The Capital Asset Pricing Model - Essay Example

?The CAPM: The Capital Asset Pricing Model (CAPM) focuses on the relationship between the required rate of return and risk of an asset when it is held in diversified portfolio. The CAPM measures the risk of a stock as beta; which stands for a stock’s contribution to the risk of a portfolio. Thus, it is the relevant measure of risk. As risk increases so does the required rate of return and market risk premium is the difference between the required rate of return on a portfolio minus the risk free rate multiplied by the beta of that stock. RPs = (km –krf) bs The basic assumptions of CAPM are that investors choose among portfolios to maximize their return and wealth. The CAPM focuses on a single holding period and assumes the investors can borrow or lend at the risk free rate. There are no limits on short sales and all investors have homogenous estimates of return, risk, and variances. There are no taxes and transaction costs and all assets are highly liquid and marketable. The quantities of the assets are fixed and there is perfect market meaning investors cannot influence price and are price takers. The CAPM is based on the Capital Market line and the Security Market Line. The CML implies that all investors under the CAPM assumption must hold a combination of risk free securities and a market portfolio. If the market is in equilibrium the market portfolio will consist of every security in the same proportion as it is in the market. The CML specifies the relationship between an efficient market portfolio’s risk and return. CAPM focuses on individual securities as well and the SML defines the relationship between the risk and return of individual securities which can be figured out by using the risk premium formula RPm = (km –krf) bm The required return on a specific stock according to CAPM would be the sum of the risk free rate and the product of the risk premium into beta. ki = krf + (RPi)bi Expected rate of return required rate of return CML SML kep ? efficient portfolio Risk ? risk(beta) The SML signifies that the only relevant risk of an individual security is beta, the addition to the risk of the portfolio, because other risk is diversified. SML is an important part of the CAPM as it is used to calculate the cost of capital of separate projects and investments. Beta is the relevant risk of an asset and is calculated as the gradient of the characteristic line which is the plotting of historical returns of an individual stock. Beta measures the volatility of returns compared to the volatility in the market. It is the measure of risk used in the SML whereas standard deviation is used as the market risk measure in CML. Although, CAPM has been used in security valuations its assumptions do not reflect a real market setting. As most investors in the real world do not hold fully diversified efficient portfolios, the beta would not be a sufficient measure of risk and SML would not be applicable for the required rates of return. As there are taxes and transaction costs in reality and assets have different degrees of liquidity this assumption does not hold true either. All investors do not have same forecasts of expected risk and return and they usually borrow according to their credit standing which is higher than the risk free rate. There is a disparity in borrowing and lending rates which will distort the CML and thus the SML line. In many markets, large investors can influence price through buying and selling securities. Examples: Example 1: Krf= 6% Km=5% Beta for Kellogs foods is 1.2 Then the cost of equity would be = 6 + ( 6-5 ) 1.2 = 7.2 Example 2: The CAPM can be used to calculate the cost of common stock through the insertion of the risk free rate, expected market risk premium and the beta coefficient into the SML equation. For example: Krf= 8% Km=12% Beta for Kellogs foods is 1.2 Then the cost of equity would be = 8 + ( 12-8 ) 1.2 = 8 + 4.8 = 12.8 % The required return on Kellog’s stock would be 12.8%, 0.8% greater than the market return as its beta is greater than 1. However, due to CAPM’s limitations beta might be higher than 1.2 and thus 12.8% might not be a valid return for Kellog’s stock. Another factor is Kellog’s stock holders which might be individuals without market portfolios and thus may bear stand alone risk as well and require a greater return. In the same case, the market premium which is calculated to be 4% in this case, may be much more due to transaction costs, borrowing costs and taxes which are not involved in the CAPM model. When it comes to efficient portfolios and CAPM, the CML line may not be valid due to borrowing and lending at greater than the risk free rates and it s highly unlikely that investors will have efficient portfolios with the exact proportion of a security as there is in the market. The CAPM is a forward looking model and calculated expected return and risk in the future holding period. The CAPM does not take into account company specific risk and is based on historical data to calculate beta and risk premium. It also does not apply to all financial assets such as bonds and thus in not a realistic measure. It is a theory based on simplified assumptions with conceptual importance. However, it application in a real market