Finance Capital Asset Pricing Model - Assignment Example

Number: Finance Capital Asset Pricing Model During recession, there is need to stimulate the economy and hence need to avail cheap sources of funds to help stimulate the economy, which implies that the interest rate must be lower to accommodate such monetary measures. A downward sloping curve means that the short-term interest rates are higher than the long-term interest rate and the short- term interest rates are expected to decline in the near future. Therefore lower short- term interest rate in future implies that the economy needs stimulation, thus recession. 2. When the yield curve is flat, short-term interest rates are not expected to change or drop moderately in the future. This shows that there is stability in prices over the given time period hence expectation of low level of inflation in the near future. 3. Stocks can be classified as asset because they can store value and is a source of wealth to individual holders. An increase in the demand or an asset increases the wealth of individuals. With the increasing value of wealth, the demand for bonds rises and the demand curve for the bond shifts to the right. This causes the when stock prices go up, when there is an increase in interest rate (Mishkin & Eakins, 2006). 4. The CAPM function can be described as R = Rf + b (Rm –Rf). This shows that an investor is compensated for holding a risky asset by a function of (Rm –Rf) and the risk premium depend on the magnitude of beta. Beta is the sensitivity of a stocks return to changes in the market. 5. Diversification is the averaging out of independent risks in a large portfolio. In stocks, independent risks are those that affect a specific firm and are unrelated across different stocks. A combination of these stocks in a portfolio will mean that independent risks are averaged out and only market risk is retained while the returns of the stocks are expected to remain the same. 6. Using a coin flip to illustrate diversification without impairing the expected return, an investor has two scenarios to choose with each expected to have similar returns. The first scenario is to flip the coin ones and the outcome of the flip be used to determine the return (Mishkin & Eakins, 2006). The second scenario is to flip the coin more than ones, with fewer amounts to determine the expected return. In the first instance, there is no diversification as the outcome will depend on the first and only outcome while in the second scenario, there is diversification as the coin flips are independent and the risks of each flip is averaged out as the number of flips increase hence lowering the risks without affecting the returns. 7. In a portfolio of diversified stocks, different stocks with the same returns have been combined together to reduce the independent risks without impairing the returns. This means that the returns will remain constant albeit at a lower risk level due to diversification 8. Diversification in a portfolio context does not lower the beta but instead increase the portfolio beta. This is because, in a portfolio, the beta is the weighted average of all individual betas in the portfolio and the addition of more stocks in the portfolio reduces the weights used to compute the portfolio beta hence increase in beta implying increase in market risk. 9. The standard deviation is a measure of stocks volatility, that is, the measure of variations in returns of a stock, which is a composition of both market risk and stock- specific risk. Beta is a measure of a stock’s sensitivity to changes in the market returns. It is a measure of market risk only. 10. They found out that based on single risk factor, the beta of a portfolio only explains not more than 70% of its actual returns and the other 30% is caused by factors that are not linked to beta. The CAPM of a portfolio can be improved by adding two additional factors, the book/market ratio and the market capitalization. 11. An arbitrage refers to a risk- free or low-risk profit making opportunity that exists in the market because of mispricing of securities while an efficient market is a market in which profit-making opportunity is because of a created competitive advantage. Therefore, as a rational investor one will be attracted to arbitrage opportunities which are also corrective mechanism for adjusting the market for efficiencies. 12. In instances where the markets are not efficient, stock price appreciation will be based on the existing mispricing of securities which can be can be taken advantage of by any rational investor. This means that the shareholders wealth will not have been created from value-added in form of dividend from operational profits and capital gains but on capital gains alone, which may not be sustainable in the long term. 13. Market inefficiencies occur when there is an arbitrage profit making opportunity. Investors are actively looking for such inefficiencies in the market to use them (arbitrage profit opportunities) as a corrective mechanism to make the market efficient. 