Finance and accounts - Essay Example

Stock markets are very volatile and investors need to learn through various important concepts before proceeding to invest their money to ensure satisfactory returns.Many at times there may be possibilities that investors suffer on the back drop of decreased prices after they invest. These situations should at least be reduced if they cannot be reduced as a whole. The process of loss reduction involves a complex understanding about the following terminologies:1.CAPM and Arbitrage Pricing Theory 2.

Efficient markets hypothesis and Pecking order theory 3.Modigilani and Miller approach and Residual theory 4.Symbolic interactionism, ethnography and phenomenology 5.Conceptual framework of accounting and 6.Conceptual framework of management accounting.These abovementioned theories explain the basics of share trading and knowledge of them is a must to avoid risk in the stock market. 1.CAPM and Arbitrage Pricing TheoryCapital Asset Pricing Model (CAPM): It was developed to predict the future value of shares based on the previous trends in market equilibrium.

It establishes the underlying relationship between the returns expected in the light of unavoidable risk. Any investment can be classified into risk free or portfolio categories. It analyzes the return which a portfolio is expected to deliver in the form of a characteristic line which comprises of three primary measures – the alpha (α), Beta (β) and unavoidable risk. α is the simple intercept of the line and is bound to be zero and any value below that would avert the investor to participate in that particular stock.

Unavoidable risk is the risk relating to a particular stock or industry which can be avoided or reduced comprehensively in a portfolio. Hence, the main determinant of the stock price is the ? which defines the sensitivity of a stock in relation to market changes. If it is more than 1, the stock is supposed to be more volatile than the market and vice versa. The formula for evaluating ? is: Rj = Rf + (Rm-Rf)?j where Rj refers to the return expected of the security, Rm is the market return and Rf is the risk free return (treasury bond interest rate). ? is the unavoidable risk.

The values of ? for many active stocks can be obtained through data published by various financial concerns. Thus, the expected return can be calculated. The same ? can also be interpreted as the discounted rate of the dividends to ascertain the value of the stock and thus by equating both the values, one can conclude whether a particular stock is over or undervalued. The underlying assumptions are: 1. Existence of efficient capital markets 2. Zero costs for transactions 3. No restrictions 4.

Investors cannot influence the markets 5. Non-incurrence of taxes Specific situation: Let us evaluate a situation comprising of 7% Treasury bill rate and portfolio market returns of 12% to estimate the share value of pro-fli Corporation which contains a ? of 1.3. According to the formula, the share value would be: .07+(.12-.07) *1.3 which gives a result of 13.5%. This shows that when ? is more, the returns tend to be more rewarding. In the same case, if ? is estimated to