Analysis of Financial Theories

Abstract

Financial theories are just that; theories. Economists from all over have gone through working on investments and have created formulas; or ways to help forecast returns, profits, and losses. Most theories are similar yet different in the way they deal with the financial world. I intend to try and explain at least three theories or models and explain the similarities and differences. There is also the intention of trying to explain each of the three in what they do and how each one of them can help companies learn more about their financial needs, gains or losses.

Financial Theories

Financial theories have come to be the building blocks of the corporate financial world. If there are no theories, then there would be nothing but chaos and with no rules, there would be even more corruption and issues with investors and investees. Having the financial theories will also allow for modern tools to use in all areas of financial matters.

Theories

Arbitrage Pricing Theory was created in 1976 by Stephen Ross. He created the Arbitrage Pricing Theory to help forecast an asset returns and goes along with the linear relationship. The Arbitrage Pricing Theory can offer analysts and investors alike the ability to have a multi-factor pricing model. The relationship between expected return and risk looks at the fare market price which, when looking at possible incorrect prices that could be temporarily incorrect.

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The Arbitrage Pricing Theory is a more flexible, but more complex than the Capital Asset Pricing Model, which will be talked about later. What the Arbitrage Pricing Theory does allow for is a customization of the research that is conducted. There is a little more information that can be added, but it while this model or theory can be flexible, it needs time to figure out the risks and influences for the asset in question.

This theory in general is the theory of asset pricing and it hold the expected return of financial assets. While holding these assets, they can be modeled as a linear function and have various macro-economic factors or market indices. The changes in the factors are usually represented by a specific factor.

The Black-Scholes-Merton Model was created in 1973 by Fischer Black, Robert Merton and Myron Scholes. The Black-Scholes-Merton Model is the model price variation that over time the financial instruments can be used to determine the price of the European call option. This model is simple as it used to solve the prices for call options, and what’s even more unique about it is that it’s only used in Europe and doesn’t even come close to accounting for the U.S. options. This model also won a Nobel Piece Prize in the economics world.

To use the Black-Scholes-Merton Model, there needs to be five variable inputs that consist of the strike price, the current price, expiration and the risk-free rate and last nut not least the volatility. The Black-Scholes-Merton Model is, according to Brooks and Chance (2014), the Black-Scholes-Merton Model uses its model to demonstrate the relationship between the option and the its inputs.

In other words, this model is defined as a tool that models stock prices and is considered a model for pricing the options mathematically. It will consider the strike price of an underlying asset or security along with the its date of expiration. It will assume the options are exercised on their maturity date and will have a risk-free return rate. It is also assumed the stock or asset will not change throughout the life of its contract.

Capital Asset Pricing Model was created by William Sharpe in 1964 and then in 1965, Treynor and Lintner added to the model their ideas and it was adjusted again in 1966 by Mossin. It seems the Capital Asset Pricing Model was built on assumptions that that it cannot be practical or feasible since there are transaction costs along with taxes. Capital Asset Pricing Model works with a beta; a lower beta will be underestimated and a beta that is higher will be overestimated.

Capital Asset Pricing Model segregates risk as systematic and non-systematic, where unsystematic risk being not correlated with the market, unlike systematic risk. Main conclusion drawn using the Capital Asset Pricing Model were stocks with a lower beta was underestimated and that with a higher beta are assumed to be overestimated.

Improve Business Decisions

Each theory can help any business depending on what it is looking for. If business is looking to invest overseas, then they may want to look at the Black-Scholes model, if they are wanting to find out if an investment is under or overestimated, then they may want to look at using the Capital Asset Pricing Model. If a business is looking at something that is a little more flexible and a little more complex, then they will want to look at using the Arbitrage Pricing Theory.

Theories are there to help people and business understand how the world works in a systematic way. The theories can also help prevent many common errors that can happen when opening a new business. When using this theory or any other theory to make good decisions and become a better business, the managers or owners will one, need to know what it is they are actually doing and two, they will need to make sure they are following the recommendations of what the model or theory of choice is or they will need to follow the recommendations of their financial advisor.

