Essays on Financial and International Markets Coursework

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The paper "Financial and International Markets" is a good example of finance and accounting coursework.   The Capital Asset Pricing Model (CAPM) developed independently by Sharpe (1964), Lintner (1965) and Mossin (1966) assumed that asset returns are normally distributed and investors have mean preferences. Hence, it is possible to estimate expected returns, and thus cash flows, by adding an asset to a diversified portfolio. The asset in question is then sensitive to systemic risk (β , beta) as well as the expected return of the market and that of a risk-free asset.

This is expressed as [E(Ri) – Rf] / β = E(Rm) – Rf where E(Ri) is the expected risk of the asset, Rf is the risk-free asset, β is the sensitivity of the asset to the market, E(Rm) is the expected return from the market, often assumed to be the return from the market index and [E(Ri) – Rf], the difference between the expected return from the asset and that the risk-free return is the market premium. Thus, the risk from adding an asset comprises market risk, or systemic risk, or specific risk, which can be minimized by adding a large number of assets. Thus, theoretically, expected excess return may be estimated by regressing the following equation: [E(Ri) – Rf]t = α it + β [E(Rm) – Rf] - eit The average market return is usually assumed to be the historical return from the market index.

Hence, if the coefficient to the historical risk-free asset is estimated to be zero, that is investors can borrow at risk-free rates, then the expected excess return would be estimated to be sensitive to the market risk. However, empirical tests have found that the coefficient to the risk-free asset is not zero.

Besides, the model is not directly testable since historical returns may not be the same as future returns, the real structure of the market portfolio may not be known and the market index may not also be an appropriate estimation of the market portfolio (Trandafi). The CAPM model essentially rests on the assumption of normal distribution of asset returns, so that the variance of the returns appropriately measures systemic risk. However, empirical tests have shown that returns may not be normally distributed.

Further, investors are assumed to have rational expectations, capital markets perfect and that there are no asset arbitrage possibilities.

Works Cited

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Fang, H and Lai, T (1997). “Cokurtosis and Capital Asset Pricing”. The Financial Review, 32, 293-307

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Branz, R (1981). “The Relationship Between Return and Market Value of Common Stocks”. Journal of Financial Economics, 9, 3-18

Mossin, J (1976). “Equilibrium in Capital Asset Market”. Econometrica, 34, 764-783

Lintner, J (1965). “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets”. Review of Economics and Statistics, 47, 13-37

Sharpe, W (1964). “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk”, Journal of Finance, 19, 425-442

Shackleton, M and O’Brien, F (2004). “An Empirical Investigation of UK Option Returns: Overpricing and the Role of Higher Systemic Moments”. Lancaster University Management School Working Paper No 50, 2004, retrieved from http://www.lums.lancs.ac.uk/publications/viewpdf/000302/

Singleton, K.J (2006). Empirical Dynamic Asset Pricing. Princeton University Press

http://www.econ.umd.edu/~trandafi/econ435/Chapter_13.pdf

Adrian, T and F Franzoni (2006). “Learning about beta: Time-varying Factor Loadings, Expected Returns and Conditional CAPM, Staff Report number 193, Federal Reserve Bank of New York, retrieved from http://www.newyorkfed.org/research/staff_reports/sr193.pdf

Jagannathan, R and Z Wang (1996). “The Conditional CAPM and the Cross Section of Expected Returns”, Journal of Finance, 51, 3-53

Lewellen, J and J Shanken (2002). “Learning, Asset Pricing Tests and Market Efficiency”, Journal of Finance, 57, 1113-1145

Galgadera, D.U.A and Brooks, R.D (2005). Is Systematic Downside Beta Risk Really Priced? Evidence in Emerging Market Data. Monash University Department of Econometrics and Business Statistics. Working Paper 11. Retrieved from http://www.buseco.monash.edu.au/depts/ebs/pubs/wpapers/2005/wp11-05.pdf

Diboolu, S (2002). Real Disturbances, Relative Prices and Purchasing Power Parity. Department of Economics, Southern Illinois University of Carbondale. Retrieved from http://129.3.20.41/eps/if/papers/9502/9502002.pdf

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Balassa, B (1964). The purchasing power parity doctrine: A reappraisal, Journal of Political Economy, 72, 584-596

Samuelson, P (1964). Theoretical notes on trade problems, Review of Economics and Statistics. 46, 145-154

Neely, C (1996). The Giant Sucking Sound: Did NAFTA Devour Mexican Peso? Federal Reserve Bank of St. Louis Review, July-August. Retrieved from http://research.stlouisfed.org/publications/review/96/07/9607cn.pdf

Sideris, D (2005). Testing for long run PPP in a system context: evidence from the US, Germany and Japan, University of Ionnina Working Paper, retrieved from http://www.econ.uoi.gr/working_papers/Sideris1.pdf

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