Unit 3: Capital Market & Asset Pricing

Capital Market & Asset Pricing

Technical Analysis is the study of historical price and volume to predict future price movements in the financial markets. It is based on the belief that "price reflects all information".

Dow Theory

Developed by Charles Dow, it is the foundation of modern technical analysis.

Six Basic Principles of Dow Theory

Support and Resistance Levels

Support Level

A price level where buying interest is strong enough to prevent the price from falling further.

"Floor" of the market

Resistance Level

A price level where selling pressure overcomes buying, preventing the price from rising further.

"Ceiling" of the market

Term	Meaning
Support	Buying zone, price bounces back upward
Resistance	Selling zone, price falls from the top

Traders use these levels to enter or exit trades.

Types of Charts & Their Interpretations

Technical analysts use price charts to visualize market movements.

A. Line Chart

• Plots only closing prices over time.
• Simple but lacks detail.

B. Bar Chart

• Shows open, high, low, close (OHLC) for a given period.
• Useful for detailed trend analysis.

C. Candlestick Chart

• Most popular chart type.
• Visual representation of price movement in a time frame.

 Common Candlestick Patterns (Interpretation)

Capital Market & Technical Analysis

Trend Line

A Trend Line is a straight line drawn on a price chart to identify the direction of the market (trend).

Types of Trend Lines

Gap Theory (Price Gaps)

Gaps occur when there's a sharp price movement with no trading in between. They appear as blank spaces on the chart.

Types of Gaps

 Wave Theory (Elliott Wave Theory)

Proposed by Ralph Nelson Elliott, this theory states that market prices move in repetitive waves influenced by investor psychology.

Wave Patterns

• Impulse Waves (5 waves): Direction of the main trend
• Corrective Waves (3 waves): Move against the trend

Pattern:

Relative Strength Analysis (RSI)

RSI (Relative Strength Index) is a momentum indicator that measures speed and change of price movements.

RSI Scale: 0 to 100

Technical vs Fundamental Analysis

 Nature of Stock Markets & EMH (Efficient Market Hypothesis)

What is a Stock Market?

The stock market is a platform where buyers and sellers trade company shares. Think of it like a bazaar for businesses — people buy ownership in companies in hopes of making profits.

What is Efficient Market Hypothesis (EMH)?

EMH is a theory that says: “Stock prices always reflect all available information.”

In simple words:

• You can’t consistently beat the market because whatever you know, the market already knows.
• Prices are fair most of the time.

Three Forms of EMH

Implications of EMH on Investment Decisions:

Criticism of EMH (Why Some People Disagree)

Real-Life Example

Suppose a company announces a new product today:

• In an efficient market, the stock price immediately adjusts to the news.
• So, by the time you decide to buy the stock tomorrow, it's already too late to profit.

What Should Investors Do (MBA Perspective):

• Don’t chase hot stocks or rumors
• Diversify your portfolio to reduce risk
• Invest in index funds or ETFs (especially if you believe EMH)
• Avoid frequent trading unless you have solid, proven strategies

• Use fundamental analysis for long-term investing (if you believe markets are not fully efficient)

Efficient Market Hypothesis is not a trading strategy but a philosophy. It encourages passive investing, staying rational, and believing that the market is usually right — though not always perfect.

Capital Market Theorem, CAPM & APT

The Capital Market Theorem is based on Modern Portfolio Theory and leads to the Capital Market Line (CML).

📌 What is it?

Imagine you're choosing from thousands of investments (stocks, bonds, etc.). The theorem says:

"There is one best line (the CML) that shows the highest return for every level of risk."

CML = Risk-free return + (Market risk premium × Portfolio risk)

$$R_p = R_f + \frac{R_m - R_f}{\sigma_m} \cdot \sigma_p$$

Where:

• $R_p$: Portfolio return

• $R_f$: Risk-free rate (e.g., government bond)

• $R_m$: Market return

• $\sigma_p$: Portfolio risk (standard deviation)

• $\sigma_m$: Market risk

The Capital Market Line is used to build an efficient portfolio — one that gives maximum return for a given level of risk.

CAPM – Capital Asset Pricing Model

The CAPM is one of the most famous models in finance. It helps us calculate the expected return of a stock, based on how risky it is compared to the market.

📌 What is it?

"The more risky an investment is, the more return investors expect."

📊 CAPM Formula:

$$R_i = R_f + \beta_i (R_m - R_f)$$

Where:

• $R_i$: Expected return of stock

• $R_f$: Risk-free rate

• $R_m$: Market return

• $\beta_i$: Beta of the stock (how volatile the stock is compared to the market)

🧠 In simple terms:

• Suppose Bank FD gives you 5% (risk-free).

• You want to invest in a risky stock — CAPM helps you find out how much extra return (risk premium) you should get.

• The more volatile the stock (higher beta), the more return you should expect.

📌 Example:

• $R_f = 5\%$, $R_m = 12\%$, $\beta = 1.5$
  

$$R_i=5\mathrm{\%}+1.5(12\mathrm{\%}-5\mathrm{\%})=5\mathrm{\%}+10.5\mathrm{\%}=15.5\mathrm{\%}$$

So, if you're taking more risk, you deserve more return!

APT – Arbitrage Pricing Theory

APT is like a more flexible version of CAPM.

📌 What is it?

APT says that a stock’s return is influenced by multiple factors, not just the market.

🧠 In Simple Language:

• CAPM says: 🧍“Stock depends on one thing — the market.”
• APT says: 👥“Stock depends on many things — interest rates, inflation, oil prices, GDP, etc.”

📊 APT Formula:

$$R_i=R_f+b_1{F}_1+b_2{F}_2+b_3{F}_3+\mathrm{.}\mathrm{.}\mathrm{.}+b_n{F}_{\mathrm{n}}$$

Where:

• $R_i$: Expected return

• $R_f$: Risk-free rate

• $F_1, F_2...$: Risk factors (e.g. inflation, GDP)

• $b_1, b_2...$: Sensitivity to each factor

Example:

Let’s say the price of a stock depends on:

• Inflation

• Interest rate

• Industrial growth

APT allows you to include all 3 in one model to calculate the return.

Comparison Table: CAPM vs APT

Feature	CAPM	APT
Risk Factors	Only 1 (Market)	Multiple (macro factors)
Simplicity	Very simple & widely used	More flexible but complex
Practical Use	Good for general return estimate	Good for advanced risk modeling
Formula	Single beta	Multiple betas

Concept	What It Tells You	Main Use
Capital Market Line	Best return per unit of total risk	Portfolio construction
CAPM	Return expected from a risky asset	Stock valuation, pricing
APT	Return from multiple risk factors	Detailed investment analysis