Capital Market Theory Research Articles

Total Beta—A Capital Market Analysis with Empirical Evidence

Abstract Some authors have postulated that Total Beta (“Tβ”) is an appropriate measure of risk for undiversified investors to use in developing the cost of equity capital for valuing a privately held company. This paper offers a mathematical analysis of Total Beta based upon the Capital Market Theory in the Expected Return-standard deviation framework, reviews the arguments offered by supporters of Total Beta, and challenges their assumptions and logic. The author offers the first direct evidence that refutes these assertions and arguments.

Portfolio Selection using Cointegration and Modern Portfolio Theory: An Application to the Colombo Stock Exchange

Profitable stock market investments have never been easy due to the lack of predictability and higher risk of stock returns. Hence the necessity of portfolio selection has arisen in order to find the ideal portfolio which best suits the stock market behavior. This study aims at devising the ideal sector portfolio and identifying a better strategy for developing the ideal sector portfolio in the Colombo Stock Exchange (CSE). It covers a period when CSE was one of the best performing stock exchanges in the world; the post civil war period in Sri Lanka. In this study better portfolios were derived from two strategies: (1) Cointegration approach; and (2) Modern Portfolio Theory (including Capital Market Theory) where both are widely used to derive portfolios related to stock market trading. Then the performances of the better portfolios derived were compared by means of the Sharpe Ratio, Information Ratio, Return and Risk in order to determine the ideal portfolio as well as the better strategy. Final conclusion of the study states that “Market portfolio” obtained from the Modern Portfolio Theory performs better than “Best Cointegrated portfolio” obtained from the Cointegration approach in the considered period of time by dominating most of the comparison measures. Also the ideal portfolio consisted of eight sectors out of twenty sectors in CSE with varying weight percentages. Further the best portfolio selection method between the two strategies could have been obtained regardless the period if the methodology is implemented for several Stock Exchanges. However, limitations in accessing necessary data prevented this implementation in the study. Keywords: Sharpe Ratio; Information Ratio; Cointegration; Modern Portfolio Theory; Capital Market Theory; Colombo Stock Exchange. 2010 Mathematics Subject Classification: 62P20

Concepts of Risk in Construction Projects

Risk is a part of business endeavours because of uncertainty (Flanagan and Norman 1993; Fischer and Jordan 1996). Portfolio theory and capital market theory stipulate that risk consists of two types, First, systematic risk, which cannot be controlled, emanates from external factors such as acts of God, natural disasters, market risk, interest-rate risk, and purchasing-power risk. Second, unsystematic risk, which can be controlled, relates to organization-specific factors such as business risk and financial risk(Fischer and Jordan 1996). These forms of risk are fundamental to the construction and the insurance industries.( Tah et al. 1993) . The construction project is a complex sector which characterized with low productivity, cost and time overruns and conflicts. The major challenges in construction project risk assessment which may attributed to knowledge requirements for determining the level of uncertainty and development of complex models to predict . To identifies the risk factors that influence the cost-effective management, operation, and maintenance of construction project, as well as how and when in the project life cycle the identified risk factors impact to the associated costs .The web- based tool can be used by decision -makers during the pre-planning stage of construction projects to estimate cost and duration implications of various risk occurrence scenarios, determine contingencies and prepare risk management plans . In this research the author considered all key articles in the related research streams in recent 30 years and analyzed the risk management views in order to identify key risk factors and its impact on the construction projects.

Developing a Model for Risk and Responsibility Management Share Amongst Stakeholders Consortium in Construction Projects

The construction project is a complex sector which characterized with low productivity, cost and time overruns and conflicts. The major challenges in construction project risk assessment which may attributed to knowledge requirements for determining the level of uncertainty and development of complex models to predict . Portfolio theory and capital market theory stipulate that risk consists of two types, First, systematic risk, which cannot be controlled, emanates from external factors such as acts of God, natural disasters, market risk, interest-rate risk, and purchasing-power risk. Second, unsystematic risk, which can be controlled, relates to organization-specific factors such as business risk and financial risk (Fischer and Jordan 1996).) . To identifies the risk factors that influence the cost-effective management, operation, and maintenance of construction project, as well as how and when in the project life cycle the identified risk factors impact to the associated costs . The identification and design of risk is the first step of risk management. It contain the recognition of potential risk event conditions in a project and the clarification of risk responsibilities. A total of 50 risk factors on construction for stake holders (client , contractor ,consultant ) share projects were identified after conducting an extensive literature survey. A questionnaire survey was conducted from 60 project managers(20 from each category) in all three proficiencies with background experience in buildings ,road and bridges with minimum 15 years experience , to identify the most significant risk factors impact in construction projects . Interviews were conducted face to face, ensuring a 100 percent response rate. The questionnaire was amended by incorporating feedback of the experts to suit the local environments of the construction industry. The weight or rate of each risk factor gained by using a five-point Liker scale from a consolidated conceptual framework of all 50 risk factors identified from the deep literature work . The main aim of these research is to identify ,categorize and ranking common risks, exert management techniques to address those risks , effective risk management and risk status in the construction industry and to help stakeholders to take stock of their ongoing and future projects, with a focus on important risks, their management techniques and barriers to effective implementation of risk management systems.

