Usefulness of Capital Asset Pricing Model - Essay Example

? USEFULNESS OF CAPITAL ASSET PRICING MODEL (CAPM) By s Usefulness of Capital Asset Pricing Model (CAPM) Sharpe and Lintner introduced CAPM and its development was greatly boosted by Jack Treynor’s early work. The CAPM is one of the economic theories that give a description of the relationship between expected return and risk and is used to price risky securities. The model perceives systematic risk as the only risk which rational investors price because the risk cannot be eradicated by diversification (Sharpe 1964, p.425: Linter 1965, p.13). The CAPM states that a security’s or a portfolio’s expected return is equivalent to the rate on a risk-free security added to a risk premium then multiplied by the systematic risk of an asset. In this sense, a high quantity of a security’s beta would result in a high expected return of an asset and vice versa. After CAPM was published, and after actual returns were compared with expected returns, many economists have since then criticized the simplicity of and the reality of application of CAPM. The CAPM is still subject to empirical and theoretical criticism despite it being the basis for over a hundred academic papers and having affected non-academic fiscal community considerably. Although it has an apparent invalidity, the CAPM is still widely used by companies as a valuable model for computation of capital cost through justification of high returns in correspondence to higher beta. Therefore, this paper will discuss the implications with regards to the current developments in the area. The paper will first explain and discuss various assumptions in relation to the model and thereafter discuss the key theories as well as the whole debate that surround this area particularly through the criticizing the assumptions. There are numerous economic applications of the CAPM. It is used in valuation of a company’s common stock, for acquisition and merger analysis, capital budgeting and the valuation of convertible and warrants securities (Naylor & Tapon 1982, p.1166). To ensure validity of the CAPM, William Sharpe came up with numerous assumptions designed for investors in the creation of market equilibrium. The supporters of the model postulate that the capital market functions as though the above assumptions were met. The model derives the price to be commanded by any asset to make the investors happy to retain the present market portfolio. Under the CAPM, each person carries similar risk in diverse amounts. Investors have different portfolios, and they will need a return for their portfolio’s systematic risk because the removal of the unsystematic risk has been done and therefore, can be disregarded. An investor will give a ranking to the portfolio in accordance with a utility function which is dependent on the expected return rate of this portfolio. Because everyone has the same risky assets’ portfolio; it is normal that everyone is exactly happy to purchase the market portfolio, that is, the portfolio of every asset available in the market. Furthermore, part of the risk can be diversified through purchasing many dissimilar assets. The level of stock risk not necessarily related to how variable its return is. The variability is an appropriate measure only if one investor invests all his/her money in one asset. In reality, part of the risk is diversified through purchasing many dissimilar assets. In fact, through diversification, there is a possibility of averting the risk associated with each stock as opposed to the risk which the whole market may decline. The non-diversifiable risk originates form macroeconomic factors which affect all assets simultaneously. For instance, in the credit-crunch many firms have the tendency of having negative cash flows and low profits. As much as the assumptions contained in CAPM permit it to concentrate on the relationship between systematic and return risk, they propose an idealized world that is different from the real world where investment decisions are majorly made by firms and individuals. The degree to which the assumptions are not satisfied in the real world will influence the validity of CAPM (Pratt & Grabowski 2008, p. 122). The assumptions form a major part of the doctrine of classical economics. Indeed, these assumptions are related to an ideal market, and the literature has widely discussed their merits. To emphasize this, William Sharpe refers to the assumptions as being undoubtedly unrealistic and highly restrictive assumptions. Indeed, there no doubt that the actual capital markets are imperfect. Although well-developed stock markets demonstrate high efficiency, there is some extent of mispricing of stock market securities (Sharpe 1964, p. 425-442). The CAPM does not assume any transaction cost, such that there is no cost for trading but there is the pricing of all investments to stay within capital-market line. Nevertheless, it is clear that several investments like acquiring a small business involve large transaction costs. Moreover, under the CAPM, taxes do not affect returns and investment trading is not taxed. However, majority of the returns including capital gains and dividends are taxed in indirectly thus forcing investors into considering taxes. In addition, capital gains of lots of investment transactions are taxed. In reality, different investors are taxed differently in relation to their status: individuals against pension’s plans. Additionally, the assumption suggesting that investors varied portfolios implies that every investor desires holding investments that reflect the whole stock market, the market portfolio. On the other hand, it is not possible to hold the market portfolio. In the CAPM, investors are able to borrow money at rates free of risk. Risk-free asset refers to an asset that has a definite future return, for instance, treasuries (T-bills). In so doing, there will be an increase in the amount of risk asset within a portfolio. But in reality investors cannot borrow at a risk-free rate since there is much higher risk associated with investors than it is associated with the Government. It is clear that the CAPM has the assumption that there are zero-risk securities for a range of maturities as well as enough quantities to permit adjustments on portfolio risk. On the contrary, Treasury bills, for instance, have diverse risks such as inflation, currency risk or reinvestment. Hypothetically, in market equilibrium, homogenous investors can access and make use of identical information and have an identical behavior in relation to risk in portfolios. Each one has the same information and therefore, they will purchase less bad stocks and more good stocks. It is assumed that investors valuate information in the same manner through the same newspapers and articles and eventually arrive at the same conclusions. William Sharpe believes that every investor has the same beliefs on investment strategies, available investments’ risks, and expected returns if they remain risk-averters. Nonetheless, in