Financial Theory Discussion & Analysis
Content
A. Capital Asset Pricing Model
B. Advantages & Disadvantages of CAPM
C. Security Market Line
D. Systematic & Unsystematic Risk
E. Business Cycle
F. Efficient Market Hypothesis
G. Firms of Efficient Market Hypothesis
H. Selective Publicity and Stock Prices – Discussion upon Journal
Question 1:
a). Why do financial managers have some difficulty applying capital asset pricing model (CAPM) in financial decision-making? What benefit does CAPM provide them? .
Introduction
Capital Asset Pricing Model establishes a linear relationship between return required on an investment and its systematic risk. It helps in theoretical assessment of risk return profit by considering the market specific risk estimated by Beta. The model was introduced by Jack Treynor in year 1962, followed by William Sharp, Linter and Mossin as an extension of modern portfolio theory.
Structure, Expression & presentation
Capital Asset Pricing Model establishes a linear relationship between return required on an investment and its systematic risk. It helps in theoretical assessment of risk return profit by considering the market specific risk estimated by Beta. The model was introduced by Jack Treynor in year 1962, followed by William Sharp, Linter and Mossin as an extension of modern portfolio theory.
The formal or computation methodology stands as:
RM= Rf + Beta*(Rm-RF)
Where,
RM = return on market
Rf = Risk Free Return
B= beta, which determines the sensitively of the stock in return to the market.
It takes into consideration of Security Market Line and establishes relation between expected risk and return therefore reflecting how price is determined by security.
The disadvantage...
... middle of paper ...
...in a very unrealistic way and we have seen prices crashed as investors go short in the market aggressively out of panic. Therefore a new terminology has been arrived in the market need as News Traders. These News Traders highlight or market the news in such a manner that they try to influence market participant to trade on the news. Sometimes we have seen that company themselves appoint such Traders and Investor Relation Firm to create a price bubble in the market based upon some price sensitive information.
Therefore in the light of the above scenarios, efficient market hypothesis will not be able to stand true as people responsible for providing the information is psychologically trying to manipulate the prices of shares. There in today’s practical world markets are highly perfect and everyone is trying to make excess return by some or the other means.
The estimates of cost of capital for equity 6.14% are making by using the capital asset pricing model (CAPM) to generate forecast of DDM and RIM. This method is defined by the sum of risk free rate plus beta that multiplied with a risk premium. Particularly, the beta, which is a quantitative measure of the volatility of company stock relative to the unstable of the overall market, found in JB HI-FI case at 0.56 (JB HI-FI financial statement 2016). It
... Capital, Corporation Finance and the Theory of Investment", The American Economic Review, vol. 48, no. 3, pp. 261-297.
However, we cannot deny that the efficient market hypothesis has several paradoxes. In the first place, a main theoretical cornerstone for the EMH to be a consequence of equilibrium in capital markets is that markets are always rational. This is against the realism. Even if the foregoing assumption turns out to be entirely possible, many recent studies have concluded that rationality is not always a realistic assumption as investors in many cases engage in irrational investment (Kahneman and Riepe, (1998)). Second, the efficient market hypothesis cannot explain market anomalies.
The concept of beta has gained prominence due to the pioneering works of Sharpe (1963), Lintner (1965) and Mossin (1966). There are many studies that examine the behaviour and nature of beta. These studies include the impact of the length of the estimation interval, the stability of individual security beta as compared to portfolio beta, factors influencing the beta as well as the stability of beta in various market conditions.
This assignment is concerned with your understanding of the key issues relative to portfolio analysis and investment. In completing this assignment you are to limit your scope to the US stock markets only. Use the Cybrary, the Internet, and course resources to write a 2-page essay which you will use with new clients of your financial planning business which addresses the following issues and/or practices:
The measurement of risk is the main reason for the concept of risk free rate and its importance to the theory of finance. All investments are made with the expectation that returns will be made over the life of the asset. Risk free rate comes into effect when the actual and expected rate of return differs. The concept of risk free is that actual returns equal expected returns. An investment is risk free when there is no variance around the return (Damodaran, 2014). This introduces the concept of risk premium. Risk premium is calculated by deducting the riskier return from the risk free rate. T...
Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002).
The efficient market hypothesis states that it is not possible to consistently outperform the market by using any information that the market already knows, except through luck. Information or news in the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.
Chapter 11 closes our discussion with several insights into the efficient market theory. There have been many attempts to discredit the random walk theory, but none of the theories hold against empirical evidence. Any pattern that is noticed by investors will disappear as investors try to exploit it and the valuation methods of growth rate are far too difficult to predict. As we said before the random walk concludes that no patterns exist in the market, pricing is accurate and all information available is already incorporated into the stock price. Therefore the market is efficient. Even if errors do occur in short-run pricing, they will correct themselves in the long run. The random walk suggest that short-term prices cannot be predicted and to buy stocks for the long run. Malkiel concludes the best way to consistently be profitable is to buy and hold a broad based market index fund. As the market rises so will the investors returns since historically the market continues to rise as a whole.
Primarily, financial managers look at the market price in maximizing the value of the firm. The market value is the present value of the net cash flow divided buy the risk. Investors consider the firm’s future and present earnings, disadvantages or risks and other factors that will influence a firm prior to deciding to create an investment decision and the market price of the stock that will reflect all the information considering these factors (Arain, 2011).
... the public and private sector. It uses both the weak form and semi strong from to make decisions. When an investor is given both public and private information the investor would not be able to profit about the average investor even if he was provided with new information at any given time. These investors are given name such as insiders, exchange specialist, analyst and money mangers. Insiders are senior managers that have access to inside information of that company. The security exchange commission prohibits that allow of inside information use to achieve abnormal returns on investments. An exchange specialist can achieve above average returns with specific order information on a specific equity. Analysts can analyze whether an analyst opinion can help an investor achieve above average returns. Institutional money mangers work handle mutual funds and pensions.
Most critical to this discussion is a clear understanding of what a financial manager is and does and how his or her role aids in helping to establish the valuation of a corporate entity in today's global financial market. Quite simply, a financial manager helps to measure a company's market value and its risk, while also helping to systematically reduce its costs and the time necessary to make informed decisions regarding objective driven operations. This is quite a demanding game plan for an individual and most often financial managers, in the corporate world, working in cooperation with a team of financial experts. Each member of that team perhaps having expertise in differing areas of activity, but each however, being no less expert in his or her respective area of endeavors on behalf of the corporation. The team is assembled under the direction of the officer known in the corporation as the Chief Financial Officer who today is becoming increasingly indispensable to the CEO who directs a modern model of action driven, bottom-line oriented corporate activity (Couto, Neilson, 2004).
Stock Market Predictability Stock market prediction is the method of predicting the price of a company’s stock. It is believed that stock price is led by random walk hypothesis. Random walk hypothesis states that stock market price matures randomly and hence can’t be predicted. Pesaran (2003) states that it is often argued that if stock markets are efficient then it should not be possible to predict stock returns. In fact, it is easily seen that stock market returns will be non-predictable only if market efficiency is combined with risk neutrality.
The cost of changes is divided into several groups, which include various elements associated with the stages of investment in the project.
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.