Finance theories are helpful for providing an understanding and appreciation of the importance of finance in markets. Finance theories aide in the evaluation of investment risks and values as well as the return on investments. In other words, finance theories is a tool for successful investment analysis.

A good example of investment analysis is Capital Asset Pricing Model (CAPM). The CAPM model is used to identify the relationship between the risks and returns. It is also used for the purpose of pricing securities at risk. CAPM takes into consideration the fact that investors aim to be rewarded in two ways. They are; time value of money and risks.

The symbol rf (risk free rate) is used to represent time value of money. The investor will be compensated eventually. The remaining half of the model reflects risks and ‘the amount of compensation the investor needs for taking an additional risk.’(Capital Asset Pricing Model) This is measured by ‘taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium. (Rm-rf) (Capital Asset Pricing Model) See below.

By virtue of the CAPM it can be determined that the anticipated return on a security or a portfolio is equal to a risk-free security together with a risk premium. If the return is not calculated to equal or exceed the desired return, it would be unwise to engage the investment. ‘…If the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%))’ (Capital Asset Pricing Model).

The risks associated with CAPM can be divided into two separate groups. They are systematic and unsystematic risks. A systematic risk is a risk attributed to the economic environment and investments as a whole. Non-diversified risks fall under the umbrella of systematic risks. Non-diversified risks are usually associated investments in one faction. ‘Unsystematic risks are the risks attributed to a particular company as a result of internal difficulties such as bad management, strike or disaster and with diversification’ (Russell).

The Security Market Line (SML) is a graphic version of the CAPM. It is capable of predicting that if a security is accurately priced, the anticipated return on the security, the security will meet the ‘security beta the securities market line’ (Russell). In the event security is priced above value, it is overvalued and if the security is priced below value, it is undervalued. Whatever the case may be alterations will have to be made.

Both SML and CAPM are tools for theoretical risk management. Risk management is a finance theory used for the identification, controlling and minimizing ‘the the financial impact of events that cannot be predicted’ (Russell). When a company capitalizes on risk management theories it is in a position to minimize risk and consequently any resulting losses. A common method of risk management is by diversifying investments. ‘A company might do any one of the following to diversify and reduce risk including long term forward contracts, currency swaps, cross hedging and currency diversification. By doing these things a company is placing it's funds in various areas so that if one area is hit hard by something unforeseen the other areas should be unaffected’ (Russell).

Another useful tool for risk management is the Efficient Market Hypothesis (EMH). The EMH ‘asserts that financial markets are "efficient", or that prices on traded assets, e.g. stocks, bonds, or property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects’ (Efficient Market Hypotheisis).

EMH insinuates that by merely using the information that is already known to the market, it is impossible to outperform the market on a consistent basis. By merely relying on this kind of information, the investor is depending on mere luck for success. The nature of EMH encompasses any unknown or unascertainable information currently affecting stock prices, but could be revealed in the future at random. This random information generally results in changes in the future stock prices.

Agents are required to have rational expectations and will alter their expectations to reflect new and relevant information. ‘All that is required by the EMH is that investors' reactions be random enough that the net effect on market prices cannot be reliably exploited to make an abnormal profit. Thus, anyone person can be wrong about the market--indeed, everyone can be--but the market as a whole is always right’ (Efficient Market Hypothesis).

EMH is encapsulated in three different forms. There are three common forms are, ‘weak form efficiency, semi-strong form efficiency and strong form efficiency, each of which have different implications for how markets work’ (Efficient Market Efficiency). Weak-form efficiency is a risk management strategy providing for the formation of investment strategies with reliance upon historical data relating to share prices. Weak-form efficiency is a safeguard against technical analysis consistently outperforming the market. In weak-form efficient markets, the present share prices are the best, unbiased, estimate of the value of the security. Theoretical in nature, weak form efficiency advocates assert that fundamental analysis can be used to identify stocks that are undervalued and overvalued. Therefore, keen investors looking for profitable companies can earn profits by researching financial statements’ (Efficient Market Hypothesis). MORE…