The relevance of security pricesThe existence of a market that trades in securities at prices that will tend to reflect
the expected returns and risks of the securities concerned has led researchers to try to
develop theories as to how the stock market pricing mechanism works. This was felt
to be particularly important in financial management because:l Financial managers are concerned with the way that their businesses’ securities are
priced in the free market as this might well have some impact on their financing
decisions, for example at what price to issue new shares.
l Financial managers are also concerned with the relationship between how securit-
ies are priced in the capital market, on one hand, and their businesses’ investment
decisions, on the other. Businesses make decisions concerning investment in real
assets on the basis of anticipated returns and of the risk attaching to those returns.
The capital market is a free market, which deals in precisely those two commodit-
ies: return and risk. Thus we have a free and apparently efficient market that sets
prices for return and risk. A vast amount of historical data is available on security
prices and dividends, so we can readily observe what has happened in the past and
draw conclusions on how return and risk seem to be related. In other words, we can
see how risk is dealt with in the pricing mechanism of a free market. This should be
useful to financial managers since there seems no logical reason why they should
take a different view of return and risk from that taken by investors in the capital
market.The market’s pricing mechanism for securities becomes even more relevant to us
when we remind ourselves that managers are seeking, through their investment and
financing decisions, to increase the wealth of the shareholders, partly through the
business’s value on the capital market. It seems even more logical, therefore, that man-
agers should take a similar attitude to risk and return to that of security investors in
the market.
Researchers felt that if they could come to some sensible conclusion on the way in
which risk and return are priced in the capital market, financial decision makers
would be provided with a useful basis for the business to assess real investment
opportunities.
What we are now going to discuss is generally referred to as portfolio theory. More
particularly we shall be considering the capital asset pricing model (CAPM), which is
an equation for estimating the required return from an investment with a particular
risk profile. CAPM began to emerge in the early 1960s. Extensive tests were carried out
to try to assess the effectiveness of the model in explaining and predicting real-life
events. These tests generally tended to be supportive of CAPM and so, by the 1990s, it
had become fairly widely well established among larger businesses throughout the
world (see section 7.11). Unfortunately, at the same time that CAPM was becoming the
standard way of deriving the required return from a risky investment in practice,
researchers were continuing to test the validity of the model and were casting increas-
ing doubt on its credibility and practical usefulness. We have now reached the posi-
tion where the practical weaknesses of CAPM have rendered it not able to be
recommended to be used in practice.
Despite the deficiencies of CAPM, we are now going to take a fairly brief look at the
ideas on which it is based and how the model theoretically achieves its purpose. This
is because these issues continue to a great extent to be valid and it is useful to under-
stand them.‘