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SUMMARY: Fear is a defense mechanism. It bursts forth in our brains the instant we sense that we, or others near us, are threatened. When fear leaps from one person to another, it turns into panic. Viewed this way, today's financial markets -- in which tens of millions of investors watch each other's fears unfolding in real time on television and online -- constitute one giant panic-transmission machine.

Article:

Panic.
Panic is a wild, irresistible fear that spreads through crowds like an epidemic -- and it may be upon us now, with day after day of multi-hundred-point swings in the Dow.

The word itself seems almost primeval; it derives from Pan, the goat-headed god of shepherds and flocks in Greek mythology, who was believed to startle people with outbursts of mysterious music in frightening places such as steep mountainsides or dark caves.

Fear is a defense mechanism. It bursts forth in our brains the instant we sense that we, or others near us, are threatened. When fear leaps from one person to another, it turns into panic.

You can catch other people's emotions as easily as you can catch a cold. In an experiment by neuroscientist Elizabeth Phelps at New York University, people either watched someone else get a mildly painful electric shock or suffered the shock themselves. Their brain responses and their dread before the shock were highly similar in both cases, suggesting that seeing another person's fear is all it takes to make us afraid. Even encountering the circumstances under which the other person was shocked is enough to trigger your own fear.

Viewed this way, today's financial markets -- in which tens of millions of investors watch each other's fears unfolding in real time on television and online -- constitute one giant panic-transmission machine.

Research at the University of Toronto shows that in a panic, your eyes widen, your eyelids rise and your eyebrows shoot up, making you hypersensitive to any threat that might come from above.

As you look up at a wall-mounted TV screen, wide-eyed to catch the latest news, you mimic the physical posture of fear. That action may, in itself, make your brain more sensitive to negative tidbits of news -- and more anxious to act on them.
Meanwhile, the sight of someone tensing up in fright not only triggers the fear center in your brain but also prepares your muscles to strike the same pose. Thus, like soldiers or policemen on patrol in a danger zone, investors are now abnormally "trigger-happy," because panic has tensed their muscles for instant defensive action.

Fear also changes the way you think, reducing your ability to solve problems creatively, making you reluctant to consider a wider set of choices and causing you to distrust others. That means you are now unusually prone to acting on a gut feeling, instead of thinking.

With panic pervading the markets, every company's assets may seem worth less now. (Even professional accountants, when temporarily frightened, will value a business's inventory at a 10% discount.) And you may be inclined to shun anything unfamiliar, like international or emerging-markets stocks. Yet the underlying value of most businesses does not hang on what happens in the stock market, and many stocks overseas have become even bigger bargains than U.S. shares.

You cannot brush panic away with willpower alone, but you can quarantine yourself from contagious settings:
Break the circle. Instead of socializing with other investors nursing their losses, hang out with folks who do not obsess over the market. You are less likely to be spooked by dilated pupils, grim faces and quavering voices.

Turn off the tube. The sight and sound of screaming traders with fear in their eyes are enough to fill you with fright, whether you are conscious of it or not. If hitting the mute button won't suffice to calm you down, turn off the TV.

Think positive. When Warren Buffett feels his blood pressure rising or his nerves on edge, he calms himself down by gazing at snapshots of his family or playing a game of bridge with his friends.

Stick to it. Set yourself the simple, stark goal of investing more money in something you don't want to own. You may need help fighting your fears, so visit www.stickk.com and make a public commitment to your future action. Buying a stock fund next week is mentally easier than buying it today -- especially if you recruit some friends to cheer you on.

QUESTIONS:

1. How is the market risk premium related to risk aversion and to the level of risk in the market?

2. How are changes in the market risk premium related to changes in the price of the market portfolio?

3. How does a drop in market prices, due to panic, differ from a drop in the market, due to an increase in risk aversion or an increase in the expected volatility of the market?

4. Do you think the drop in the market over the past year stems from an increase in risk, an increase in risk aversion, panic, or some combination of all three? Justify your answer.

5. How should your investment strategy depend on your answer to question 4?

Solution Preview

1. How is the market risk premium related to risk aversion and to the level of risk in the market?
Answer:
The market risk premium indicates that the investor requires reward for the risk they are going to take in the market. A risk adverse person will always choose less risky investment and would always ask for an extra return for any type of risk it takes. As most of the investors are risk-averse, the market offers the risk-averse investors a premium over the risk free rate to attract them for investing in that particular stock.

2. How are changes in the market risk premium related to changes in the price of the market portfolio?
Answer:
As we know that a risk adverse person always choose less risky investment and always ask for an extra return for any type of risk it takes. This activity forces ...

Solution Summary

The solution discusses fear and panic in market risk premium, risk aversion, pricing, and investment strategy.

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