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Beta is no doubt one of the common risk factor used in estimating the expected stock returns. However there is popularity of the relation between beta and realized stock returns but several past studies verified this association as weak, which led researchers to proclaim that beta is “dead”.
In 1992 the main news in the financial world is that the beta is dead. Fama & French, the two well known energy economics, made well researched attack on a measure of beta which is nothing but the risk contained in the share price. Although at that time the estimation of beta had been an indispensable tool for managers, regulators and companies. The attack leads to the beta verification. A year later three well noted studies suggest that, even if beta is not proved upto its point, its failure report had been talked at an unnecessary level.
One of the most profound theories in financial arena is Beta. It measures a relative volatility in stocks. It shows up to what level the price of a particular stock jumps relative to the stock market movement, both at the same time. If the stock moves exactly with respect to market, the beta takes the value of 1; if the stock rises when the market rises, then beta takes the value greater than 1. Thus we say that the share which is more volatile with respect to market, the more riskier it is.
In layman words CAPM said that the investor should gain more by investing in the share which is more risky than the other share. But, Fama & French during his study found that the difference in beta failed to justify the performance of different shares on international stock exchanges (NYSE, NASAQ, etc.). However the explanation comes from the company total market value and the ratio of book value to its market value. All this indicates that either the CAPM is wrong or the other factors proved a better justification to the riskiness of a share.
One of the difficulties in describing beta is that it means different to different people, in the same way as in the parable about elephant and blind man where elephant is appeared different to all five blind persons.
The capital asset pricing model represents one of the most influential theory in financial arena. It is used as the most important tool for investment purposes as it helps in estimating the expected
return on an asset and it’s relation with beta. It is also highly recommended tool in corporate finance as the discount rate of a project depends upon the Beta of a project.
Over the years CAPM formed the strong foundation of the financial accounting . From empirical point of view the model is testable, beta is easily testable by time series regression. But is it? I review various literatures which assert that the CAPM test is ambiguous. The mentioned points, helps us to understand better whether CAPM is justifiable or not:
- Portfolio of market is mean variance efficient
- Atleast one positively weighted efficient portfolio should be there
- Should be a linear relation between the expected stock return and overall beta
- Beta is the only tool to measure the risk that is needed to explain the expected stock return
Black and schools (1970) employed the cross sectional model to test the CAPM. The results were published to create disequilibrium in the financial world. Findings justified the linear relation between beta and average return but the calculated slope of the security market line is almost flat and there is a high value of intercept. All these evidences confirm the rejection of the previously successfully tested model.
But, Fama & French (1992) find no relationship between average returns and beta. However, at the same time report that size and book-to-market ratio justifies the dependent variation in stock returns. For a moment the CAPM is useless.
In 1992, Fama & French gathered and justifies the empirical failure of CAPM. They proved their claim by employing the cross-sectional regression model, which said that besides the market beta which explains the expected stock return, it also depends on the various other factors like:
- Scale or size,
- debt/equity ratio and
- book/market ratio
In 1996 Fama and French used the time-series regression approach applied to portfolios of stocks and come to same result. They also found that the price ratios of different stocks have provided almost the identical information. This is not an unusual given that the driving force in the price ratios is the price, and the numerators would act like scaling variables that is used to fetch out the information about expected stock return. Fama and French (1992) also justifies by gathering the evidence that after the sample used in the early CAPM model relation between average return and beta for common stocks is flatter than before.
The collection of the evidences, by Fama & French, on the problems of the CAPM act as a catalyst, when it is generally acknowledged that the CAPM had serious problems.
The most notable point which we derived from the above arguments is that both the time-series as well as the cross-sectional regression failed to test the CAPM model. Exactly seeing the tested model is to see whether a particular proxy for the stock portfolio is found efficient in the set of portfolios which were made from it and the assets on the left hand side that are used in the test. We should conclude that the model had never been tested, and prospects for testing it are not good because
- assets on the left-hand-side does not comprise all marketable assets, and
- data for all assets to form a true market portfolio is not within the reach
But this criticism can be true for any economic model if the tests done are not exhaustive or when the economist uses the proxies for the variables used in the model.
In simple words exchange rates is function of demand and supply on the macro-economic level. It varies as the demand and supply function varies based on the macro economic situation.
Balance of Payment
BOP is the value of the net monetary transactions between the resident of country and rest of the world; it is composed of two accounts:
- current account, and
- capita; account
The transactions included in the BOP are:
- payment of goods and services
- capital; and financial transfers
BOP (balance of payment) o some of the useful model to predict the exchange rates, it is also known as General Equilibrium Theory. According to this theory exchange rates are determined by free market forces, that is, depend on the demand and supply of the foreign exchange. The theory stated that the external value of the domestic currency depends upon the demand and supply of the domestic currency. This forms the basis for the country BOP, which is either in surplus or deficit. When the country BOP is in deficit, the exchange rates depreciated and when the BOP is in surplus then the exchange rate is appreciated, which lead to the healthy foreign reserves. Under BOP deficit, the local resident demands increases for foreign currency which leads to the fall in valuation of the local currency with respect to foreign currency, which leads to currency depreciation..
