CAPM (Capital Asset Pricing Model) and Its Practical Use - Essay Example

CAPM and Its Practical Use CAPM refers to the capital asset pricing model, a widely adopted model within the financial field in order to determine the value of the appropriate rate of return for an asset. Generally speaking, the model has been extensively adopted by portfolio managers and by financial analysts in order to infer asset required and expected returns on a standardized basis. It is carried out through a properly designed and professional model that does not require to be completely renewed on a case by case basis. It has, therefore, met the requirements of the Asset Management industry in which the capacity to correctly price securities, and to properly infer the right rate of return. These are used to determine traditional and innovative alternative assets and provide all qualities that can make possible for a portfolio manager to gain an early lead over competitors (Brigham and Houston). The model, from a technical perspective, has been based on the works of Dr Harry Markowitz, a widely renowned professional and researcher who had been able to conduct important studies and researches in the field of diversification and of modern portfolio theory. According to his studies, some fundamental proven hypotheses can be synthesized as follows: Harry Markowitz, Nobel Prizer, investigated the effects of correlation rates and of diversification policies and strategies. As a result, he found that diversification in this sense, when correctly computed and carried out, can reduce and minimize the risk of a portfolio, together with an improvement of its required rate of returns. In this perspective, a Markowitz Efficient Portfolio has been defined as the portfolio where no added diversification can lower its risk for a given return expectation. In this sense, the ability to properly synthesize the main portfolio requirements is needed in order for a portfolio manager to meet the expectations and to reach the highest expected return. Once this efficient portfolio and its relative asset allocation is reached, no investor can minimize the risk further, and any departure from this allocation is perceived as something that impairs the risk level, and any asset added to the portfolio in this sense increases the risk level of the portfolio. An accurate selection of the most efficient portfolio, hence, can be reached through the analysis of the various possible portfolios of the given securities in the light of their degree of diversification. Dr Harry Markovitz also developed and implemented the so called “efficient frontier”, which represents the total and integral selection of the most efficient portfolios, analyzed on a risk return perspective. Under this view, the portfolios of assets that compose the efficient frontier are the ones that maximize return levels for certain given amounts of volatility (defined as risk). In this perspective, Harry Markowitz developed a mean Variance model that maximizes returns for given risk levels; the major assumptions of the model are the following: Investors tend to be rational Investors can easily determine the set of efficient portfolios highlighted above and can maximize their returns for a given level of risk There is a single period investment, as compulsory one for the analysis Risk of a portfolio is highly dependent on the variability of returns An investor prefers to increase the consumption Investors are risk averse by their nature The utility function of investors has a concave shape Major technical aspects of this model make possible to infer some major behavioral characteristic: firstly, investors prefer to retain a portfolio with lower risk, for a given return level. In addition to this, for a given risk (and volatility) level, investors tend to prefer portfolios with higher returns (Markowitz). Investors can be defined as risk averse when their expressed main priority is to minimize risk, and therefore, choose portfolios with lower risk. While, on the other side they are believed to be rational when they prefer asset combinations with higher expected returns. A graphical representation can be synthesized in this sense as follows: In the light of the process of selection of the optimal portfolio, it is evident to infer that the higher the risk reluctance of a hypothetical investor, the higher will be his sensitivity to volatility and risk levels, so that, he will prefer any portfolio that lays on the left of the chart. Vice versa, investors that are willing to invest on a rational perspective will be ready to bear more risk and will therefore be located on the right side of the chart. Indifference curves, as represented below where each point of a specific indifference curve shows a different combination of risk and return, provides the same satisfaction to the investors, so that, the ones located on the left can be considered the most efficient ones from a practical perspective. The point of intersection between the indifference curves in this perspective is considered to be the most efficient one, and is for this reason called the “market portfolio”. It maximizes the investor’s characteristics and requirements in terms of risk and returns, and is able to comprehend, on a theoretical perspective, all traded assets. As the chart below highlights, R represents the optimal portfolio in this sense. All portfolios so far have been evaluated in the terms of risky securities only. It is also possible to include risk-free securities in ones portfolio. A portfolio containing risk-free securities will enable an investor to achieve a higher level of satisfaction. Briefly speaking, this strategy would allow complying with investor’s utility ratios and at the same time to either borrow or invest part of the money amount at disposal into