Impacts of Changing World Order on Capital Asset Pricing Model's Main Assumptions

Date:  2021-03-30 19:05:25
2 pages  (557 words)
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Carnegie Mellon University
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This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

The Capital Asset Pricing Model (CAPM) is widely applied by investors and traders in security markets around the world to mitigate financial risks that are likely to be faced in the current volatile financial markets. It does this by allowing investors to draw conclusions on the profitability of specific stocks based on the market's general stocks performance. The CAPM model encompasses a number of assumptions that the investors bear concerning the expected return on certain investments. Some of the main assumptions include perfectly competitive markets with many small traders and investors who act as price takers, frictionless markets with no transaction costs or taxes, equilibrium regarding the portfolio held, and composition of the portfolio.

With the recent World orders such as the United States elections, Brexit and the European Central Bank monetary policies taking shape, the assumptions of the CAPM are without a doubt being impacted majorly due to the changing world security markets. The just concluded US elections and the results have, for instance, generated a lot of short run ripple effects on the US economy and the world economy as a whole. The markets reacted to the news of Donald Trump winning the presidency by the US dollar valuation dropping sharply across most security markets in the world. This was mainly attributed to the fact that Donald Trump strongly advocated for stringent measures and economic policies that would see taxes lowered and trading ties and agreements between the US and other trading partners such as China cut. The upturn of events after the elections directly impacted the otherwise competitive financial markets as many traders suffered massive financial losses and decided to leave the markets. This consequently led to fewer traders and investors in the security markets around the world.

Britain's exit from the European Union also saw the security markets around the world suffer a significant blow as the markets reacted negatively to the surprises emanating from Britain cutting ties with other European countries albeit not entirely. The British pound dipped 7.6 percentage points against the US dollar making it the worst plunge since 1985. Brexit also saw the American shares decline by 3.6 percentage points and the industrial average for Dow Jones sink by a staggering 611 points since August. The British stocks suffered a 3.2 percent erosion in value and the broader European stocks sunk by an overwhelming 8.6 percent. The consequence was a sharp decline in the investor confidence that previously existed, rising uncertainty levels and lack or limited central banks' responses. The portfolio composition assumption was as a result set aback as most investors chose to shift their portfolio from the riskier markets to less risky securities. The investor shifts extensively affected the global economy with countries that traded with the euro being the worst hit.

The recent European Central Bank's conventional and unconventional monetary policies have rubbed investors the wrong way. Failure by the bank to announce the new stimulus and the QE have delved the European stock markets into the red. The equilibrium assumption has hence been affected by the stringent policies making investors seek alternative ways of averting risks. This is particularly so since the risk variance, and the average investors' risk aversion are proportional to the risk premium. The recent changing economic world order has, therefore, resulted in major effects experienced in relation to the assumptions assumed in the Capital Assets Pricing Models.

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