Challenges faced by financial asset pricing models Essay

Challenges faced by financial asset pricing models - Essay Example Even then these models would serve as a better guide to the market than the lessons taught by a financial ruin. That is a strong reason for understanding the challenges faced by the financial asset pricing models, so that these models can be used with discretion to understand the market better. Seen from that angle understanding the correlation between risk and returns, by using a tool, in this case the financial asset pricing models is vital. Any pricing errors would affect the valuation models, jeopardize value judgments and therefore give rise to incorrect risk assessment. The challenges faced by the asset pricing models are on the rise due to the intermingling of economies due to globalization. Along with the increase in challenges the number of critics also increases. These pressures and requirements in turn give rise to new models of financial asset pricing. However the scope of this essay is limited to the empirical challenges faced by financial asset pricing models. To make a base for this study I start with comparing and contrasting different financial disasters that made headlines in the past with the more recent ones. In the past all the noted failures were either due to lack of analytical capacity, absence of systems, error in using models or failure to appreciate risks. The inadequate appreciation of yield curves resulted in S&L bailout. Askin Capital management fiasco was as a result of inadequate analytics and Kidder Peaboy tragedy occurred due to the imperfect management risks. In contrast to this is the more recent failures where even the financial entities known for their efficiencies were dragged to take knee jerk reactions to address huge market dislocations like Russia's default and a collapse in liquidity. The problem solving capacity of an investor has increased manifold through the years. Powerful machines today help investors solve problems, which were considered beyond scope, just a few years ago. The right kind of codes put together (software) by a programmer can have a path breaking consequence on the computational capability of an investor. Side by side with this technological breakthrough, there is also a reduction in cost of computation and emergence of better financial theories. Today's investors are much more aware of the market conditions and have a greater capacity to analyze and take logical decisions about investments due to the availability of different computation methods and real time accessibility to information. But paradoxically usage of these refined method for investment have made the markets more risk prone due to the intermingling of the market in a globalized economy. A direct consequence of this is the rise of common risks. Traditionally investors used to div ersify their portfolio in an attempt to beat an existing market risk and they were successful in this due to the difference in risk associated with different securities. But now with the increase in awareness about the different tools with which they can make decisions there is a commonality of reaction to a crisis resulting in potential catastrophes. At the time of a crisis the investors try and reduce risk by selling their illiquid positions. But since by now the demand for it would go down due o the similar stance all over by the investors, they try to sell their liquid positions no matter which market they are in. Due to this massive movement the market gets