Capital market theories

From CEOpedia | Management online
Capital market theories
See also

Capital market theories are the main source when valuing financial assets. The main goal of the capital market is a world in which markets achieve maximum efficiency. Assets are carefully analyzed, contain new and reliable information as soon as they appear [1]. The capital market is a complex system created by humans and very difficult to understand. When describing an uncertain system, it is considered random and unintentional. An example would be the capital market theory based on probability statistics. The creator of this theory made many assumptions, however, investors' behavior and their psychology did not go hand in hand with statistical market assumptions. The capital market has a very complex internal structure. We need certain results, justified assumptions, which is the reason for investor behavior and price fluctuations. Theories should be reliable and verifiable [2].

Efficient capital market

An efficient capital market is characterized by the fact that the investor achieves maximum speculative profit. This is achieved thanks to public information about companies whose securities are on the market. The analysis allows for the effective purchase and sale of shares. The whole success lies in the assessment of stock analysts and investors. Their goal is the highest possible profit, which is why they carefully identify securities whose value is undervalued or overvalued. Thanks to the analysis, they have investors gain information about what market prices are and what could be achieved. The analyst sets real prices through the purchase, sale or recommendation of securities. This whole process ensures that market prices are well defined [3].

Theories that are prepared based on an effective capital market consist of [4]:

  1. Efficient market hypothesis (EMH)
  2. Modern portfolio theory
  3. The separation theorem
  4. The capital asset pricing model (CAPM)
  5. The arbitrage pricing theory (APT)

Modern portfolio theory (MPT)

appropriately selected shares that have a precisely defined level of risk allow maximizing the return on investment. The assumption in this theory is that profitability and equity risk can be measured by analyzing daily relative price changes and standard deviations of shares. The basis of this theory is the assumption that the distribution of relative past price changes will repeat in the future. If it wasn't like that, the theory would be limited to the identification of the former optimal portfolio [5]. Hodnett and Hsieh indicate, that the task of MPT is a completely diversified market portfolio whose risk is optimal. The market portfolio is owned by all investors, 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 [6].

References

Footnotes

  1. K Hodnett, HH Hsieh 2012, p.1
  2. J Ding 2011, p.361
  3. DR.Fischel 1978, P.5
  4. K Hodnett, HH Hsieh 2012, p.2
  5. FM Turcaş 2010, p.702
  6. K Hodnett, HH Hsieh 2012, p.1

Author: Karolina Kaleta