Question

You notice that a manufacturer of ramen noodles has increased sales during recessions, as people substitute away from fancier food toward cheaper noodles. Make a prediction about this stock's expected return with reference to the models of asset pricing discussed in class.

Answer 1

This stock’s expected return will increase in future.

Using the CAPM (capital asset pricing model) we know that:

Expected return = risk free rate + (beta*(return on the market – risk free rate))

Now we will modify the CAPM model and here we will now use a consumption capital asset pricing model i.e. CCAPM. As per this model:

Expected return = risk free rate + (consumption beta*(return on the market – risk free rate))

In the above model consumption beta is the coefficient of the regression of an asset's returns and consumption growth. This is different from CAPM’s beta which is the coefficient of the regression of an asset's returns on the market portfolio returns.

When consumption of ramen noodles increases then its consumption beta will increase and this will lead to an increase in its expected return as well.