Scholarly Research Journal for Interdisciplinary Studies,

Online ISSN 2278-8808, SJIF 2016 = 6.17, www.srjis.com

UGC Approved Sr. No.49366, NOV-DEC 2017, VOL- 4/37

CRITICAL APPRAISAL OF FINANCIAL MODELS IN INVESTMENT DECISIONS

& SECURITY TRADING

Ayushi Mundra
Student, Management. Faculty of Management Studies, MLSU, Udaipur, India

The current research aims to appraise financial models and analyse their usefulness in security trad-
ing. One of the main issues considered in this paper is the Capital Asset Pricing Model and the Arbi-
trage Pricing Theory, their major differences and implication in portfolio management. The results
showed that these two theories, despite common ground, differ in terms of systematic risk measure-
ment. However, both theories are used as a fundamental for portfolio management. The second issue
analysed in the research is the logic of theBehavioural Finance Theory. The theory is a background
for the application of technical analysis which is used to maximise investor’s profit and make deci-
sions for buying and selling. Finally, the third part of the study investigates the application of the
yield curve in trading securities. As results demonstrated, the yield curve is applied not only in in-
vestment decision making processes, but in forecasting economic situations. Itprovides information on
future inflation and interest rates and helps to determine if the fixed-interest security is under-priced
or overpriced.
Keywords – CAPM; AP; Behavioural Finance Theory; Yield Curve

Scholarly Research Journal's is licensed Based on a work at www.srjis.com

1. Introduction
Taking the decision for investing in different assets and contracting the portfolio investors
and managers are guided by two major variables, expected return and risk that they can bear.
However, there are also a number of financial theories and models which can be used in the
investment decision making and the security trading process. The Capital Asset Pricing
Model (CAPM) and the Arbitrage Pricing Theory (APT), as well as behavioural finance and
yield curve models are the main ones which are applied in trading securities. Both the CAPM
and the APT are used for portfolio construction, while behavioural finance studies the biases
in human behaviour and serves as a background for the technical analysis in the investment
decision making processes. The yield curve construction, in its turn, helps not only to make
strategic investment decisions but also predict future economic conditions in general. Thus,
the objective of the current study is to critically investigate the above mentioned theories and
analyse their usefulness in security trading.

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2. Comparison of the CAPM and the APT
The CAPMis one of the financial tools used by professionals to calculate the expected return
of a particular investment portfolio based on a risk measurement. The risk in this model relies
on the systematic risk multiplier that isBeta coefficient. The implication of the CAPM is the
evaluation of the performance of managed portfolios (Bodie, Kane, & Markus, 2008, p. 293).
The APT, in its turn, is also an asset pricing theory with the main objective to secure better
understanding of portfolio establishment and the estimation of return and, thus, to improve
the overall portfolio performance. The APT is different from CAPM due to the underlying
reason that it is less restrictive in its assumptions.Moreover, the APT equated the expected
return of an asset to number of macro-economic factors, so each of them comes with a spe-
cific Beta coefficient factor.
Although the CAPM model is known to be one of the best theoretical models which provides
explanation of expected return on risky assets, it fails empirically since it depends on a single
factor only which means that the return of the portfolio is determined by only one factor of
risk, that is the systematic risk or Beta (Fama & French, 2004).Both theories, the CAPM and
the APT, provide information to financial decision makers regarding the estimation of the
rate of return on portfolio including risky securities. But in implication they are different
from each other in terms of their assumptions, and practical usefulness for portfolio manage-
ment. The following mentioned are some of the differences between the CAPM and the APT:
1. Proponents of the CAPM argue that β, a measure of systematic risk relative to the
market portfolio, is the sole determinant of return. The expected return in the case of the
CAPM is calculated on the basis of a single factor namely systematic risk or Beta. On the
other hand, in the case of the APT it depends on multiple factorssuch as GDP, interest rates
and inflation, and likewise has multiple Betas to measure the risk of portfolio.
2. The APT is known to be an improvement over the CAPM. But as far as the implica-
tion of these theories in the real world is concerned, the APT is more complex.
3. The CAPM is more accurate to apply for the measurement of the performance of port-
folio over a short period of time as compared to APT which is more suitable over long peri-
ods of time.
4. The APT has the advantage over the CAPM as its main focus is towards risk factors
and, thus, it does not require constructing an equivalent portfolio for the measurement of risk
(Bodie, Kane, & Markus, 2008).
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5. The CAPM does not address non-systematic risk in its structure, while the APT rec-
ognises the impact of non-systematic risk in the model itself.
Even though both of these asset pricing approaches are based on unrealistic assumptions re-
garding consideration of limited number of factors to predict risk, at the same time they are
used as rule of thumb for the measurement and improvement of the well diversified portfolio.
3. Behavioural Finance and the Use of Technical Analysis
According to Zimmermann (n.d.), behavioral finance is “the application of scientific research
on the psychological, social, and emotional contributions to market participants and market
price trends”. It studies why market participants make irrational decisions influenced by their
psychological or cognitive biases when interacting with the financial markets. Based on these
suboptimal decisions, investors may over-react to market information, or make errors such as
taking profits early or holding on to losing positions. Examples for such psychological biases
are:
 Mental accounting - the tendency of people to divide their money among separate ac-
counts based on a variety of subjective criteria, such as intent for each account and the
source of the money;
 Herd Behaviour - the tendency of people to follow the majority when making decisions;
 Anchoring - the tendency of people to judge the quality or performance of an asset merely
by its face value;
 Overconfidence - the tendency of the people to overestimate their abilities and the preci-
sion of their forecasts.
Behavioural finance is the theory behind technical analysis which is often used by investors
in order to justify their spontaneous decisions specially when making short term investments.
Technical analysis is a method of analysing the performance of securities by evaluating their
past prices and volume. In other words, it tests historical data of securities in order to estab-
lish certain criteria to make buying and selling decisions with the objective of maximiz-
ing profits and minimizing losses. In contrast to a fundamental analysis, technical analysis
does not recommend measuring a security's intrinsic value, which could serve as a disadvan-
tage of the approach. However, as an advantage, it uses an array of forecasting techniques
such as chart analysis, pattern recognition analysis, seasonality and cycle analysis and com-

