Momentum and Bubbles: Application to the Cypriot Stock Exchange

Added on -2020-02-14

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Momentum and Bubbles:
Application to the Cypriot Stock
Exchange
TABLE OF CONTENTS
CHAPTER-1....................................................................................................................................1
Theoretical concepts used in practical application......................................................................1
REFERENCES................................................................................................................................4
CHAPTER-1
Theoretical concepts used in practical application
Momentum theory is the significant concept that is used by different investors. Whether,
it is retail or giant investor firm, this theory is employed by each sort of investor in order to make
profit in the business. This theory believes that in a market, there are two kinds of trends that are
normally observed. These two trends are upward and downward movement in shares price.
Upward movement in share price means that specific company’s share value is increasing
consistently. Contrary to this, downward movement of market crash means price of specific
company is declining consistently (Fama and French, 2012). This theory holds that when market
is bullish then investors must take long position on shares and must capitalise opportunities that
originate in the market due to consistent upward movement in stock market. As per this theory,
investors who hold their positions in the market for long time period when market is moving
towards its peak point earn huge amount of profit on investment. Even in a situation when stock
price decline too much, devaluation in value of shares price is not observed. This is because;
investors have strong confidence on the fact that in future also index will rose by good
percentage or points. This means that when market is bullish, investors hold long position, get
huge benefit and share price declines, at that time investor’s loss is minimised. This theory is
applied on the companies that are listed in the Cyprus stock exchange and application of this
theory is tested by taking a data related to years when market was too volatile and market rose
and falls by high percentage in specific duration. In this regard, some of the statistical and
financial tools are used and calculations are performed. Performance of shares in boom and
market crash period will be compared with each other to measure practical application of
momentum theory. Tools or concepts that will be employed in the research are explained below. Coefficient of intercept of regression- This is one of the important statistical tool that is
often used by the researchers. Under this method, one identifies the extent to which two
or more predator variables bring change in dependent variable (Vayanos and Woolley,
2013). This tool will help in understanding the extent to which changes comes in shares
price with change in index value in bullish and bearish performance of stock market.
Thus, this tool reflects whether with big percentage change in index value, type of change
comes in shares price as well. This tool will also help in testing that when market is
consistently moving upward then, share price also rise sharply.
3
CAPM- Capital Asset Pricing Model (CAPM) is well known model used by the stock
market experts. This model states that the minimum return that investor must earn for the
risk he takes in his business. This return is computed after deducting risk free rate from
the market return. By comparing current return with the CAPM value, it is measured
whether stock gives appropriate amount of return to the investors or not. In this model,
beta value is taken into consideration which reflects the percentage change that may
happen in the share price with change in index value. Risk free rate of return is also taken
into account in this model (Wu, 2011). Risk free rate refers to the return that is given by
the Treasury bill. It is assumed that shares in which investor makes an investment will at
least earn return equivalent to one that is given by Treasury bill. By comparing CAPM
value with actual stock return for 1999-2002 and 2004-2004, it will be measured whether
investors that have long position in the stock market are earning good profit when market
is strongly moving upward or not. Sharpe ratio- This is very important ratio because it indicates return that investors are
earning for each unit of risk that they take on investment. In this ratio, first of all risk free
rate of return is deducted from the market return and then divided by the standard
deviation. This ratio measures the return that investor is receiving for each unit of risk he
takes in investment. In order to measure application of this concept for momentum
theory, Sharpe ratio of specific company share for boom and market decline time period
will be compared (Edmans, 2011). If value of Sharpe ratio will be higher in boom then,
market crash period will be assumed that momentum theory is working in real world.
Risk premium- This is one of important concepts that will be used in CAPM or capital
asset pricing model. Risk premium refers to the excess return that investor is earning on
investment made in the specific company shares. For this, risk free rate of return is
deducted from the market return. The difference between both types of return is risk
premium and it is the actual amount that investor earn for risk he takes on investment in
shares. If risk premium is increasing in market boom period then, it can be said that with
increase in index value share price also rose by good percentage. Similarly, if market
slips by high percentage and risk premium decline then, it means that with the decline in
index value, share price is also falling continuously.
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