14. Weak form of efficiency states that the current market prices are a reflection of past prices movement and thus it is impossible to make consistent superior profit by studying past returns. Random walk of returns implies that the returns of stocks are independent of each other and there is no regular price change (Mishkin & Eakins, 2006). Therefore, based on random walk theory, future returns are independent of past returns and is consistent with the proposition of weak form of efficiency in which past prices are not a reflection of future prices. 15. Normal distribution implies that the probability of outcomes will fall between two limits, most of which are located around the probability’s mean. In the weak form efficiency, prices tend to be random and independent of past prices and an investor cannot consistently make superior profits from such markets. This conforms with the basis of a normal distribution curve, which is a function of random variables and the outcome of an events can fall between two limiting points(both positive and negative) around the mean as they are unpredictable. 16. Normal distribution implies that the returns of a security independent of each other and random in nature. This means that management is unable to precisely determine the average return as it is an interval estimate around the mean hence difficulty in instituting measures to manage such variations. 17. The ability of orangutans and professionals to pick stocks that can perform comparatively well depends on the form of market efficiency. This is only possible is strong- market efficiencies, in which, the current prices are a reflection of all information that has been obtained by a bold analysis of the company and the economy. In this form, orangutans can pick stocks than can do just as well as professionals as the current market prices include all pertinent information available and even insiders will not be able to earn arbitrary profits consistently. 18. An arbitrage opportunity is a situation in which two securities with identical cash flows have different prices. Limits to arbitrage refer to the inability of arbitrageurs to fully exploit the present arbitrage opportunity due to inadequacy of resources/funds to the arbitrageurs and there co- existence with not –fully rational investors. This is against the concept of efficient markets in which competition is expected to price out any arbitrage profit opportunities for markets to be efficient (Mishkin & Eakins, 2006). 19. Herding refers to the tendency of investors to emulate other investors instead of relying on other than their own analysis (Ehrhardt & Brigham, 2011). During herding, an average investor will earn a fair return on his investments, which is against the concept of efficient market hypothesis. Efficient markets hypothesis states that investors will not find positive NPV opportunities without some competitive advantage 20. The cost of active management of portfolios to beat the market outweighs the benefits that accrued as compared to passive portfolio management and the market portfolio is already a reflection of all information available at the time of analysis. 21. (a) Dimension of companies; the presence of documented evidence that the return of smaller companies is higher than the return of large companies which cannot be explained due to the difference in capitalization of the two types of companies. (b) Value vs growth companies; Value companies are those that low price –to –book ratio and price to earnings ratio while growth companies are those have higher values for price –to –book ratio and price to earnings ratio. However, there is evidence that historical returns of value stocks are more than those of growth companies (Mishkin & Eakins, 2006). 22. Keynesian beauty contest theory attempts to explain the influence of others opinions on the selections or approaches available to an individual. He states that there are more than two strategies to choose an activity. These include the naïve strategy in which an individual selected selects a contestant based on his/her own opinion of “features” of beauty and the sophisticated strategy in which an individual’s perception on beauty is influenced by the public’s perception of beauty in an attempt to have a popular opinion (Mishkin & Eakins, 2006). This applies in stock valuation when stocks price are based on what analysts think of the stock rather than from a fundamental analysis to value the share. The effect is that one usually pays more for the stock as he/she believes that the future prices will even increase further. 23. Precipitating factors can be described as those factors that cause the initial price fluctuations that lead to the actual price of a commodity being more than is fundamental values. An example of a precipitating factor during the housing bubble was the lowering of the interest rate. Amplifying mechanism are those factors that accelerate the process of bubble such as dependence on unstable short- term financing and deficiencies in risk management Work cited Ehrhardt, M. C. & Brigham, E. F., 2011. Financial Management: Theory and Practice. 13 ed. Mason: South -Western Cengage. Mishkin, F. S. & Eakins, S. G., 2006. Finacial Markets and Institutions. 5th ed. Boston: Pearson International Edition. Read More