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International Finance Essay

1289 words - 6 pages

Discuss potential explanations for the Security Market Line has been flatter than the Capital Asset Pricing Model (CAPM) would predict.

Student Name: Jiaxin Shen Student Number: 100103708

Word count: 1227

Discuss potential explanations for the Security Market Line has been flatter than the Capital Asset Pricing Model (CAPM) would predict.
The Capital Asset Pricing Model is based on asset portfolio theory and capital market theory. It emphasizes on the study of the relation between the expected return of asset and risky asset in the securities market. As one of prediction models based on the balance of risky asset expected return, CAPM elaborates on the formation of market ...view middle of the document...

Figure 1: Fama, E., F., French, K., R., (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18, 2546. The first reason of this appearance, beta is the only determining factor for the future return rate in the Capital Asset Pricing Model, variance of residuals is not important when determining stock price and expected returns. (Adair, 2006) It is concluded that beta has no explanatory relation over average stock return. In fact, there is not significant relation between beta and securities rate return. According Fama and French (2004), the return rate is influenced by the size and value. In the security market line the average abnormal return of small size stock is higher than CAPM’s. They think that the high return rate of undervalue stock is predicted by the investors, as these undervalue stock may be profitless or in terrible financial straits. Therefore, the relation between beta and average abnormal return is not described in the capital asset pricing model. The second reason is survivor bias, it means that these sample data of stocks exists higher average return and lower return variance. Fama and French eliminated a lot of bankrupted company during the research. The risk of undervalue stock is larger because they are in terrible financial straits. The value of stocks tends to a low level because of financial distress. Actually the probability of tide over difficulties is larger than the probability of bankruptcy, which due to average yield of value stocks is

higher. This would also help explain Value Premium. In the credit and liquidity crisis, the stocks have a bad performance for the company in the financial distress. (Benninga, 2011) Eliminating a lot of bankrupted company which caused the undervalued stocks in the past performance is better, so the slop is “too flat” and intercept is “too high” in the securities market line. In the capital asset pricing model, there are two hypotheses that are based on mean-variance model, one of them is that clearing the market at the period of T-1, investors agreed that the asset portfolio ratio is distributed from T-1 to T. This distribution is correct, which is tested by some sample data. Another hypothesis is borrowed by risk-free interest rate for the
( investors. In the hypothesis, the E RZM) must be the risk-free interest rate, R f , and

the model formula is E ( Ri )  R f  [E(R m )  R f ]i , i  1,......., N . According to the above mentioned assumptions the investors borrowed by risk-free interest rate to hold the asset portfolio as same as the market portfolio. But the risk-free borrowing is unreal. Moawia (2009) claimes that the beta is measured with error, then the slope coefficient of the regression equation will be biased downward and the intercept biased upward. In conclusion, expected rates if return are linear and increase with beta, the measure of systematic risk and expected rates of return are not affected by nonsystematic...

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