Omar Henry is a firm believer in capital market theory and the capita! asset pricing model. Henry has developed a model to select overpriced stocks as indicated by the security market line. The model identifies the overpriced securities and then executes a short position in the overpriced stocks. Which of the following practical conditions would prevent Henry from using his model to explain capital market behavior?
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A. B. C.Explanation
To explain the capital market behavior using his model, Omar Henry relies on the capital asset pricing model (CAPM) and the security market line (SML). The CAPM is a financial model that helps in determining the expected return on an investment based on its systematic risk. The SML is a graphical representation of the CAPM, which plots the expected return of an asset against its beta.
Based on the information provided, Omar Henry's model aims to identify overpriced stocks by locating securities that deviate from the security market line, and he takes short positions in those overpriced stocks.
Let's analyze each answer choice to determine which condition would prevent Henry from using his model to explain capital market behavior:
A. All investors use exactly the same two-stage dividend discount model to evaluate stocks. This condition would not prevent Henry from using his model. The two-stage dividend discount model is a method used to value stocks based on expected future dividends. Since Henry's model is based on the CAPM and SML, which assesses the relationship between risk and expected return, the valuation approach used by other investors would not directly impact his model's ability to explain capital market behavior. Hence, option A is not the correct answer.
B. All investors pay the same commission rate of $0.03/share on all equity trades. This condition would also not prevent Henry from using his model. The commission rate charged on equity trades is a transaction cost that does not directly influence the underlying principles of the CAPM or SML. It may affect the profitability of trades but does not impact the validity or applicability of Henry's model in explaining capital market behavior. Therefore, option B is not the correct answer.
C. All changes in Federal Reserve policy are perfectly anticipated by investors. This condition would prevent Henry from using his model to explain capital market behavior. The CAPM and SML are based on the assumption that investors have rational expectations and make decisions based on all available information. If all changes in Federal Reserve policy are perfectly anticipated by investors, it implies that the market efficiently incorporates these policy changes into stock prices. As a result, it would be difficult for Henry's model to identify overpriced securities since all relevant information, including anticipated policy changes, is already reflected in stock prices. This condition undermines the assumptions of the CAPM and SML and hinders Henry's ability to explain capital market behavior. Therefore, option C is the correct answer.
In conclusion, the practical condition that would prevent Omar Henry from using his model to explain capital market behavior is when all changes in Federal Reserve policy are perfectly anticipated by investors (option C).