To try and decide which theory is best suited or how each one will improve a company or business, is not necessarily possible. The company must know what it is trying to accomplish and what their main goal it. Is this company trying to go public? Is the company already public and trying to go private so it can fix and change things? Is the company trying to gain more in their stocks or are they trying to figure out realistic goals for the future?

Similarities/Differences

The three theories are similar in that they will all pretty much do the same thing. The only major difference there is between the three is that one, the Black-Scholes-Merton Model is used in Europe and not in the United States. The Black-Scholes Merton model will include the dividend payout of the stock and eventually takes on the company’s credit risk and puts it into account; it will also look at the volatility of the stock.

The Capital Asset Pricing Model and the Arbitrage Pricing Theory are very similar, especially if looking at their formulas. Their formulas are almost identical to one another. The main differences between the Capital Asset Pricing Model and the Arbitrage Pricing Theory are the Capital Asset Pricing Model is a one factor model and can be easier to use due to that fact. The Capital Asset Pricing Model is the difference between the expected rate of return, and it considers the risk-free rate of return. The Capital Asset Pricing Model will allow investors to quantify any expected return on any given investment, along with the beta of the asset or portfolio.

The Arbitrage Pricing Theory of course, has multiple factors and it includes non-company factors within its formula. This theory also does not show insight into what any of the non-company factors can or could be. Since the Arbitrage Pricing Theory does not show the insight, it can skew the affect on the asset’s returns. This theory is an alternative to the Capital Asset Pricing Model and can be much more difficult to implement.

Recommendation

While all financial theories and models are all similar, yet very different, it will be rough choosing the one that will best fit a business of any type or size. After just looking at the three I chose, I would have to say if I was over in Europe, I would most definitely get to the Black-Scholes-Merton model as it is more common there than in the United States.

When looking at the other two that I chose, the Capital Asset Pricing Model or the Arbitrage Pricing Theory, the choice is simple, choose the Capital Asset Pricing Model. Since the Capital Asset Pricing Model is much easier to use, and it seems to take more into consideration about the company, it would be the go-to model or theory. On the other hand, I would like to think the Arbitrage Pricing Theory would also be a good choice. I believe that at some point, a company would need to use this theory since it takes so much more information into consideration. It will never hurt any company to use more than one theory and just because one financial person prefers a model or theory, does not mean the other financial person will prefer the same theory.

Conclusion

In closing, I think financial theories and models are just that, theories and models. The theory or model that is chosen by an investor, a company or a financial advisor looking at a portfolio, it will all determine what the end goal is going to be or what it should be. While they all tend to be similar, they are all quite different. It’s difficult to try and explain everything and choose just one of three when there are literally hundreds of different theories and models out there to choose from.

I will say it again, the theory that is best for any company is going to be the decision of the financial planner and the financial analyst that is working for that company. They will have to take their time when it comes to trying to choose. While going for the theory that is the simplest vs. a theory or model that will take into consideration all outside or non-company factors.

References

• An Empirical Test of the Black-Scholes Option Pricing Model and the Implied Variance: A Confidence Interval Approach. (1987). Journal of Accounting, Auditing & Finance, 2(4), 370–374. https://doi.org/10.1177/0148558X8700200404
• Brooks, R., & Chance, D. (2014). Some Subtle Relationships and Results in Option Pricing. Journal of Applied Finance, 24(1), 94–110. Retrieved from https://search-ebscohost-com.libauth.purdueglobal.edu/login.aspx?direct=true&db=bth&AN=96241614&site=eds-live
• Robin, A., & Shukla, R. (1991). The Magnitude of Pricing Errors in the Arbitrage Pricing Theory. Journal of Financial Research, 14(1), 65–82. https://doi.org/10.1111/j.1475-6803.1991.tb00645.x
• Terence Tai-Leung Chong, Qing He, Hugo Tak-Sang Ip, & Siu, J. T. (2017). Profitability of Capital Asset Pricing Model Momentum Strategies in the Us Stock Market. International Journal of Business & Society, 18(2), 347–362. Retrieved from https://search-ebscohost-com.libauth.purdueglobal.edu/login.aspx?direct=true&db=bth&AN=126051764&site=eds-live