(a) If investors become more jittery (more risk-averse) about investing in the s
ID: 2726330 • Letter: #
Question
(a) If investors become more jittery (more risk-averse) about investing in the stock markets based on new growth fears about the U.S. and global economies, then what will happen to current stock prices and expected stock returns according to the predictions of the Capital Asset Pricing Model (CAPM)?
(b) Also, some may describe CAPM in a simple, non-technical way that it rewards investors for "waiting and worrying about their investments". Discuss what CAPM variables may correspond to the waiting part and worrying part of your invested money. Limit your answers to no more twelve sentences.
Explanation / Answer
a) As per CAPM, increase in risk aversion will decrease current stock prices and increase expected stock returns. Both these things move in opposite directions, means when one increases, other decreases. CAPM theory suggests that every investor must be compensated for the extra risk taken by him, which implies the more risk-averse investors are, the higher will be expected return.
b) "Waiting" part refers to the time value of money. An investors earns a certain return over a period of time for the time he keeps invested. This is paid off by risk-free rate in the market.
"Worrying" part refers to the extra risk taken by investors. The risk refers to uncertainity in return on investment, for which investors need to be compensated with extra returns. This risk part is taken into account in the form of Beta in CAPM model.
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