Question

Because of the outbreak of Covid-19, the S&P 500 stock index fell over 30% from its recent high level. At the same time, the volatility index of the S&P 500 (a measure of the market's expectation of 30-day forward-looking volatility) spiked from 14 to 80. Assume that in December 2019 (before the outbreak of the Covid-19) the expected growth rate of the index was 5%, the discount rate was 10%, and the risk-free rate of return was 3.5%. Also, assume that investors maintain the same Sharpe ratio before and after the outbreak.

a) Evaluate the following statements and support your evaluation with relevant calculations and/or derivations. .

1.The fall of the index is the result of a permanent change in the expected future growth rate caused by the virus. (2 pts)

2.The fall of the index is the result of a permanent change in future cash flows of the companies included in the index. (2 pts)

3.The fall of the index is the result of a permanent change of volatility in the market. (3 pts)

4.The fall of the index is the result of a deferral of future cash flows of US companies for a certain number of periods. (3 pts)

b) Propose possible explanations for the fall of the index; do you think such price movements triggered by the outbreak of the virus are rational? Explain carefully. (7 pts)

Answer 1

1. The xepcted future growth rate in near term is shaky but in the long term the growth rates will rise and teh markets will find their feet again. So the fall is not the result of a permanent change in the expected growth rate it is due to temporary fall in growth rate and majorly due to uncertainity of how long the virus can have impact on the real economy.

2. The change in cash flows of the companies is also temporary as the current problem of cash flow will be due to lockdown and broken supply chain and demand concerns. But this will be a small blip as once the virus scare goes off the supply chains will be fixed immediately and demand will come back which will improve the cash flows of the companies.

3. Volatilty index as we know spikes during high unceartinity and that is the case right now as well. As we have seen in history also the VIX spikes during election years and in the recession periods like in 2008. The fall is not due to increase in VIX as VIX spikes due to unceartinity. But the history has suggest that the VIX never remain at the elevated levels for a long time it does revert back to it mean.

4. This statement is true as it is the deferals of cash flows which is hurting the sentiment rather than the permanent damage of the cash flows. The cash flows will be defered but how long is the question which needs to be answered and that is the reason Markets are falling. Because in many cases teh cash flows will be healthy as a person thinking of purchasing a car has jsut postponed it but it will happen in future and hence deffered. but in some cases it can be a complete loss of cash flows like hotels, tourism, etc.