T bonds or T bills. A comprehensive representation of the so called Capital Market Line, that has major similarities with the Capital Asset pricing model developed by Markowitz, is represented below: The Capital market line equation can be defined by the formula: RP = IRF + (RM - IRF)?P/?M Where: RP = Expected Return of Portfolio RM = Return on the Market Portfolio IRF = Risk-Free rate of interest ?M = Standard Deviation of the market portfolio ?P = Standard Deviation of portfolio Its slope is dependent on the volatility of the market portfolio and is given by (RM - IRF)/?M In this sense, the efficiency of a set of assets is proven to be dependent on the volatility of the market portfolio, another element on which the CAPM builds (Markowitz). This model, however, needs many computational efforts, and the CAPM, hence, gives a better and more comprehensive overview of the needed analysis effort building on the same Markowitz assumptions, but with a more standardized and improved outcome (Brigham and Daves). The model of Capital Asset Pricing Model is characterized by a unique and standardized approach toward asset management and portfolio investment strategy. Proper conclusions are difficult to be drawn, although some major points and characteristics can be adequately highlighted: Building on the highlights of outcomes of Markovitz, the major formula under which all the theory is based may be interpreted as follows, (Khan and Jain) Where: can be seen as the necessary expected return on the capital asset is considered as the risk-free rate of interest, more precisely the interest arising from government bonds and T bills (the beta) is the sensitivity of the expected excess asset returns to the expected excess market returns, or also , can be seen as the expected return of the market is sometimes known as the market premium (the difference between the expected market rate of return and the risk-free rate of return). is also renown as the risk premium Geometric average is the method adopted to estimate expected and realized returns on a wider perspective, as highlighted on a theoretical and academic perspective (Brigham and Houston). The given security market line, through appropriate hypotheses, can be represented as follows: {SML}: E(R_i)= R_f+\beta_i (E(R_M) - R_f). On an analytical basis we can easily see how the model requires a deep and technical investigation of major aspects and factors that characterize the portfolio field of operational activity: Investors have to be compensated taking into account two major elements: from one side the time value of money is a major and broad factor of stability and of efficiency for an investment portfolio, while on the other side risk is the second major factor that requires investors to be compensated. Time value of money in the given CAPM formula is represented by the first part of the formula itself, more precisely by the risk free rate, while on the other side, the second part of the formula represents the required return by investors determined by the risk component, as expressed in the formula more precisely (Brigham and Ehrhardt). The figure above also highlights the Security market line, and states that the investors can choose, according to their utility, any point on that line, and more precisely taking into account the following parts: on the market portfolio (where 100 per cent of the investment will be dedicated completely to that market portfolio On the left side, where part of the investment amount will be invested or lended at the risk free rate of return, and the rest on the market portfolio On the right side of the line, where a quantity higher of the 100 percent of the amount to be invested will be dedicated to the Market portfolio, the invested quantity in excess of the amount owned is borrowed at the risk free rate (of course considering a strong hypothesis of parity of interests under which money can be lent or borrowed). The CAPM states that the expected return of a security or a portfolio equals the rate on a risk-free security with addition to a risk premium. If, somehow, this expected return does not manage to meet or beat the required return, then the investment, preferably, should not be undertaken. The line of the security market plots the results of the CAPM for all different types of risks (betas). The practicality of the model is clear, since it makes possible to compute the investor’s required rate of return in light of few elements such as the market volatility (building on markowitz assumptions). The CAPM's general problem, however, is that variation in unrelated to size and value-growth goes unrewarded, so that a more accurate and comprehensive methodology in this sense is widely believed to be investigated with a prominent role. In addition to this, events and externalities such as the momentum strategies, the growth in alternative asset management, and the higher volatility levels registered within recent market trends and fields have improved the necessity to further test the Capital Asset pricing model validity in the marketplace, despite its actual prominence and popularity within asset management bureaus and investment firms. References Brigham, Eugene F, and Houston, Joel F. Fundamentals of Financial Management.Mason,OH: South-Western Cengage Learning, 2009. Print. Brigham, Eugene F, and Daves, Phillip R. Intermediate Financial Management. Mason, Ohio: South-Western, 2012. Print. Brigham, Eugene F, and Ehrhardt, Michael C. Financial Management: Theory and Practice. Mason, OH: South-Western Cengage Learning, 2011. Print. Khan, M Y, and Jain, P K. Financial Management. New Delhi: Tata McGraw-Hill, 2007. Print. Markowitz, Harry. "Rady School: Faculty." Rady School of Management - UC San Diego. University of California, San Diego, n.d. Web. 7 Apr. 2013. Read More