THE EFFECT OF MONETARY POLICY ON CREDIT SPREADS

AbstractWe analyze the effect of monetary policy on yield spreads between corporate bonds with different credit ratings over the business cycle. We use futures contracts to distinguish between expected and unexpected changes in the Fed funds target rate and several indicators to distinguish between different phases of the business cycle. In line with the predictions of imperfect capital market theories, we find that yields on corporate bonds with low credit ratings widen (narrow) with respect to those with high credit ratings following an unexpected increase (decrease) in the Fed funds target rate during recession periods. Several tests suggest that our results are robust to outliers, potential endogeneity problems, empirical specification, control variables, countercyclical risk premium in futures, and alternative definitions of credit spreads and economic conditions.

Capital Market Theories: Market Efficiency Versus Investor Prospects

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.

Revisiting Total Beta: Round Two

As of late, the business appraisal profession has been inundated with articles defending or rebutting Total Beta, and discussing various related aspects of capital market theory. . . . . Much of the discussion is convoluted and, alas, much misstates fundamental concepts and theory. There appear to be as many opinions regarding every aspect of modern portfolio theory and its application (or lack thereof) to privately-held companies as there are writers to opine. This paper will provide a review of the theory and calculations underlying several key propositions in finance that are fundamental to the ongoing Total Beta debate. These propositions also form the basis for meaningful resolution of that debate. This paper will not address all aspects of modern portfolio theory, the derivation of common ordinary Beta, or the Total Beta debate. It will also not address the problems of investor lack of diversification or quantifying company specific risk. These are for later papers. This paper will address certain propositions by Total Beta advocates, Peter Butler and Gary Schurman. These are found in “A Tale of Two Betas” (Butler & Schurman, Value Examiner. January-February 2011. pp. 21-26) and “Derivation of the Butler Pinkerton Model” (May 2010 whitepaper by Gary Schurman on his website).

Market-to-revenue multiples in public and private capital markets

The behavior and determinants of market-to-revenue ratios in public and private capital markets is examined. Three samples are analysed: (1) all publicly traded stocks listed at some time on the New York Stock Exchange/American Stock Exchange/National Association of Securities Dealers Automated Quotation System in the 1980—2004 period; (2) sample of over 300 so-called ‘internet companies’ in the 1996—2004 period; and (3) over 5500 privately held venture capital-backed companies in the 1992—2004 period. Both company size and the most recent revenue growth rate are found to explain significant variation across companies in their market-to-revenue multiples — smaller companies and companies with higher recent revenue growth rates have higher multiples. We also document how the capital market appears to use a broad-based information set when setting market-to-revenue multiples for companies with negative revenue growth rates — transitory revenue growth components appear to be identified (in a probabilistic sense) by the capital market. Contrary to much anecdotal comment, we present evidence that the capital market behaved directionally along the lines predicted by capital market theory in the pricing of internet stocks in the 1996—2004 period.

Market-to-Revenue Multiples in Public and Private Capital Markets

The behavior and determinants of market to revenue ratios in public and private capital markets is examined. Three samples are analyzed : (1) all publicly traded stocks listed at some time on the NYSE/AMEX/NASDAQ in the 1980 to 2004 period, (2) sample of over 300 so-called “internet companies” in the 1996 to 2004 period, and (3) over 5,500 privately held venture capital backed companies in the 1992 to 2004 period. Both company size and the most recent revenue growth rate are found to explain significant variation across companies in their market to revenue multiples - smaller companies have higher multiples and companies with higher recent revenue growth rates have higher multiples. We also document how the capital market appears to use a broad based information set when setting market to revenue multiples for companies with negative revenue growth rates - transitory revenue growth components appear to be identified (in a probabilistic sense) by the capital market. Contrary to much anecdotal comment, we present evidence that the capital market behaved directionally along the lines predicted by capital market theory in the pricing of internet stocks in the 1996 to 2004 period.

