Question

b. Many celebrated economists have likened the recent novel covid-19 pandemic to “the great depression” of the 1930s. One of the havocs this pandemic has caused is the general decline in the value of most stocks. As a student of corporate finance, what cardinal concept in finance will you attribute this

to and what are the critical issues involve in this concept.

Answer 1

Solution:-

Both the current situation and the great depression have one thing in common so far- The huge and speedy declines in the stock markets. While the great depression included the greatest economic decline ever which lasted for over a decade, the decline in GDP growth due to COVID-19 and the duration of that decline is yet to be seen.

So, we will here focus on the similarities of great depression and COVID-19 related to their impacts on financial markets as we have enough information to comment on that. Let's take a look at the fundamental concepts in finance that make the two events relatable.

One of the most fundamental concepts in finance says- 'Higher the risk, higher the required return and lower the risk, lower the required return.'

The valuation of stocks (or any other asset class for that matter) in financial markets is directly dependent on the perceived risks of cash flows of the stocks. If the risk is high, the valuation would be low (in order to ensure a higher return against high risk) and vice-versa. Whether we see the great depression or the current pandemic, the similarities are that the perceived risks in the eyes of the market participants went up which resulted in the rapid declines in the price levels of stocks. The increase in perecived risk has been duly based on expectation of change in fundamentals. While the reasons of change in fundamentals could be different- Banking crisis in 1929 and a health pandemic today, it nonetheless holds true that the impact on fundamentals is the same, i.e. they are expected to impact the cash flow of businesses, resulting in hammering of stock prices.

So, we see that the cardinal concept in finance that we must look at while trying to understand the similarlities in stock crashes of 1929 and today is the basis of valuation of any financial assets and the role that risk plays in it. The risk of the assets plays the fundamental role in the valuation of assets and when the risk of the assets goes up due to events such as great depression or COVID-19, the stock prices get hammered so that the expected returns from those assets can go up to make for the increased risk.