Capital Markets

Conceptual Overview

Models that explain the pricing of securities historically have been problematic. Economic common sense suggests that risky securities will have a higher rate of return, but no capital-asset pricing model has fully explained this risk–return relationship. In the 1950s and 1960s, the academic field of finance adopted the methodology of economic science, creating a variety of new models that better explained the world of finance, including security pricing. Decades later, many of the pioneering academics were awarded the Nobel Prize in economics.

Portfolio theory is among the most prominent theoretical breakthroughs in finance. In his 1959 work, Harry Markowitz established the importance of considering the risk–return relationship of securities within a portfolio of securities. The diversification of risk in a portfolio shows that a securities risk is reduced as the stock price movements of different stocks cancel one another out. The result is that, in a well-diversified portfolio, all the diversifiable risk is eliminated and an investor is exposed to less risk.

The development of the capital asset pricing model (CAPM) is attributed to a number of theoretical studies, including William Sharpe's in 1964. The CAPM provides a market price for risk. The market model is related to the CAPM and is used extensively to estimate returns and risk for a single security or portfolio. The development of the CAPM resulted in an astounding number of academic empirical research papers and applications by finance practitioners.

Capital market efficiency is concerned with the price of securities instantaneously reflecting all relevant available information. E. F. Fama has provided a framework to study market efficiency. Efficiency is important in that market prices allocate resources. Buyers and sellers in the market rely on prices to reflect the true economic expected performance of securities. Corporate managers consider their securities' expected return as a benchmark of performance. Efficiency also means that one cannot beat the market by buying or selling underor overvalued securities. A variety of models exist to test for market efficiency, including event-study methodology created by Fama, Fisher, Jensen, and Roll. A sizeable body of literature exists that studies capital market efficiency. The results generally show that markets are “efficient,” which means that security prices do reflect all available public information, though of course some anomalies exist. Some market anomalies exist, often to be explained by subsequent research.

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