Experiential Learning of the Efficient Market Hypothesis: Two Trading Games

In goods markets, an equilibrium price balances demand and supply. In a financial market, an equilibrium price also aggregates people's information to reveal the true value of a financial security. Although the underlying idea of informationally efficient markets is one of the centerpieces of capital market theory, students often have difficulties in grasping and accepting that asset prices fulfill this dual role of information revelation and demand-supply aggregation. The author presents two simple classroom games that illustrate the workings of information transmission and aggregation through prices. The games are easy to comprehend, simple to implement, and short. Each game, including classroom discussions, takes about 30 minutes. By the end, students will have an intuitive feel for informational efficiency.

The Effect of Monetary Policy on Credit Spreads

We analyze the effect of monetary policy on yield spreads between corporate bonds with different credit ratings over the business cycle. We use futures contracts to distinguish between expected and unexpected changes in the Fed funds target rate and several indicators to distinguish between different phases of the business cycle. In line with the predictions of imperfect capital market theories, we find that yields on corporate bonds with low credit ratings widen (narrow) with respect to those with high credit ratings following an unexpected increase (decrease) in the Fed funds target rate during recession periods. Several tests suggest that our results are robust to outliers, potential endogeneity problems, empirical specification, control variables, countercyclical risk premium in futures, and alternative definitions of credit spreads and economic conditions.

Real Options 'in' Economic Systems: A Proposed Resolution to Problems in Modern Market and Neo-Classical Economic Theory

“I contend that rational expectations theory totally misinterprets how financial markets operate. Although rational expectations theory is no longer taken seriously outside academic circles, the idea that financial markets are self-correcting and tend towards equilibrium remains the prevailing paradigm on which the various synthetic instruments and valuation models which have come to play such a dominant role in financial markets are based. I contend that the prevailing paradigm is false and urgently needs to be replaced.” George Soros. 2008.This conceptual paper will take on the Soros challenge, using the concepts and methodologies of “real options in economic systems” and adding fresh thinking about data sources and the meaning of risk. It will examine the shortcomings and fallacies associated with modern portfolio and capital market theory and neo-classical economics and ask many disquieting questions. General solutions, based in real options thinking, will be proposed and extended to the outer edge of global economic systems as found in the underground economies of the developing world.

Day of the Week Effect and the Stock Returns in the Colombo Stock Exchange: An Analysis of Empirical Evidence

It has generally been assumed that the daily returns are the same for all days of the week. That is, expected return on a given stock is the same for Monday as it is for Tuesday as it is for Wednesday as it is for Thursday and as it is for Friday. However, a number of studies have uncovered the evidence that have been refused this belief. The day of the week effect is a phenomenon that constitutes a form of anomaly of the efficient capital market theory. This research study aims at analyzing the impact of day of the week effect on stock returns in the Colombo Stock Exchange. The main source of data for this research is the daily All Share Price Index of Colombo Stock Exchange for a sample period starting from 02nd January 1985 to 31st December 2004. To investigate the day of the week effect in relation to stock returns both descriptive statistics and autoregressive model were used. To test the day of the week effect four dummy variables, Tuesday through Friday, and five-lag variable to test lag effect have been introduced in the autoregressive model. The finding of the descriptive statistical analysis shows that there is a day of the week effect in stock returns at the Colombo Stock Exchange. However, the trend of this effect is not similar over the sample period. This may be due to the changing socio economic and political conditions of the island. The first finding of this research from the autoregressive model is that there is statistically significant day-of-the week-effect in stock returns of the Colombo Stock Exchange for the overall sample period, and Friday returns are significantly higher compared to the other days. The second finding is that there are lag effects existing in stock returns relating to the day of the week effect.

A real option-based simulation model to evaluate investments in pump storage plants

Investments in pump storage plants are expected to grow especially due to their ability to store an excess of supply from wind power plants. In order to evaluate these investments correctly the peculiarities of pump storage plants and the characteristics of liberalized power markets have to be considered. The main characteristics of power markets are the strong power price volatility and the occurrence of prices spikes. In this article a valuation model is developed capturing these aspects using power price simulation, optimization of unit commitment and capital market theory. This valuation model is able to value a future price-based unit commitment planning that corresponds to future scope of actions also called real options. The resulting real option value for the pump storage plant is compared with the traditional net present value approach. Because this approach is not able to evaluate scope of actions correctly it results in strongly smaller investment values and forces wrong investment decisions.

