Relative Merits of the Capital Asset Pricing Model - Case Study Example

Table of Contents 1.Introduction 2 2.CAPM Model and its Relative Merits 3 2.1.The Assumptions of CAPM Model 4 2.2.Fama and French Model and CAPM Model 6 3.Securities Market of Europe, Greek and Pakistan, the Application of CAPM Model 7 3.1.European Security Market 7 3.2.Greek Security Market 8 3.3.Pakistani Security Market 9 4.Conclusion 9 5.Reference 11 1. Introduction With development and expansion of business and trade, the business related activities have increased significantly that strives to support the financial activity of business. The money market, banking sector, capital market, insurance sectors etc are very essential for the growth of business. Nearly three decades ago, the business used to be limited within the local and regional boundaries. However, at present, it has expanded in the overseas market. The primary necessity of trade and business is the proper availability of necessary funds that is very important in running the operational activities. ‘Finance’ can be termed as the ‘Life Blood’ of business as it provides life to the business by collecting necessary fund. The different types of market like money market, capital market and banking sectors etc provide necessary fund to business. In order to raise sufficient amount of money, the publicly listed companies issue shares through capital market, and institutional or individual investors buys these shares from the issuing firms. In theses respect, these investors are very important for capital market. The primary aim of business organisation is to increase the shareholders’ wealth by increasing the profitability of firms. The investors are also very concern regarding the company’s performance in which they invest their valuable money. They keep analysing the market using various financial tools and methods. Many scholars have developed their models that help to predict the share price, and according to prediction, the investors invest in different profit making companies. The main objective of these financial tools and models is to avoid the risk of investors. The Capital Asset Pricing (CAPM) Model, Arbitrage Pricing Theory (APT) model, dividend growth models etc are various financial models that help to determine the risk and return of a particular stock. This paper will attempt to critically analyse the relative merits of the capital asset pricing model (CAPM). The CAPM model is the most popular and widely used financial model for calculating the risk and return. In order to critically analyse the CAPM model, some empirical test on securities markets of Europe, Greek and Pakistan will be analysed. The last section will conclude the entire discussion pointing out the important findings of this paper. 2. CAPM Model and its Relative Merits The Capital Asset Pricing Model (CAPM) was developed by John Lintner (1965) and William Sharpe (1964) and it is the first asset pricing theory that determines the risk and return based of the market movement. William Sharpe and John Lintner won Nobel Prize for this important contribution in 1990. After the fifty years of CAPM model, it has been still one of the most important models for calculating firm’s cost of capital and for evaluating the performance of portfolio. The main advantage of CAPM model is that it is able to provide powerful and effective prediction regarding the risk measurement. It is the first model that develops and clarifies the relationship between the risk and return of a stock or of a managed portfolio. 2.1. The Assumptions of CAPM Model However, William Sharpe and John Lintner also stated some important assumptions related to the behaviour of market and investors which are mandatory for supporting the validity and reliability of the CAPM model. These important assumptions are given below. The first assumption states that the capital market is primarily composed of the investors who want to averse the risk by maximising the return simultaneously. Such investors make their investing decisions on the basis of calculated risk and return. In this process, they calculate the mean, variance, standard deviation, coefficient and probability etc. All the investors maintain and manage their portfolio and they have certain expectation regarding the risk and return in future. All these investors have some kind of expectations or specifically, their expectations are ‘homogenous’. The third assumption focuses on the behaviour and nature of the capital market. William Sharpe and John Linton stated that the capital market is perfect. It means that all the assets are infinitely and equally divisible. The capital market is free of any kind of tax or transaction cost. According to the last assumption, the participant investors in the capital market can easily borrow and lend money at risk free rate of return. This