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Is a negative expected rate of return possible?
I've a situation where expected rate of return of a stock, calculated using CAPM model is coming negative. Is it practically possible? If yes then what does it mean?
Rf = 4%
B = -3
Rm = 6%
Rf = 4%
B = -3
Rm = 6%
Tags: rate of return
Views: 2083
Replies to This Discussion
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Permalink Reply by muhammad hanif on -
hi narang!
Technically speaking its impossible....!
as CAPM based on the assumption that equity holder requires return at least risk free rate + market premium.. which compensates the risk borne by equity holders....!
here you've mentioned negative beta....! this may cause you trouble ....! think about a company which share prices inversely respond to market...! is it possible??? exceptions could be there!
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Permalink Reply by sergei on -
This would be a hedging asset. If beta of an asset is negative (because of negative correlation between a stock and the market), then an asset is even more valuable. So you can agree to a negative return, as this compensates the fluctuations of market portfolio.
For more on this and how it is possible see
Ariel, Robert, 1998, “Risk adjusted discount rates and the present value of risky costs”, The Financial Review, Vol. 33, pp. 17-30.
Beedles, William L., 1978, “Evaluating negative benefits”, Journal of Financial and Quantitative Analysis, Vol. XIII, pp. 173-176.
Beedles, William L., 1978, “On the use of certainty equivalent factors as risk proxies”, The Journal of Financial Research, Vol. I, No. 1, pp. 15-21.
Booth, Laurence D. Correct procedures for the evaluation of risky cash outflows. Journal of Financial and Quantitative Analysis, v. 17, n. 2, June 1982, pp. 287-300.
Booth, Laurence D., 1983, “On the negative risk premium for risk adjusted discount rates: A comment and extension”, Journal of Business Finance & Accounting, Vol. 10, No. 1, pp. 147-155.
Brigham, E.F., Gapenski, L.C., Ehrhardt, M.C., 1999, “Financial Management: Theory and Practice”, 9th Ed. (Dryhen Press, Orlando, FL).
Celec, S.E., and R.H. Pettway, 1979, “Some Observations on Risk-Adjusted Discount Rates: A Comment,” Journal of Finance, (Vol. XXXIV, No. 4, September), pp. 1061-1063.
Ehrhardt, Michael C., Phillip R. Daves, 1999, “Capital Budgeting: The Valuation of Unusual, Irregular, or Extraordinary Cash Flows”, Working Paper, Social Science Research Network.
Hartl, Robert J., 1990, “DCF analysis: The special case of risky cash outflows”, The Real Estate Appraiser and Analyst, Vol. 56, No. 2, pp. 67-72.
Lewellen, Wilbur G., 1977, “Some observations on risk-adjusted discount rates”, The Journal of Finance, Vol. 32, No. 4, pp. 1331-1337.
Lewellen, Wilbur G., 1979, “Reply to Pettway and Celec”, The Journal of Finance, Vol. 34, No.4, pp. 1065-1066.
Miles, James, Dosoung Choi, 1979, “Comment: Evaluating Negative Benefits”, Journal of Financial and Quantitative Analysis, Vol. XVI(5), pp. 1095-1099.
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Permalink Reply by saurabh narang on -
hi sergei,
thnks for replying. i would definitely look thru ur suggestions. If u've some more time then please look through the uploaded file and comment on the model with specific emphasis on 1 yr worksheet. - Attachments:
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Educomp.xlsx, 18 KB
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Permalink Reply by sergei on
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I have looked... but... It is not transparent to me.
Can you explain the notation? Specifically, yes, CNX, Kj, CNX Ret, g.sec, AAA, Km, New Kj...
If I correctly understood, the Km is a market return... But why do you calculate Km as
(CNX Ret + g.sec + AAA)/3 ??? It needs explanations...
And the time series are too short for statistically significant results...
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Permalink Reply by saurabh narang on
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yes km is market return and i've assumed market as a mix of theses three things to get vaible results from CAPM.....CNX is stock exchange, CNX Ret is CNX monthly return, Kj is monthly return of stock, g.sec is yield on government securities, AAA is AAA corporate...
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Permalink Reply by sergei on
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>
i've assumed market as a mix of theses three things
(CNX Ret + g.sec + AAA)/3 ???
It is a strong assumption. I am not sure it is an admissible assumption...
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Permalink Reply by Milos on
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Why would anyone agree to have expected return on an investment that is negative??? How could that be used as a hedge??? Instead of listing the articles, try to read them.
Negative beta could be found with some gold mining companies, but I assure you it cannot be as large as 3.
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Permalink Reply by aa on
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The reason for negative returns is apparent - Beta is negative 3 which indicates as market moves up the stock moves down and similarly for down and up movements respectively. It is difficult to find such a scenario in reality.
Keep everything same and use CAPM with Market rate of return as negative. Say Rf 4 %, B -3 % and Rm - 2 %, what is the expected rate of return for the stock - you get a positive 22 %. So CAPM holds in theory and practice given the assumptions that are there with CAPM.
Note on market returns -
In case you are calculating market returns as - (CNX Ret + g.sec + AAA)/3 - it is incorrect since g sec return is risk free return. For market return if we take ( Nifty + G sec return) it is incorrect as market return = risk free return + risk premium, so you are adding market return incorrectly.
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Permalink Reply by Milos on
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I fully agree. If you expect a market contraction in the next period, then it would be logical to buy negative beta stocks.
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Permalink Reply by sergei on
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No. The theory does not allow the expected stock market rate of return to be negative. If you expect that the whole market will go down in the long run, is it reasonable for you to hold such a portfolio? If a single stock produces negative returns it can hedge the market. But if the whole market is expected to be negative, then according to market efficiency principle, it should immediately adjust the prices so that the expected return should be positive. Recall that market price is based on expectations. If you change your expectations, the market price also changes. If you expect negative market return, then the value of the market will be negative. I cannot imagine this scenario. We should not confuse historic realized returns with expectations.
However, what concerns the validity of CAPM... I am not sure that the CAPM is a correct model of reality. There is a lot of critics. But CAPM is still very popular.
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Permalink Reply by Bill Rempel on
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I am sure that CAPM is NOT a correct model of reality. I consider it dangerously irrelevant. But as Sergei states, it is popular.
Personally I ignore CAPM wherever possible, and if forced to use it in some project, do so, but point out the debate over its flaws and distribute links or copies of academic refutations to those that show interest.
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Permalink Reply by Lin Giralt on -
It appears to me that there is an error here - the impact of which I do not know - in that it is mixing up stock returns with fixed income returns. The return on the equities market for an investor is relevant, the return of the fixed income market for the CAPM equation is irrelevant
Best Lin Giralt
PS I do agree that with a negative Beta, negative Re's are possible and that this is a hedging instrument
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