From the Efficient Market Hypothesis to Behavioral Finance: How Investors' Psychology Changes the Vision of Financial Markets

This paper confronts the main foundations of the neoclassical theory of the capital market and asset pricing with allegations of behavioral finance. Cornerstones of the traditional theory are discussed in the first section. It is followed by a brief presentation of the behavioral approach. Further, the paper discusses consequences of the new view of finance to capital market practitioners - investors, corporate finance, and policy-makers. The paper concludes with final remarks and some thoughts on the future development of the capital market theory.

Owner's Lack of Diversification and the Cost of Equity Capital for a Closely Held Firm

Abstract Capital market theory suggests that undiversified investors may have a higher cost of capital than do diversified investors. Private companies generally trade at a discount to similar publicly traded companies. From a discounted cash-flow viewpoint, this implies that the cost of capital for the private company is higher. We suggest that a large component of the private company discount is due to the entrepreneurial investor's lack of diversification. Using basic capital market theory, we provide a cost of capital model that depends on total risk faced by the entrepreneurial investor. We then propose a methodology based on a certainty-equivalent approach and Monte Carlo simulation to quantify this risk. We also provide a simple case to illustrate its application. Our results suggest that the risk borne by the undiversified entrepreneurial investor is a major contributor to the private company discount through the cost of capital.

Testování slabé formy efektivnosti na českém akciovém trhu

Efficient Market Hypothesis has dominated the field of research on capital market theory. It postulates that asset prices are rationally connected to economic realities and always incorporate all the information available to the market. A huge quantity of theoretical works around the world have been devoted to testing this hypothesis. In this paper, the weak form of the Efficient Market Hypothesis is tested on data from the Czech stock market of period 1996-2006. The tested hypothesis is verified by both linear and nonlinear methods. Those linear are: Box-Pierce test, variance ratio test, test of sequences and reversals nad Hurst exponent. The nonlinear ones are: White test, Engle test, Hinich test and BDS test. These tests are carried on stock returns time series of Czech stock market index PX and individual stocks as Telefónica, Komerční banka and ČEZ and series with randomly changed order from original series. The results of the testing indicate that returns, when randomly permutated, are independent, hence they follow a random walk. But it is impossible to maintain it in case of original returns series.It implies that returns of either Czech stock market index or its stocks are not independent and do not follow a random walk.

Implications of IFRS for the European Insurance Industry—Insights From Capital Market Theory

AbstractThe European insurance industry is currently undergoing a substantial change in financial reporting requirements. Beginning in 2005, compliance with the International Financial Reporting Standards (IFRS) has been required in the European Union. Substantial sections of the IFRS—leading to a market‐oriented valuation of insurance contracts—are still under construction and will be introduced in the next few years. To date, assessment of the potential impact of the new IFRS accounting and reporting system is largely found in trade literature, and in insurance industry business leader and expert commentator statements. The tenor of opinion is that the IFRS will create a serious challenge for the European insurance industry. To evaluate the impact of IFRS more scientifically, this article applies—where indicated—capital market theory and the concept of information efficiency. The article suggests that concerns about the effects of IFRS are exaggerated, and reveals that the main area of IFRS impact on the European insurance industry is likely to be on insurance product design.

Experiential Learning of the Efficient Market Hypothesis: Two Trading Games

In goods markets an equilibrium price balances demand and supply; in a financial market an equilibrium price also aggregates people's information. And while the underlying efficient market hypothesis is one of the centerpieces of capital market theory, students often have difficulties grasping and accepting that asset prices fulfill this dual role of information and demand-supply aggregation. In this essay I present two simple classroom games that illustrate the workings of information transmission and aggregation through prices. The games are easy to comprehend for students, simple to perform and short. Each takes about 30 minutes, including classroom discussions, and by the end students will have an intuitive feel for the efficient market hypothesis.

Implications of IFRS for the European Insurance Industry - Insights from Capital Market Theory

The European insurance industry is currently undergoing a substantial change in financial reporting requirements. Beginning in 2005, compliance with the International Financial Reporting Standards (IFRS) has been required in the European Union. Substantial sections of the IFRS - leading to a market-oriented valuation of insurance contracts - are still under construction and will be introduced in the next few years. To date, assessment of the potential impact of the new IFRS accounting and reporting system is largely found in trade literature, and in insurance industry business leader and expert commentator statements. The tenor of opinion is that the IFRS will create a serious challenge for the European insurance industry. To evaluate the impact of IFRS more scientifically, this paper applies — where indicated — capital market theory and the concept of information efficiency. The paper suggests that concerns about the effects of IFRS are exaggerated, and reveals that the main area of IFRS impact on the European insurance industry is likely to be on insurance product design.