Reference no: EM133633480

Background Information:

Historically, average returns among all asset classes sold in major financial markets tend to be distributed normally. While average returns of major asset classes are characterized by differing means, and different degrees of volatility, we expect that - given this historical and statistical normalcy we have seen to characterize financial markets - extreme outcomes (i.e. major falls in market prices) will occur only very rarely, perhaps less than 5% of the time. In fact, extreme falls in value and uncharacteristically extreme volatility in pricing occurs so rarely that we remember vividly the handful of instances when these have occurred. We label these as "historic," and do not consider these circumstances as likely to be replicated in the normal course of market activity. These historic drops have been associated, in the past, with extraordinary circumstances. Since the Great Depression, monetary authorities step in to assist markets, and at times, trading in financial markets is halted to allow for a restoration of calm, prior to a resumption of trading.

Nevertheless, academics and others that study financial markets find that extreme events should be expected to occur periodically (Deboss, 2017). Finance Professor and Options Trader, Nassim Nicholas Taleb, has argued that we should not view extreme events as Black Swans (rare and unexpected), but as part of the ordinary functioning of financial markets. He advocates less intervention in markets by authorities, as a means of building their resilience - making them "antifragile." In this discussion, building on these developments, we explore our changing understanding of market volatility (Deboss, 2017).

Discussion Prompt:

In this discussion, assume that you are assigned to address colleagues who are new to your firm. Your colleagues have a basic understanding of finance but are unfamiliar with the history of financial markets and how financial market activity might affect your firm in terms of its general approach to financial policy.

Tasks:

Using graphical and mathematical visual aids or demonstrations found in course materials or elsewhere if you find these applicable, brief your colleagues regarding the history of average returns on major classes of assets traded in major financial markets, the definition of normalcy which we have understood to characterize these historically and statistically, and implications for your firm. Please note that graphical or algebraic analysis may aid you in presenting your views, but this is not a required component of tasks set forth below.

Address the following:

(a) Assumptions of normalcy affecting discounts rates used in valuing cash flows associated with investment projects (consider average returns, volatility, and derivation of the Capital Asset Pricing Model-CAPM model);

(b) Criticisms of an assumption of normalcy (consider the Black Swan phenomenaLinks to an external site., kurtosisLinks to an external site., and market fragility); and

(c) Implications for financial decision-making given course materials and materials introduced in this discussion (consider how a typical firm may be affected if normalcy fails, and how a firm might prepare for this possibility).