5. Stock Market, Capital Asset Pricing Model, and Introduction to Systemic Risk

What are equity markets?

• A stock, aka ‘equity’, is a security that represents a fractional ownership of issuing corporation

• A unit of stock is a share, which entitles an owner to a portion of the companies profits equal to how much of it they own

• Stocks are often bought and sold on exchanges and are the foundation of many investors’ portfolios

Background on the Capital Asset Pricing Model (CAPM)

• Provides a framework for answering the question, ‘what is the relationship between risk and expected return of an investment?’

• Marks the birth of asset pricing theory

• Entails a methodology which converts risk into expected return on equity (ROE)

• Still used in applications but scholars think it is based on unrealistic assumptions 

• Developed by Harry Markowitz

CAPM assumptions

Markowitz:

• Investors are risk averse

• When choosing between portfolios, investors only care about the mean return and the variance (risk) of their one-period investment 

Sharpe and Lintner:

• Capital markets are perfect, meaning all assets are infinitely divisible, no transaction costs, taxes occur, all information is free and available to everyone, everyone earns at the risk-free rate

• Investors have the same investment opportunity and estimate the same returns and risk from investment on assets

CAPM Formula

E(R_i) = r_f + B_i(E(R_m) - r_f)

• Where E(R_i) is expected return on investment, r_f is the risk-free rate of interest, B_i is the Beta of investment i, and E(R_m) is the expected return of the market return 

• To calculate, we need the risk free rate, the Beta, and the expected return of the asset portfolio 

Systematic and non-systematic risk

• Non-systematic risk is often internal and can be mitigated through diversification

• Systematic risk often can’t be mitigated against internally and can be understood through the CAPM Beta

• The banking sector is heavily linked to systematic risk

The CAPM Beta

• Calculates the rate of return of a stock of portfolio by measuring a stock risk in relation to the whole market

• β = Covariance of Market Return with Stock Return / Variance of Market Return

• Represents the sensitivity of the stock to market fluctuations, where 1 is sensitivity in line with the market, >1 means it’s more volatile, and <1 means it is less volatile than the market 

• Risk-free investments like Treasury Bills have a beta of 0, whilst the most volatile often have a value no greater than 2.5

• Measures systematic risk 

Difference between systematic and systemic risk

• Systematic risk concerns non-diversifiable risk factors which affect everyone through mediums like the stock market; can be a predictor for systemic risk

• Systemic risk is the risk of the entire financial system collapsing 

Systemic risk

• Economies with foundations in finance might be more susceptible

• Risk can be endogenous (from the behaviour of collective financial institutions) or exogenous (when its sources are outside the financial system, perhaps in the real economy)

• The closest we got was 1914, where, due to a failure in confidence before the second world war, liquidity disappeared

• Occurs because of pro-cyclicality, information asymmetries, interdepence, and perverse incentives

• Can be understood as having a shock mechanism and a subsequent transmission mechanism

Types of systemic risk

1. Asset price bubbles, particularly real estate

2. Liquidity provision and mispricing assets

3. Multiple equilibria and panics

4. Contagion

5. Sovereign default

6. Currency mismatches in the banking system

What is pro-cyclicality?

• Fire-sale externalities occur when institutions desperately need liquidity and so try to convert risky assets into cash

• There are many sellers and even fewer buyers meaning that pricing collapses

• This leads to banks trying to convert even more risky assets, causing a vicious cycle

How does information asymmetry cause systemic risk?

• A loss of confidence leads to bank runs and failures, regardless of whether the loss of confidence is due to truth or just rumours 

• Counterparties may refuse to enter into new contracts with banks if they suspect they are in trouble 

How does interdependence contribute to systemic risk?

• An institution is exposed to another institutions state without having any direct dealings with it

• A bank might owe money to the same institutions which owe it money, causing the financial system to be fragile

How do perverse incentive contribute to systemic risk?

• Banks have incentives to become as big and interconnected as possible to maximise the chance of a bailout

• To stop the entire system collapsing, a government will have no choice but to bailout an interconnected bank