Question

You notice that a manufacturer of ramen noodles has increased sales during recessions, as people substitute away from fancier food toward cheaper noodles.

Make a prediction about this stock's expected return with reference to the models of asset pricing

Answer 1

Capital Asset Pricing Model (CAPM) highlights the relationship between the expected return and risk associated with the security. Expected return is equal to the risk free return and the risk premium above the risk-free return. In the above case, the expected return of the ramen noodles stock will increase as the demand is increased as it is a substitute of other fancier food. Ramen noodles stock price will increase because of the increase in sales, thus the expected return will also increase as it is riskier to invest in this stock because if the recession gets over people might shift back it's consumption to the fancier food items. Thus, during the recession the expected return will increase because of the availability of systematic risk (beta) due to recession.

The formula of CAPM is:

Ra = Rrf+[Beta*(Rm-Rrf)]

Ra is expected Return on security a

Rrf is risk free return

Rm is return on the market portfolio.

CAPM model highlights that market information is transparent and capital market reflect the true information about security. Thus, expected return will increase of the ramen noodles stock.