Chapter 7
7.1 The relevance of security prices
Most of the developed countries of the world have a market in which shares in local
and international businesses may be bought and sold. These capital markets, known
typically (in English-speaking countries) as stock markets or stock exchanges, also
provide a forum for the purchase and sale of loan notes, of both private sector busi-
nesses and governments. Research evidence shows that in many of these markets
(including the UK one), the market forces that set the prices of individual securities
(shares and loan notes) lead to pricing efficiency. ‘Efficiency’ in this context means
that all available information concerning a particular security’s future prospects is at
all times fully and rationally reflected in the security’s price. In Chapter 9 we shall take
a more detailed look at the workings of the UK capital market and at the evidence for
the efficiency of its pricing. At present it is sufficient that we appreciate that such a
market exists and that its pricing mechanism tends to be efficient.Portfolio theory and its relevance
to real investment decisions
In this chapter we shall deal with the following:‘the mean (expected value)/variance criterion
‘the effect on risk and return of holding risky assets in portfolios
‘efficient portfolios and the efficient frontier
‘the risk-free rate and two-fund separation
7.5 Capital asset pricing model
‘the relationship between the risk and expected return on individual
assets‘the practical limitations of using knowledge of the theoretical risk/return
relationship7.12 Arbitrage pricing model viii
Objectives
‘
‘
‘