reality, investors can have divergent risk preferences, opinions, expectations, and investment horizons. The CAPM does not consider the diversity. The assumption of homogenous expectation results into a high inefficiency in the market with periodic, predictable crashes and booms (Levy 1988, p. 360). According to George Soros, classical economic theory has the assumption that market participants operate based on of perfect knowledge. This assumption is false. It is not possible for the participants to attain the market’s perfect knowledge since their thinking is constantly influencing the market while the market is also influencing their thinking. In reality, some investors can attribute a large significance to numerical data such as price earnings ratio and accounting data while others can have a prediction formulas base on trends. In such a case, investors may have diverse expectations as well as diverse strategies for optimal diversification (Soros1995, p. 90). The CAPM has many advantages over any other methods for calculation of required return. This is the min reason why it has retained its popularity for over 40 years. The CAPM pays attention merely on systematic risk depicting a reality in which the majority of investors hold diversified portfolios where there has been the removal of unsystematic risk. The association between systematic risk and required return has led to many scientific inquiries. The CAPM is perceived as a useful tool for obtaining the cost of equity when used conversely with other techniques, because it considers a systematic risk level of a company in relation to the entire stock market. Furthermore, compared with the WACC, the CAPM is superior in the provision of discount rates for utilization in investment appraisal (Watson & Head 2007, p. 222). Years after the introduction of the CAPM, many researchers in the area came up with models to oppose it. The CAPM has the assumption that risk is measured using the systematic risk standard deviation of an asset when compared to that of the whole market. However, Fama and McBeth in 1973 emphasized that Beta is insignificant and that explaining excess of any asset using the standard deviation on its return is irrelevant because it does not consider risk when there is an even distribution of returns around the mean (Fama & McBeth 1973, p. 608). In 1977, Richard Roll while analyzing the model asserted that the CAPM is not testable because of such factors like the impossibility to test the benchmark error and the actual market portfolio by use of an inefficient market proxy. According to him, difficulties emerge in the use of a market portfolio proxy. While Roll dismisses mathematical testability of the CAPM, other economists take into consideration other risk variables that result into the model’s misspecification (Roll 1977, p. 134). For instance, Rolf Banz through an empirical research found out that on average, smaller companies have had higher returns adjusted by risks than larger companies (Banz 1981, p. 17) have. Berk emphasized that companies will have higher expected returns and lower market values and made a conclusion that the relationship between risk and firm size is not evidenced by empirical size effect, by itself (Berk 1995, p. 278). Fama and French came up with a multi-factor model considers market index and book-to-market ratio. Both argue that the two variables generate undiversifiable risks on returns which the market returns do not capture and their prices are separate from the market beats. To sum up, the nondiversifiable risks are not related to the beta factor. Therefore, the CAPM does not show them. The authors introduced the “Three Factor Model” which they believe is a more empirically accurate and complete version of the CAPM. The CAPM display difficulty when quantifying the behavior of the investor. In their model, Fama and French studied the consistency of stock prices’ behavior with the earnings’ behavior, in relation to book-to-market-equity and size and in their conclusion stated that this may be correct for rational pricing (Fama & French 2004, p. 12). Regardless of the evident lack of convincing validity of CAPM, this concept is still being used by organizations a common model of computing the cost of capital. As Harvey and Graham (2000) allude, the CAPM is extensively the most common techniques for cost of equity capital approximation in organizations with respondents in excess of 73.5% using it (Graham & Harvey 2000, p. 240). Moreover, the possibility of the model to compare two fundamental variables in relation to capital budgeting in its formula such as return and risk as represented by beta makes it a comparatively simple but mathematically accurate model. The actual results merge the anticipated ones in such a way that the project with the most risk has highest returns reinforces its common use in corporate finance applications. Nevertheless, the CAPM is founded on the assumptions of investor’s actions and although the may be unreal in application, the model examines ideas such as clients decision to diversify as risk reduction measure logically. The model cannot be reliable fully because of the presence of alphas, which points to the variations away from the MSL (Market Security Line). This is occasioned by variables in the risk such as investors’ behavior, which are not measurable mathematically. Since CAPM is computes the expected returns and the inaccurate prediction of the future, it is reliable for estimating the cost of capital through risk and return simulation. References List Banz, R. F., 1981. The Relation between Return and Market Value of Common Stocks. Journal of Financial Economics, 9(1), pp.3-18. Berk, J. B., 1995. A Critique of Size Related Anomalies. Review of Financial Studies, 8(1), pp. 275-286. Fama, E. and Macbeth, J., 1973. Risk Return and Equilibrium: Some Empirical Tests. Journal of Political Economy, 8, pp.607-636 Fama, E. F. and French, K. R., 2004. The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18(3) pp.25-46. Graham, J. R., Harvey, C. R., 2001. The Theory and Practice of Corporate Finance: Evidence from the Field. Journal of Financial Economics 60, pp.187-243. Levy, H. 1992. The Capital Asset Pricing Model with Diverse Holding Periods. Management Science, 38, pp. 1529-1542. Lintner, J. 1965. The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. The Review of Economics and Statistics, 47(1), pp. 13-37. Naylor, T. H. & Tapon, F. 1982. The Capital Asset Pricing Model: An Evaluation of Its Potential as a Strategic Planning Tool. 28(10), pp. 1166-173. Pratt, S. P., & Grabowski, R. J. 2008. Cost of Capital: Applications and Examples. 3rd ed. Hoboken, NJ: John Wiley & Sons. Roll, R. 1977. A Critique of the Asset Pricing Theory’s Test. Journal of Financial Economics, 4, pp. 129-176. Sharpe, W. F. 1964. Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. Journal of Finance 19, pp. 425-442. Weston, J. F. 1973. Investment Decisions Using the Capital Asset Pricing Model. 2(1), pp. 25- 33. Read More