If we talk about affect of the current account on the exchange rate the very first thing we have to consider is the following factors which effect the current account:
- economic growth rate and national income
- consumer tastes profound enough to effect the export- import , and
- Comparative advantage, if any.
If talk about the balance of payment then current account is only one part of it, the other consists of capital account which has a greater influence on BOP. Therefore, the minor changes in above factors of current account do not affect the exchange rate at a large scale.
Although BOP theory provides the appropriate explanation for exchange rate determination but it also depends upon some unrealistic assumption, such as:
- perfect competition exists in foreign exchange market, and
- the impact of exchange rate on BOP is neglected
Today, this method is largely dismissed by academics, but practitioners still rely on different variations of the theory for decision making. They argue that this theory emphasizes on flows of currency, but stocks of currency or financial assets of residents play no role in exchange rate determination
Asset Market Approach
This approach assumes that the continuous portfolio equilibrium. According to this approach exchange rate is determined in the same way as the equity prices within the asset market. This model also takes in account the condition in the international asset market that effect the exchange rate. Various factors which are taken into account are:
- which asset are traded internationally
- risk characteristic of these asset
- attitude if international investors towards risk
Another important parameter which this model takes into factor is the interest rate parity. It means the rise and fall of exchange rate are depend upon the investor behavior in the market which generates interest rate parity. In this model we are not calculating the interest rate on annual basis but it is interpreted on the basis of the interest rate prevailing in two countries. In this way the interest ra6e is the average expected rate of return on a wide variety of asset in the international market. (See more about : Online Accounting Assignment Help)
The Asset Market Approach argues that the exchange rate should be determined by expectations about the future of an economy, not current trade flows. Since the prospect of an economy is reflected on the demand of financial assets in that economy, the approach believes that changes in market exchange rates are affected by variation in the supply-demand for a wide array of economical assets:
- the supply-demand shifts for the assets change the exchange rates
- this approach is also called the relative price of bonds or portfolio balance approach
- More specifically, if the demand for domestic financial assets increases, the demand for the domestic currency will increase, which could results in the appreciation of the domestic currency
- Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter the demand and supply of financial assets and thus exchange rates
Purchasing Power Parity
PPP theory describes that the exchange rate between one domestic currency and another foreign currency is in equilibrium when the rate of exchange are equivalent to their domestic purchasing powers.
In another words, it means that a bundle of two or more goods would cost same in Europe and the India, when you taken the exchange rate into account.
Purchasing-power parity theory tells us that price differentials is not sustainable between two countries as the market forces will equalize prices between countries and in the process change the exchange rates. If we consider the example that consumer crossing the border to buy only one air conditioner to save out on prices by buying at lower pieces, but the significant expense of this longer trip would nullify the savings made through buying at lower prices, therefore we say that the trip should be useless. Although it is not as useless as we think, if we imagine think about a company buying large number of the air conditioner in China and then shipping them to the India. In the long run the different prices in the China and India are not sustainable because there is an arbitrage profit which is eliminated in short run by the punters. Therefore, the price of any good should be equal across all the markets. That’s the theory, but it doesn’t always work in practice
The Overshooting model established by Rudi Dornbusch, helps in describing the reason behind high variance in exchange rates. The most important finding is that the volatility in some parts of the economy can induce compensating volatility in others.
Dornbusch developed proving wrong the strongly held view that the perfect markets should reach equilibrium at some point. From this point of view, volatility could only be a result of asymmetric information. Going against this strongly held view, he argued that volatility is one of the profound basic properties than what should be considered.
In simple words, Dombusch established this model by estimating that prices of goods are ‘stickier’ in the short run, while ‘prices’ in financial markets adjust to disturbances quickly.
Let us understand through example, the market will adjust to a new equilibrium when a change in monetary policy occurs, When there is ‘stickiness’ in prices of goods, shifts in financial market prices helps in achieving the new equilibrium level. Gradually, when prices of goods ‘unstuck’ and shift to the new equilibrium, the financial market is allowed to adjust in a move that should approach its original levels. A new long-run equilibrium will be attained between money, supply of goods, and the finance, when this process has run its course. (See more about : Restaurant Business Plan Assignment Help)
- Suranovic, Steven M., 2003, International Finance Theory and Policy – Chapter 30.
Jay Kaplan, 2002. The Balance of Payments and Exchange Rates
Turnovsky, Stephen J., The asset market approach to exchange rate determination: Some short-run, stability, and steady-state properties
- Jiri Novak. 2007, Is CAPM Beta Dead or Alive? Depends on How you Measure It.
- Richard S Grinold. 1993, IS Beta Dead Again, Fiancal Analyst Journal, July-Aug. 1993
- Jonathan Lewellen and Stefan Nagel. 2006, The Conditional CAPM Does Not Explain Asset-Pricing Anomalies. Journal of Financial Economics.
- Robert Grauer. 1999, Is the CAPM Testable? CIR Summer.
- Eugene F. Fama and Kenneth R. French. The Capital Asset Pricing Model:Theory and Evidence. Journal of Economic Perspectives—Volume 18, Number 3—Summer 2004
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