is very important assumption for explaining the CAPM model. This assumption is based on the portfolio theory which is the main base of CAPM model. This assumption offers the lowest level of return that is required by all the investors. The following figure shows the risk free rate of return. Figure 1: The Security Market Line (Source: ACCA, 2008) The above figure shows the security market line (SML) and Rf is the risk free rate of return which lies at the conjoint of return and SML. After considering the above assumptions, the CAPM model has been shown below. ‘E(Rk) = Rf + βk (E(Rm) - Rf)’ Here, E(Rk) is the expected return on security k; Rf is the risk free rate of return and E(Rm) is expected return on market. In order to calculate the expected return o9f security k, the necessary calculating method has given below. ‘(E(Pk) + E(Dk) – Pok)/ Pok’ Here, (E(Pk) is the expected price of the security k; E(Dk) is the dividend paid on the security k and Pok is the present price of the security k. βk is the beta or volatility of the security k. This is known as the systematic risk on the security k which is non-diversifiable. The calculation method of βk has been given below (Modigliani, Pogue and Solnik, 1973). ‘(Covariance of return on security k and the return on market)/ (variance of return on market)’ The volatility or beta is calculated based on the historical performance of any security and market. The historical performance helps to indentify the typical trend of a particular security or market and it is expected that in future, the particular stock follow that trend. 2.2. Fama and French Model and CAPM Model Fama and French Model of portfolio management are developed by Eugene Fama and Kenneth French and it is very useful in describing the behaviour of the capital market. It is also known as the ‘three Factor Model of Fama and French’. Basically, this model is helpful in expanding the use of capital asset pricing model (CAPM). The three factor model of Fama and French strives to add some important factors of risk in the CAPM model. In the earlier section, it has been described that the CAPM model considers only one factor i.e. the market risk. However, Eugene Fama and Kenneth French identified other factors that outperform the capital market. William Sharpe and John Lintner failed to recognise these factors. However, their CAPM model is the prime basis of the three factor model of Fama and French. “Fama and French (1992) argue size and the book-to-market equity ratio capture the cross-sectional variation in average stock returns associated with size, the earning-price ratio, the book-to-market equity ratio and leverage” (Lam, 2005, p.8). According to them, the book-to-market equity ratio is very important but without the size, it is impossible to explain the average return of market or any security. Hence, they included these two factors in CAPM model that is better in explaining the associated risk and return. The following model is the three factor model of Fama and French. Equation 1: Fama and French Three Factor Model (Source: Lam, 2005, p.8) As per the above equation, in CAPM model the two additional factors SML and HML have been included. The SML is the ‘small minus low’ that is the difference between return of the small cap and large cap stock. HML is the ‘high minus low’ that represents the difference between book-to-market ratio of highest return and lowest return. These two additional factors has added value to the relative measures of CAPM model. 3. Securities Market of Europe, Greek and Pakistan, the Application of CAPM Model 3.1. European Security Market In order to test the validity and reliability of the Capital Asset Pricing Model (CAPM), empirical test of CAPM model on various security markets is the most appropriate method. Franco Modigliani, Gerald A. Pogue and Bruno H. Solnik tested the effectiveness of the CAPM model on European capital market. The Europe is considered to the most developed continent in this world and the financial conditions of European countries like UK, Germany, France, Italy etc are quite developed due to rapid growth of trade, business and financial markets. Franco Modigliani, Gerald A. Pogue and Bruno H. Solnik used eight major capital markets of European countries like Italy, UK, Germany and France to test the validity of CAPM model. They chose different number of stock from different countries and collected the historical performance of stocks and market for six years (from 1967 to 1971). They conducted statistical research using these data and reached to the final conclusion. They found that the systematic risk is one of the most important factors for calculating the pricing of European securities. Except German security market, the CAMP successfully determined the relationship between the calculated risk and return. The empirical test of CAPM on European market indicated that European market is rational and efficient (Modigliani, Pogue and Solnik, 1973). 