scenario is flawed. When used in practice, it provides answers that may not represent the true picture as it uses historical data to predict future risk and returns. CAPM’s factors are difficult to estimate and the model cannot be proven. The results from CAPM may predict correct relationships but are not accurate in their results. As a theoretical tool, it is useful in explaining risk and return and behavior of investors and market but it has many limitations when applied to practice. The Main Advantages of CAPM: Capital Asset Pricing Model has its own set of advantages too. The biggest advantage of CAPM is the fact, that it is an approach which revolves around industry standards. It is primarily to set the most apt and accurate benchmarks for most industries. . It is easily understandable, implementable and interpretable. The estimations of beta are very accurate in the CAPM model. Most of the beta estimates for regulated industries are not too far from one. Thus, when implemented, it resembles the use of market return as an appropriate equity benchmark. The axioms followed by this model are reasonable and standard behavioral. (Muneesh, 2000) Dis-advantages of CAPM: On the major drawbacks of the CAPM approach is the fact that its foundation rests on un-observable variables. This led to some problems related to conceptualization. Empirically speaking, CAPM method has not been very outstanding in its performance. However, there is no proof to claim whether this is a result of the absence of proxies for variables or is it because the model itself failed. Yet another problem, is related to the high volatility of the data which is incorporated to make estimations in the CAPM based model. (Sanjay, 2001) Dividend Valuation Model: The dividend valuation model is a method of valuing a company’s risks based on facts and future expectations from the company’s business. It keeps into perspective the expected future cash flows and the likely risks. It is considered to be one of the oldest and most conservative valuation methods but continues to be widely used world over. Dividend valuation model is also called the dividend discount model. The formula that it uses to derive the value of the stock is based on the dividend yield. This process in which known factors are plugged in to determine the price of a stock, is called discounting. It is thus for these reasons that dividend valuation model is often called the dividend discount model as well. The primary purpose of this kind of valuation model is to value stocks, check which stocks are cheap and which are expensive and then decide about purchasing and sell out accordingly. Features: The dividend discount model has four main parts. These include: 1. The dividend per share 2. The rate of return 3. The beta value of the stock 4. Dividend growth rate There are different variations to the dividend discount model. Most investors use different methods to figure out the inputs needed to plug in the dividend valuation formula. Dividend valuation model is useful for most Americans who are investing in heavy amounts. They tend to be conservative and a little cautions. This is where dividend valuation models in pointing out various dislocations in the market. Dividend discount model tends to undervalue the net worth of a company that has intangible assets like brand equity and reputation. On the other hand it may even overvalue the stock in favor of the market. Careful evaluation and calculation will have to be done to estimate the future movement of stock, determine market stability and to make the model less vulnerable. Comparison and interaction of CAPM and Dividend Discount Model: The scope of dividend growth model is very limited in its application and practice. It is because dividend growth model assumes that the dividends will grow at a constant rate g per annum forever. Secondly, it also demands the expected growth rate of divided should be less than the overall cost of equity, Ke, to zero down to the growth formula. However these assumptions are not applicable to all companies. They will not suffice to satisfy those companies who are not paying dividends or whose growth rate of dividends is really high and where the dividend policies are relatively volatile. Thus the dividend growth model fails to encounter and incorporate risk factor completely. On the other hand, the scope of CAPM is fairly large even when it has extremely restrictive assumptions. The only condition on which it thrives on is the fact that the company’s share should be quoted in the stock exchange. Moreover, the data and the variables that are used in CAPM are specific to companies and can be applied to all companies. Beta can be easily determined using statistical methods. However the only drawback with beta is the fact that beta remains constant and will change gradually. 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Craig, (1995), Multifactor models do not explain deviations from the CAPM, Journal of Financial Economics 38, 3-28. Muneesh, Kumar and Sanjay Sehgal, (2000), Company characteristics and common stock return: the India experience, working paper, University of Dehli. Sehgal, Sanjay,( 2001), Investor behaviour in Indian capital markets, working paper, University of Dehli. Read More