Inefficient Market Hypotheses

  You will recall that a representative domestic expenditure basket includes some imported products but places a relatively heavier weight on goods and services produced domestically. At the same time, the representative foreign basket is skewed toward goods and services produced in the foreign country. Thus, a rise in the price of the foreign basket in terms of domestic baskets, say, will be associated with a rise in the relative price of foreign output in general relative to domestic output. 3 To determine how such a change in the relative price of national outputs affects the current account, other things equal, we must ask how it affects both EX and IM . When EP * > P rises, for example, foreign products have become more expensive relative to domestic products: Each unit of domestic output now purchases fewer units of foreign output. Foreign consumers will respond to this price shift (a real domestic currency depreciation) by demanding more of our exports. This response by f...

 THE CAPITAL ASSET pricing model, almost always referred to as the CAPM, is one of the centerpieces of modern financial economics. The model gives us a precise prediction of the relationship that we should observe between the risk of an asset and its expected return. This relationship serves two vital functions. First, it provides a benchmark rate of return for evaluating possible investments. For example, if we are analyzing securities, we might be interested in whether the expected return we forecast for a stock is more or less than its “fair” return given its risk. Second, the model helps us to make an educated guess as to the expected return on assets that have not yet been traded in the marketplace. For example, how do we price an initial public offering of stock? How will a major new investment project affect the return investors require on a company’s stock?Although the CAPM does not fully withstand empirical tests, it is widely used because of the insight it offers. All gen...

 The index model introduced in Chapter 8 gave us a way of decomposing stock variability into market or systematic risk, due largely to macroeconomic events, versus firm-specific or idiosyncratic effects that can be diversified in large portfolios. In the single-index model, the return on a broad market-index portfolio summarized the impact of the macro factor. In Chapter 9 we introduced the possibility that risk premiums may also depend on correlations with extra-market risk factors, such as inflation, or changes in the parameters describing future investment opportunities: interest rates, volatility, market-risk premiums, and betas. For example, returns on an asset whose return increases when inflation increases can be used to hedge uncertainty in the future inflation rate. Its price may rise and its risk premium may fall as a result of investors’ extra demand for this asset.Risk premiums of individual securities should reflect their sensitivities to changes in extra-market risk f...