APT- Arbitrage Pricing Theory and CAPM-Capital Asset Pricing Model - Research Paper Example

APT- Arbitrage Pricing Theory and CAPM-Capital Asset Pricing Model PART I APT- Arbitrage Pricing Theory and CAPM-Capital Asset Pricing Model alike are methods applied in the assessment of any given investment’s expected returns and risks going in tandem. In both, formulas are used in the determination of the required rate of return for a given investment in order it be considered worthwhile. In the action of comparing investments’ returns and risks, if CAPM or APT is well utilized, they will reflect on whether one ought to invest in a given firm or another. The formulas to these two methods are given under; CAPM Re= Rf + β*(Rm – Rf) Where; Re = Required return rate Rf =Risk-free return rate β = Beta, which is the market risk factor premium Rm = Expected overall market return rate (valuebasedmanagement.net, 2011) APT Re = Rf + (Individual risk factor premium*Relationship between the factor and price) + (Individual risk factor premium*Relationship between the factor and price) Generally, these two methods are different in that one (CAPM) uses beta- which is the risk factor of a given stock in relation to that of the market. Therefore, if beta equals 1 this stock is equally risky with the market, if it is 2 the same stock is twice risky in comparison to the market. While on the other hand, APT utilizes individual factors in place of beta. Also APT does not apply the market return rate and thus considered to be more particular to a given stock in focus. CAPM’s data is objective while APT applies data from a single stock. Thus, CAPM is recommendable to an investor who is relatively dormant as compared to APT, which if correctly applied is better placed to assess projects. (Grover, 2010) Some authors have applied APT and compared the resultant estimates with those of CAPM. Patterson notes one of the cases where such has been done is the electric utility’s, written by Ross and Roll in their 1983 book. According to Patterson the end results of APT were credible in comparison to those of CAPM. But, this was without enough justification of the results. (Patterson, 1995 p151) Besides the first two, there are methods of assessment like the Dividend Growth Model and Modern Portfolio Theory. The Dividend Growth Model shows the value of ordinary shares in present value of the prospected future flows of cash which has been invested by an investor. The receivable cash inflows are taken as dividends as well as the expected price in future while the stock will be disposed. An ordinary share usually does not possess maturity and thus, it is held for numerous years. Therefore, a general ordinary shares’ valuation introduced by Gordon would be as below; P0 = ∑t= 1…α Dt/ (1+r)t Where; Dt = dividend in duration t P0 = current stock price in the market r = constant yearly rate of growth of dividends t = number of given durations of periods (Siegel, et al 1997 p140) Just to mention, the other model investment assessment is known as MPT- Modern Portfolio Theory. This is a theory applied by investors who are risk averse and at the same time they want to achieve maximum or optimum level of expected return which is based on the market risk level. It emphasizes that risk is inherent in the process of getting the rewards associated with it. MPT is sometimes called the ‘Portfolio Management Theory’. As per the argument of this model, it is a possibility to come up with an efficient frontier that depicts optimal levels of a portfolio giving the maximum rate of expected return at the given risk levels. (investopedia.com, 2011) The study is set out to explain that the most recommendable model in the assessment of investment projects is CAPM. First things first, though, since lack of consideration of the assumptions would not lead to a comprehensive outcome of the study. The model of CAPM has the assumptions mentioned below forming its basis; Persons seek to achieve maximum utility of their investment portfolio over a given duration of planning horizon, Persons involved are risk averse, Persons have expectations which are homogenous in nature. That is, they have similar variances, co-variances and subjective estimates, Persons are able to lend or borrow freely at the risk free interest rates, The market in consideration is perfect; without transaction costs, taxes, it is competitive and that stocks are perfectly divisible, and The