Behavioral Finance and Analysis of American Financial Essay

  • Length: 8 pages
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  • Subject: Economics
  • Type: Essay
  • Paper: #42185362

Excerpt from Essay :

Behavioral Finance and Analysis of American Financial Crisis

Financial theories are the cornerstone of the modern corporate world. They lay the foundation for most tools used in areas like asset pricing and investment banking. Most theoretical concepts like general equilibrium analysis and information economics are planted in the field of microeconomics. There are several different financial theories based on both consumer behavior, as well as how they impact decisions made by financial managers.

One financial theory that many business managers use is The Modern Portfolio Theory,

or MPT. It suggests how investors use diversification to enhance their portfolios, as well as how to price an asset based on the risk, in relation to the market as a whole. Modern portfolio theory displays the return of an asset as a variable, and the portfolio as a combination of all of the assets. The return of a portfolio is also a random variable and it has an expected value with variance.

The type of risk in this model is viewed with the general variance of a portfolio return. It assumes that an investor picking from multiple portfolios, all with the same expected rate of return, will choose the portfolio with the least amount of risk." The use of the MPT, over time assumes risk assets may yield a higher rate of return, as a financial reward to the investors who are willing to accept a high risk. At some point, this will reduce collecting assets to the portfolio, decrease the risk, and increase the expected rates of return. The purpose of the MPT, is to develop an optimum investment portfolio, that will yield the highest rate of return. while determining level of risk for the business or investor. It affects global and domestic financial managers using capital market line and securities as the basis for portfolio investments. The MPT sets the investment portfolios, and are utilized by companies like Fidelity or E. Trade for strategies in the long and short-term cycles.

Another financial theory financial managers use is the general equilibrium theory. This analysis targets the question; How does a market economy allocate it resources? The equilibrium theory is primarily built on that of consumer behavior developed in the study of microeconomics. It "examines how the interactions of economic agents determine equilibrium in the markets for all goods simultaneously" (Spear, 2005). It attempts to understand of the entirety of an economy by utilizing a bottom-up approach, beginning with individual markets. The equilibrium theory intertwines the cost of goods, and their development. For example, a change in the price of a child's toy, may affect the price of something else, such as the wages of the employee who made the toy. The demand for that toy may be affected by the wage alteration of its maker. So, determining the equilibrium price of a single item, requires an analysis that accounts for all of the millions of different items on the market, in this theory.

One of the most prominent financial theories that analysts use is The Efficient Market

Hypothesis, or the EMH. It establishes that stock prices are figured by a discount procedure so they are equal to the present value of expected future cash flows. It portray stock prices as currently reflecting the known information, making it accurate, while the future stock prices are currently variable and random. THE EMH is based on notions of rational expectations. It also implies that it is not usually possible to earn above-average returns in the stock market through trading, except with luck or the ability to trade on inside information.

The EMH is derived in three forms: weak, semi-strong, and strong. The weak version states I is impossible to predict future movements in asset prices based on past movements. The semi-

strong form states asset prices as good as any estimate made with information available to the public. The strong version, which few people believe in, states that asset prices represent the best known estimate, taking into account all information, both public and private.

In the past few years, many economists have questioned the EMH theory, since there are several recorded instances where market prices did not accurately reflect available information.

Furthermore, times of large-scale irrationality, like the "bubble" of the nineties, have convinced several analysts that this financial theory should be rejected. Also, many econometricians state that stock prices are somewhat predictable on the basis of past returns and/or previous dividend yields.

Monetary policy is a procedure where the government and banks determine the quantity of money within an economy, as a way to reach macroeconomic and political goals. The top goals are economic growth, alterations to the rate of inflation, greater employment levels, and exchange rate adjustment. It is categorized into two types; Tight and loose. The former policy aims to decrease the amount of money circulating within an economy, as well as decrease short-term economic growth, with the hopes of long-term growth. The loose policy, attempts to increase the money supply and short-term economic activity, while long-term activity may suffer as a result. The gross discount product usually indicates the economic health of a country, and helps determine that country's standard of living. Many critics say that using the gross discount product to measure the health of an economy is inaccurate because it does not take into consideration the underground activities, or those that are not reported to the government.

A country's unemployment rate reveals the percentage of the total workforce that is unemployed to macroeconomists. The employment rate is measured by determining who is currently unemployed, however eligible to work. This group is seen as potential workers. The second groups is composed of those who are unemployed, and not trying to find work. The last group is called the labor force, which are those who are gainfully employed.

Another factor macroeconomists take into consideration is the inflation rate, which is the rate at which prices increase. It is calculated by two methods: The Consumer Price Index and the GDP deflator. The CPI gives the current price of a selected group of goods and services that is updated ever so often. It is then calculated by using price changes for each item in the predetermined group of goods, then coming up with an average. CPI change is used to determine price changes in relation to the cost of living. The gross domestic product deflator is the ratio of nominal GDP, in relation to the real GDP. It displays how much a change in the year's GDP is reliant on changes in the current price.

The strongest weapon in the Federal Reserve arsenal, is their ability to influence which way interest rates go. These are the yearly prices that lenders charge to borrowers for the privilege of getting a loan. It is generally expressed as a percentage of the amount of money loaned. If interest rates are low, capital for individuals and businesses is easy to obtain. Low interest rates help fuel economic development since the more cash on can spend, the more likely they are to spend it. The downside is that it can promote inflation, when businesses see the demand has risen. This encourages them to charge higher prices for goods and services, then it has a domino effect, as everything begins to become pricey. The price increases creates a need for more money and this becomes a burden on the consumer.

Many people do not understand money creation. One of the main misconceptions, is that banks or governments are the ones who create all of the money. However, governments simply borrow money from banks, who manage and redistribute the money to individuals and businesses. It is hard to imagine, but people are the source of potential wealth. This is due to the fact that a person's labor can be traded for one of three things; barter for other goods and services, through use of currency or through money creation. Everyone who buys or sells goods, services or labor, are considered producers, consumers, or traders. (Krumm, Paul, 2007)

The Great Depression of the 30's was one of the worst times for almost every American. Any "depression" is best characterized by large levels of unemployment, severely decreased consumer demand, very little, if any family disposable income and a substantial amount of non-utilized industrial capacity. Unlike the recent "Great Recession" since 2008, the Great Depression was marked by severe levels of despair, homelessness, and hunger for many years. However, there was a light at the end of the tunnel. Although unemployment levels were high in the 30's, there was hope amongst the American people. This is mostly thanks to President Franklin D. Roosevelt and his fireside chats and "New Deal" that helped create jobs and increase American wealth.

There is little doubt that the Great Depression had a negative impact on millions of Americans. However, throughout the course of 1929 through 1937, the Gross National Product

(GNP) in America improved. FDR's New Deal created greater industrial production in many industries, thus improving…

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