently.
If we assume that the CAPM theory holds, we will use the Capital Market Line to asses the
return of the investment of Mt Canons because the CAPM theory states that M is the
optimal portfolio to invest to. That is,
0.141415 0.05
() = 0.05 +
0,5 = 0,4364379983
0.118279
The return of the investment of Mr Canons will be 44%.
Continuing with the CAPM we will invest a proportion X in portfolio M that has a return
associated and a proportion (1-x) in the risk free asset with its return. That is:
! = ! + (1 )
0,436437 = 0,141415 + 0.05 1
= 4.2272
That is, Mr Canons will invest 422,72% of his budget or 42272,82 in M and will borrow
322,72% from the risk free asset or 32272,82. If the proportion of the stock 3 in the market
is 19.72%, Mr canons will invest 0,1972*42272,82 in 3. That is a total of 8336,20.

Faculty of Economics and Business

Department of Business
FINANCE I (102329) Groups 4 & 53 2013-14
Dr. Joan Montllor & Dr. Maria-Antonia Tarrazon

6. Finally, explain why stock 4 yields less than the risk-free asset despite bearing a total
risk of 50%? Is it true that its contribution to M is negative? What does this imply in
terms of risk reduction through diversification?
Stock 4 has a negative correlation with all the other assets in the market. Because of that,
the return is very low even though the risk is 50%. Yes, it is true that the contribution to the
risk of the market is negative. We can see that calculating the systematic risk:
= (! ! )!
(0.218782 0,118279). = 0.02588
This implies that including this stock even if it has a very low return and high risk, since the
correlation coefficient is negative with all the stocks, not only it add less that the weighted
average risk but subtracts risk to the market portfolio.