3.2. Greek Security Market The Greek capital market has emerged during the last decade. Grigoris Michailidis, Stavros Tsopoglou, Demetrios Papanastasiou and Eleni Mariola conducted a testing of CAPM model on the emerging Greek security market. Their primary aim was to identify the importance of CAPM model in Greek security market as well as to check the validity of this model. They selected 100 companies from the Athens Stock Exchange of Greece and collected weekly return of those 100 companies stocks for five years i.e. from 1998 to 2002. Before conducting the research with the gathered data, they have realized the major challenges of CAPM theory. They calculated the beta of each company and determined the yearly security market line. They finally reached to the findings that did not support their hypothesis. They found that in Greek security market, the higher return is not associated with the higher risk. This finding rejects the primary theory of CAMP model. According to them, the CAPM model failed to identify and to explain the excess return on stock or market. The overall finding of this study confirmed that the result of using the CAPM model on Greek security market contradicts the relationship of risk and return i.e. ‘high risk and high return’ (Michailidis, et al, 2006). 3.3. Pakistani Security Market Attiya Y. Javid has tested the validity and reliability of the CAPM model on Pakistani Equity Market. In this process, Javid chose the Karachi Stock Exchange and gathered historical data relating to stock return and market movement for eleven years (form 1993 to 2003). In order to verify the relationship between the risk and return, the CAPM model was extended from mean to kurtosis model. The Pakistani security market is emerging market and it includes all the features of an emerging security market like unusual relationship of risk and return, autocorrelated returns, abnormal returns and highly volatile stock prices. The CAPM model proved as inadequate and insufficient for the Pakistani security market. Like Greek security market, the CAPM failed to explain the theory of high risk and high return. One of the main reasons for the failure of this theory is that the primary assumptions of CAPM model did not match with Pakistani security market. The behaviors of the Pakistani investors are not rational and the market is not efficient (Javid, 2009). 4. Conclusion The above analysis and discussion has focused on the findings regarding the CAPM model of William and Lintner. This paper has dealt with four main sections. The first section has described about the CAPM model and its importance for security market. The investors are the main users of this model as it helps them in determining the expected risk and return. The second section has talked about its assumption and the equilibrium model of CAPM. The assumptions are very essential in explaining the validity of CAPM model. The third section has discussed about the relative advantage of CAPM model in context of Fama and French three factor model. This three factor model adds certain factors in CAPM that influence the movement of market. The last section has dealt with the analysis of empirical tests of CAPM model on European, Greek and Pakistani security market. The last section has portrayed very crucial findings regarding the validity of CAPM. The CAPM model is valid for the security market which satisfies the assumptions of CAPM. Due to emerging security market of Greece and Pakistan, the CAPM Model fails to prove the relationship of risk and return. However, the European security market is developed and matured and hence, the CAPM model is applicable for such market. 5. Reference ACCA. June/July 2008. CAPM: Theory, Advantages, and Disadvantages. [Pdf]. Available at: http://www.accaglobal.com/pubs/students/publications/student_accountant/archive/sa_jj08_head.pdf. [Accessed on November 11, 2010]. Javid, A. Y. 2009. Test of Higher Moment Capital Asset Pricing Model in Case of Pakistani Equity Market. European Journal of Economics, Finance and Administrative Sciences. Lam, K. 2005. Is Fama and French Three Factor Model Better Than the CAPM?. [Pdf]. Available at: http://ir.lib.sfu.ca/retrieve/2131/etd1764.pdf. [Accessed on November 11, 2010]. Michailidis, G., Tsopoglou, S., Papanastasiou, D. and Mariola, E. 2006. Testing the Capital Asset Pricing Model (CAPM): The Case of the Emerging Greek Securities Market. International Research Journal of Finance and Economics. Modigliani, F., Pogue, G. A. and Solnik, B. H. July 1973. A Test of the Capital Asset Pricing Model on European Stock Markets. [Pdf]. Available at: http://dspace.mit.edu/bitstream/handle/1721.1/1871/SWP-0667-14514026.pdf?sequence=1. [Accessed on November 11, 2010]. Read More