Question

1. Is the Capital Asset Pricing Model a good description of the way financial markets work during a global crisis? Justify your answer and explain why or why not.

2. Barber and Odean, in their 2002 Journal of Finance paper entitled “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors” state that:

“Our most dramatic empirical evidence supports the view that overconfidence leads to excessive trading. On one hand, there is very little difference in the gross performance of households that trade frequently (with monthly turnover in excess of 8.8 percent) and those that trade infrequently. In contrast, households that trade frequently earn a net annualized geometric mean return of 11.4 percent, and those that trade infrequently earn 18.5 percent.” Attempt to explain these findings using the behavioural finance theory.

Answer 1

                        A Capital Asset Pricing Model [CAPM] is used to calculate the expected return from an asset, especially stocks by proper analysis of the expected risk of the asset in a financial market. It is widely used in a market for pricing risky securities and generating expected returns with considerations on the cost of capital also along with the risk factors. The formula to find out the expected returns is given by

Expected return of investment = Risk free rate + [β * marker risk premium]

                                    With considerations on the above formula, it is evident that the investors in a market are expected to be compensated for risk and the time value of money. If the stock is riskier, the Beta value would be greater than 1 to take in to account the additional risk taken by the investor in such times. The market risk premium is the return expected from the market above the risk-free rate. The major advantage of this model is that it would help in evaluating the fair value of stocks while taking in to consideration the risk and time value of money and compare it with the rate of return. Although the modern financial theory makes assumptions that the markets are competitive and the investors are risk-averse, the given model is suitable for the analysis of financial markets during a global crisis due to the following reasons

· It is simpler and helps in the easy comparison of investment alternatives.

· The price volatility of the stock is taken in to consideration with the inclusion of the Beta factor in the formula for assessing the expected returns.

· It helps the investor to manage their risk.

Although the above factors assume that this model is suitable, there are several flaws also associated with this model

· The stock returns are not normally distributed and hence the volatility movements may not be equally risky in both directions.

· It also assumes that risk-free rate would remain constant over the discounting period.

· Thus, with an increase in the risk-free rate, the investment cost of capital would increase and hence it may cause the stock look overvalued.

· It assumes that future cash flows can be estimated for the discounting process

Thus, with due considerations on the above factors, the CAPM could help the investor to understand the relation between risk and reward and thus would help them in making better decisions on addition of securities in a stock.