quantity of the stocks that are risky is provided. (Chandra, 2008 p247) The origin of the CAPM model can be traced back in the 1950s and its originator was Harry Markowitz. Markowitz came up with this theory while working upon his PhD, in which he sought to come up with a tool for investors to compute weights and eventually reach an investment with a maximum return and that minimizes on the risk at the same time. (Montier, 2010 p4) In CAPM the risk free interest rate estimates are lifted from the rates of government bonds in the short-run and this can be obtained from a proper newspaper. The expected interest rate for a given market is also not ascertainable in a direct manner since a market is expected to be unpredictable, but the prevailing return rate in the market can be gotten through the yields and prices in the current times. The relationship that is existing between the stock and the entire market is that covariance obtained between the two over the market portfolio variance. The movements of the stock and the market’s are used to derive the covariance. (Puxty, Dodds and Wilson, 1998 p115) CAPM is not without merits. For instance, there are the following merits; this model is industry standard particularly for the estimation of the set benchmarks for returns in industries that are regulated, it is based upon standard and reasonable axioms of behavior, and it is an easy model to interpret and apply. (caa.co.uk, 2001) The demerits associated with CAPM include the unanswered empirical validity, the restrictive assumptions, and also the assumptions that are rather subjective in order to be able to use this model. (Catty, 2010) In years running from 1980s through 2000, CAPM was the major model applied by individuals in investments’ assessment. It was more so applicable since, as Carlson puts it, it is the most befitting in a bullish market. Purchasing as well as holding portfolio stocks of a particular market’s indexes is impactful in that it maximizes the returns in a bull market that has been extended over time. CAPM is expected to perform dismally in trying to assess stocks in a bearish market. This is as seen in the S&P 500 stocks behavior. (Carlson, 2007 p61) Having gotten a grasp of what CAPM is and the merits and demerits associated with it, it is therefore a recommendation to the investors that it be applied while assessing the investments. It is very much appreciated since it puts into consideration that this is a market place that has in it many other stocks which may impact on a particular stock’s return due to the risk involved. It is also the most objective in application in comparison to APT and MPT. PART II Using the information given; FedEx Re = 1% + 1.26%*(4.50% - 1%) Re = (1% + 4.41%) Re = 5.41% McDonalds Re = 1% + 0.43%*(4.25% - 1%) Re = (1% + 1.3975%) Re = 2.40% Looking at the two investments and after applying CAPM to determine their expected rate of return, then FedEx is the appropriate to take. This is since it has the highest expected rate of return at 5.41% compared to McDonald’s 2.40% which is relatively low. References: caa.co.uk. (2001). Economic regulation and cost of capital. Retrieved 19 May 2011 http://www.caa.co.uk/docs/5/ergdocs/annexcc.pdf Carlson, Robert C. (2007). Invest Like a Fox... Not Like a Hedgehog: How You Can Earn Higher Returns With Less Risk. Edition Illustrated. John Wiley and Sons. p61. Chandra. (2008). Investment Analysis 3/E. Tata McGraw-Hill Education. p247. Grover, Sam. (2010). How to Compare CAPM & APT. Retrieved 19 May 2011 http://www.ehow.com/how_7508497_compare-capm-apt.html investopedia.com. (2011). Modern Portfolio Theory – MPT. Retrieved 19 May 2011 http://www.investopedia.com/terms/m/modernportfoliotheory.asp Joel G. Siegel, et al. (1997). Schaum's quick guide to business formulas: 201 decision- making tools for business, finance, and accounting students. Edition Illustrated. McGraw-Hill Professional. p140. Montier, James. (2010). Value Investing: Tools and Techniques for Intelligent Investment. John Wiley and Sons. p4. Patterson, Cleveland S. (1995). The cost of capital: theory and estimation. Edition illustrated. Greenwood Publishing Group. p151. Puxty, Anthony G., Dodds, J. Colin and Wilson Richard M. S. (1988). Financial management: method and meaning. Taylor & Francis. p115. valuebasedmanagement.net. (2011). Capital Asset Pricing Model (CAPM). Retrieved 19 May 2011 http://www.valuebasedmanagement.net/methods_capm.html Read More