William Bruce

Date of Award

Spring 2021

Degree Name

Bachelor of Science (BS)

Advisor(s)

James McCann

Abstract

This paper investigates the capabilities of producing a Capital Asset Pricing Model (CAPM) that incorporates pandemic risk and evaluating this model at different stages of the pandemic. However, there is no current investor base for pandemic resilient investing, making the additional weighted component of industries’ pandemic resilience ill-plausible. By building the traditional CAPM and evaluating mean-variance efficient frontiers for 10 assets of varying pandemic resilience, 5 assets of low resilience, and 5 assets of high resilience, I establish that, in the absence of a pandemic resilient CAPM, the most optimal portfolios require diversification across as many assets as possible, regardless of pandemic resilience. The emergence of COVID-19 and its aftermath came as a shock to investment markets, but there is ample research that suggests that the market should have been prepared for the possibility of pandemics such as this one. In the wake of the Ebola outbreak in recent years, world leaders such as Bill Gates and Barack Obama have been vocal about the need to take the threats of future pandemics seriously (Lee). Despite United States observance of outbreaks in other countries such as the 2003 SARS outbreak and the Ebola virus, our society has viewed these outbreaks as one-off encounters and not prepared for the likelihood of future pandemics. “Ru et al. (2020) find that stock markets in countries with 2003 SARS experience reacted more quickly to the outbreak than countries without prior experience” (Pagano, Wagner and Zechner), but US investors during the emergence of COVID-19 took little action to prepare their portfolios for the spread of adverse effects of the virus to infect US markets. In the US stock market, “There were more than 1,100 daily stock market moves (up or down) greater than 2.5 percent from 1900 to 2019. Next-day newspaper accounts attribute not a single one of these jumps to infectious disease outbreaks or pandemic related developments. From 24 February to 20 April 2020, newspapers attribute two dozen such jumps to coronavirus-related developments.” (Baker, Bloom and Davis). The United States stock market has never been so greatly impacted by viral outbreaks, and, consequentially, investors were unprepared for the diminished value of their portfolios as the result of the COVID-19 pandemic. While the pandemic has taken an immense downturn as the US market as a whole, it has affected different industries to a varying degree, particularly according to how greatly the industry has been impacted by adopted social distancing laws. This hence implies that industries will have varying risk to one another in terms of impact exposure to pandemics and are a key component towards constructing a portfolio that shields investors from unacceptable pandemic risk exposure. Utilized for decades, CAPM takes a set number of assets and weights them such as that the portfolio’s return is optimized for any given risk level of the portfolio. In plotting a line of the portfolio returns for every risk level, we define the mean variance efficient frontier (MVEF), which outlines the limits of investment returns. “An underpinning of CAPM is the observation that risky stocks can be combined so that the combination (the portfolio) is less risky than any of its components” (Mullins). Therefore, in utilizing CAPM, investors have been able to optimize their portfolios and mitigate the risk of their investments by using historical data and expected future risk/return values. However, CAPM is laden with assumptions, and deviating from these assumptions or bringing in new factors can quickly cause the model to go astray. In particular, there are two key assumptions: “(1) securities markets are very competitive and efficient (that is, relevant information about the companies is quickly and universally distributed and absorbed); (2) these markets are dominated by rational, risk-averse investors, who seek to maximize satisfaction from returns on their investments” (Mullins). While there are these two main assumptions, they are wildly oversimplified and do not fully encapsulate the factors at play in our markets and society. This second point presumes that all investors are looking to maximize their profits through all existing investment options, but there are many investors that stray away from maximizing their profits for personal beliefs. For example, CAPM utilizes the practices of short-selling assets when necessary, but principles of Islamic Finance prohibit the practice of selling something that the investor does not have and therefore must refrain from certain investments, along with other inhibitions of CAPM. Therefore, this assumption of CAPM causes the model to be implausible in Islamic markets, and the model must be adapted in order to make it functional for Islamic investors, as done by Mohamad Hazny, Haslifah Hasim, and Aida Yusof. (Hazny, Hasim and Yusof). Similarly, sustainability conscious investors have begun to take to care to make sure that they are investing in more sustainable assets and weight them appropriately as done by Olivier Zerbib; consequentially, this changes this assumption of CAPM once again as the model needs to account for the investor’s restrictions towards certain assets (Zerbib). In invalidating this second assumption, investors are willing to accept a smaller return for equivalent risk levels, causing their portfolio to fall under the MVEF as opposed to on its line. Since traditional CAPM solely produces optimized portfolios on the MVEF, new factors must be incorporated into the derivation of this model in order to account for the personal taste of investors.

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