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puterized technical trading systems to identify patterns in order to predict future value of a
particular security.
4. The Use of Yield Curve in Trading Securities
The yield curve is a line graph that describes the relationship between yields to maturity of a
bond and its maturities. It depicts the differencesin yields starting from the shortest maturity
to the longest one. The use of the yield curve in trading securities is expressed in the two fol-
lowing points:
-Significant indicator for forecasting economic conditions steep, flat and inverted yield
curves are three main shapes of the yield curve that reflect different states of the economy:
upturn, slowdown and recession (see Appendix). The curve helps to predict the future infla-
tion and growth of emerging economies (Mehl, 2009). The monetary policy influences sig-
nificantly on yield curve shape and, hence, the state of the economy in the future (Estrella &
Mishkin, 1996; Estrella, 2005). For instance, when Central Banks increase interest rates to
restrain the inflation and stabilize economies. The significant increase of interest rates and
inflation means higher level of risk that influences the interests of investors. As a result, in-
vestors require more yield to compensate risks they may get, especially for long term invest-
ments if they expect the rapid growth of the economy in the future.
A yardstick for pricing fixed-interest securities and a fundamental for making investment de-
cisions
Firstly, the Government bond yield curve can be seen as a benchmark for pricing other fixed-
interest securities (Corcoran, 2013). Investing in Government bonds is less risky than in cor-
porate bonds or other fixed-interest securities because investors do not face default risk.
Hence, the yield ofriskier securities must be higher than the yield of Government bonds.
Secondly, the yield curve provides information on future inflation and interest rates based on
expectation or requirement of investors which is reflected on the yield shape. The steep yield
curve demonstrates the higher inflation and interest rates in the future. Hence, investors are
supposed to cash out their investments in bonds or other long-term securities to invest in as-
sets which are less influenced by changes of interest rates (Chand, n.d.).
Furthermore, there has been some yield curve strategies developed to help investors to in-
crease their returns, such as “Riding the Yield Curve” which supposes that investors should
hold their bonds or other fixed-interest securities for a period time then sell them before ma-
turity to gain. Based on the movement on the yield curve, investors can forecast the change of
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interest rates to ride the yield curve at the right time to increase their return. The strategy can
help investors to strengthentheir holding period returns (Dyl & Joehnk, 1981).
Finally, investors can identify whether their fixed-interest securities are under-priced or over-
priced usingthe fact that yields of securities with similar risks tend to lie along the yield curve
at their maturity levels (Chand, n.d.). Therefore, when the rate of security return is above the
yield curve, the security is temporarily under-priced compared to other securities of the same
maturity and investors should buy.
5. Conclusion
To reiterate, the objective of the study was to critically investigate the main finance models
and analyse their usefulness in security trading and the investment decision making process.
The findings showed that the yield curve serves as a benchmark for pricing of other fixed-
interest securities, as well as a basis for taking short or long positions through forecasting in-
terest rates. The shape of the yield curve also predicts changes in the economic conditions.
Additionally, behavioural finance aligns psychological aspects and financial decisions.
Through application of technical analysis investors seek to maximise their profit or minimise
the loss using securities performance evaluation. However, this approach is applicable only
for a short-term period.
As for the CAPM and the APT, both models aim to evaluate the expected return ofacon-
structed portfolio through risk measurement. However, the theories are different in terms of
defining systematic risk measure which is represented by only one Beta coefficient in the
CAPM and by several ones in the APT. The APT is also less restrictive and more complex
comparing to the CAPM and defined as an improvement over the latter.
References
Bodie, Z., Kane, A., & Markus, A. (2008). Investments (7th ed.). Boston: The McGraw Hill Press.
Chand, S. (n.d.). What are the important uses of the yield curve? Retrieved from YourArticleLibrary:
http://www.yourarticlelibrary.com/economics/what-are-the-important-uses-of-the-yield-
curve/1585/
Corcoran, C. (2013). Yield curve investing: optimizing risk-adjusted returns. Global Journal of
Business Research, 7(2), 95-102.
Dyl, E. A., & Joehnk, M. D. (1981). Riding the yield curve: does it work? The Journal of Portfolio
Management, 7(3), 13-17.
Estrella, A. (2005). Why does the yield curve predict output and inflation? The Economic Journal,
115(505), 722-744.
Estrella, A., & Mishkin, F. S. (1996). The yield curve as a predictor of U.S. recessions.
Current Issues in Economics and Finance, 2(7), 1-6.
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Fama, E., & French, K. (2004). The capital asset pricing model: theory and evidence. Journal
of Economic Prospectives, 18(3), 25-46.
Kerkhoff, M. (2015, July 1). What is the yield curve telling us about the future? Retrieved
from Financial Sense: http://www.financialsense.com/contributors/matthew-
kerkhoff/what-is-yield-curve
Mehl, A. (2009). The yield curve as a predictor and emerging economies. Open Economies
Review, 20, 683-716.
Zimmermann, W. J. (n.d.). Behavioral finance and technical analysis as the solution to
fundamental analysis and the efficient market hypothesis. United-ICAP. Retrieved
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Appendix
Examples of the Yield Curve Shape

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 Ayushi Mundra
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Note. Retrieved from Kerkhoff (2015)

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