Capital market theories

From CEOpedia | Management online

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].

Examples of Capital market theories

  • The Efficient Market Hypothesis (EMH): This is one of the most widely accepted capital market theories. It states that financial markets are efficient and that any new information is quickly reflected in prices. This means that investors cannot "beat the market" by relying on past performance or other information to make better investment decisions than other investors.
  • The Capital Asset Pricing Model (CAPM): This model is used to determine the expected rate of return of a security based on its level of risk. It assumes that investors demand a higher return for taking on more risk and that all investors are risk-averse and select assets that maximize their expected return.
  • The Arbitrage Pricing Theory (APT): This theory is based on the idea that the return on an asset can be predicted by looking at macroeconomic variables. It states that the returns of assets are related to a set of factors that affect the entire market, such as inflation and interest rates. It also suggests that investors can take advantage of price discrepancies between assets to make a profit.

Advantages of Capital market theories

Capital market theories provide a variety of powerful tools to value financial assets and analyze markets. The main advantages of capital market theories are:

  • They allow investors to assess the risk associated with an investment and determine the expected rate of return. This helps investors evaluate whether or not a given investment is a good use of their capital.
  • Capital market theories provide investors with a framework for understanding how various factors, such as market conditions, economic factors, and political factors, affect asset prices. This helps investors make more informed decisions about which investments to make.
  • Capital market theories provide investors with a way to value assets, enabling them to make more profitable investments. By understanding the principles of capital market theories, investors can better determine the worth of an asset and make more informed decisions about their investments.
  • Capital market theories help investors make more informed decisions by providing them with a way to diversify their portfolios. By diversifying their investments, investors can reduce their exposure to risk and improve their overall return on investment.

Limitations of Capital market theories

Capital market theories are fundamental for the valuation of financial assets, but also have some limitations. These can be summarized as follows:

  • Market Efficiency: The underlying assumption in capital market theories is that markets are always efficient, but this is not always the case. Markets can be affected by events that are not always predictable and can lead to mispricing of assets.
  • Risk Aversion: Capital market theories assume that investors are risk averse, but this is not always the case. Some investors may be risk seeking and willing to take on more risk, which can lead to mispricing of assets.
  • Agency Issues: Agency issues can also lead to mispricing of assets. Agency issues refer to the conflict between shareholders and management, which can lead to decisions being made that are not in the best interests of shareholders.
  • Behavioral Bias: Capital market theories assume that investors are rational, but this is not always the case. Investor behavior can be affected by biases that lead to irrational decision making and mispricing of assets.
  • Short-Termism: Capital market theories also assume that investors are looking for long-term returns, but this is not always the case. Many investors may be looking for short-term gains, which can lead to mispricing of assets.

Other approaches related to Capital market theories

Capital market theories provide a framework for understanding and evaluating financial assets. Other approaches related to capital market theories include:

  • Fundamental Analysis: This approach attempts to understand the underlying factors that may influence the value of a security. This includes examining the company's financials, its competitive position in the market, and its expected future performance.
  • Technical Analysis: This approach attempts to understand the behavior of investors and the trend in a security's price. This includes looking at past price movements and trading volume, as well as other indicators such as momentum, support and resistance levels, and moving averages.
  • Behavioral Finance: This approach attempts to understand the psychological factors that may influence the decision-making process of investors. It looks at how investor behavior and emotions can affect their trading decisions.

In summary, capital market theories provide a framework for understanding and evaluating financial assets. Other approaches related to capital market theories include Fundamental Analysis, Technical Analysis, and Behavioral Finance.


Capital market theories — recommended articles
Market Risk Premium — Random walk theory — Overbought oversold indicator — Look-Ahead Bias — Implementation Shortfall — Vomma — Perfect information — Impact of information on decision-making — Tornado diagram

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

Retrieved from "https://ceopedia.org/index.php?title=Capital_market_theories&oldid=90087"