What Is The CAPM (Capital Asset Pricing Model) And Of What Practical Use Is It - Essay Example

? WHAT IS THE CAPM (CAPITAL ASSET PRICING MODEL) AND OF WHAT PRACTICAL USE IS IT? Table of Contents Introduction 3 The Capital Asset Pricing Model 3 Assumptions of CAPM 4 Mathematical Formula 4 Market Portfolio and Efficient Frontier 6 The Significance of Beta Factor 7 The Practical Applications of CAPM 7 Summary and Conclusion 8 References 9 Introduction The total risk of portfolio can be divided into systematic (non-diversifiable) and unsystematic (diversifiable) risk. An investor can reduce the unsystematic risk of investment through proper diversification of securities in the portfolio. Since systematic risk cannot be eliminated, the capital asset pricing model (CAPM) can be used as a tool to determine expected return of asset that is chosen to be added in a well diversified portfolio. When the expected return of a security is determined using the model then it can be compared to the estimated return of security over a given time period. Such comparison will help the investor to analyse whether it is worthwhile investing into the security. CAPM was first conceptualised and pioneered by William Sharpe, Jack Treynor, Jan Mossin and John Lintner through their independent works (Focardi and Fabozzi, 2004, pp.86-87). The Capital Asset Pricing Model The Capital Asset Pricing Model (CAPM) is popularly used to price individual portfolio securities. The CAPM helps to determine the expected rate of return for an asset relative to market risk. Using the CAPM model an investor can eliminate the unsystematic risk through proper diversification by estimating the required rate of return for a given level of non-diversifiable or market risk. The practical application of the model is that the individual investor will be able to modify their investment portfolio according to their risk taking behaviour. The model also helps the individuals to analyse the risk-return profile in the portfolio (Gallagher and Andrew, 2007, pp.173-175). Assumptions of CAPM Investors are risk averse and rational No single investor can influence security prices No transaction cost or taxes Investors have access to all information at same time Expectation of the investors is homogeneous Mathematical Formula For individual assets, the relation between systematic risk and expected return can be estimated using the Security Market Line (SML). The significance of SML is that it can help the investor to calculate the risk-to-reward ratio for a given security relative to market. (Source: Financial Planning Body of Knowledge, 2010) The market risk-reward ratio is also known as the market risk premium. The systematic risk can be estimated using the Beta factor (?). Beta measures the sensitivity of excess expected return of security to the excess market return. Mathematically, ? = Covariance (Ri, Rm) / Variance (Rm) Excess market return or Risk Premium = E (Rm) – Rf CAPM = Rf + ? x [E (Rm) – Rf] Where, Rf = Risk-free return Ri = Security Return Rm = Market Return Market Portfolio and Efficient Frontier The concept of CAPM encourages an investor to invest a portion of his or her wealth in risky asset and the remaining portion into risk-free asset. The proportion of asset allocation between risky and risk-free asset depends on the behaviour of the investor. According to this model, a rational investor will prefer maximum return for given risk or minimum risk for given return. The optimum portfolio is a combination of securities which yields maximum returns for lowest risk or volatility. The total portfolio risk can be measured and compared to market risk using beta. The optimum portfolio is derived from the efficient frontier curve that gives the relation between portfolio risk and return. The combination of securities that is formed at the tangency of individual assets and the capital Allocation line (CAL) is called the optimal portfolio (Khan and Jain, 2007, p.16). (Source: krotscheck.net, 2008) The Significance of Beta Factor Beta indicates the stock volatility relative to a benchmark or market. The benchmark can be international index like S&P 500, FTSE 100, etc. The beta of market or benchmark is always one. The value of stock is stated relative to benchmark beta. Consider an example where the chosen benchmark is S&P 500 whose beta is 1 and the beta of particular company’s stock is 1.5 (say). It implies that stock is 50% more volatile compared to benchmark and hence more risky. For risky stocks, the market premium is also higher. Alternatively, the stock would return 15% when the market returns 10%. Similarly, beta less than one implies less volatility, more safety, lower return compared to benchmark. A desirable value of beta would depend upon individual risk tolerance. So, in case the beta is high it will mean higher return but at the same time when the market falls, the stock of companies with higher beta is expected drop much more. The Practical Applications of CAPM The real world application of CAPM is that many companies use the model to estimate the cost of equity of organisation that is further used to evaluate project’s worth of investment. The CAPM model can also be used to take the investment decisions in terms of risk, returns and cost evaluation of project. The historical returns and Betas can be used to analyse the proper risk of investment in portfolio. In short it can be said that the CAPM is used as a tool for portfolio management and investment analysis. An alternative to calculate the WACC of firm is deriving the discount rate of project using CAPM model. It can then be used to evaluate project’s investment worth by maximisation of NPV approach. The beta can be used to measure the systematic risk of individual securities, overall portfolio, or any project that involves cash flows. When an individual is considering purchasing the shares of particular company, he or she can refer to CAPM to evaluate the share’s returns by using market beta. Then the investor can decide appropriately with sufficient evidence that whether or not to invest in that company’s stock. The CAPM can also be used to determine any project’s discount rate and then such rate can be compared to the cost of project in order to decide if the project should be accepted or rejected (Fama and French, 2004, pp.43-44). Summary and Conclusion The total risk of portfolio can be divided into systematic and unsystematic risk. Since systematic risk cannot be eliminated, the capital asset pricing model (CAPM) can be used as a tool to determine expected return of asset that is chosen to be added in a well diversified portfolio. Using the CAPM model an investor can eliminate the unsystematic risk through proper diversification by estimating the required rate of return for a given level of non-diversifiable or market risk. Beta indicates the stock volatility relative to a benchmark or market. A desirable value of beta would depend upon individual risk tolerance. From the above discussion it can be said that real world application of CAPM is that it can be used to estimate the cost of equity of organisation and further to evaluate project’s worth of investment. It can also be used to determine project’s discount rate, analyse risk of investment, and evaluate riskiness of stock relative to market. References Focardi, S. M. and Fabozzi, F. J., 2004. The Mathematics of Financial Modelling and Investment Management. New Jersey: John Wiley & Sons, Inc. Gallagher, T. J. and Andrew, J. D., 2007. Financial Management Principles and Practice. United States: Pearson Education, Inc. Khan, M. Y. and Jain, P. K., 2007. Financial Management. 5. New Delhi: Tata McGraw-Hill Education. Fama, E. F. and French, K. R., 2004. The Capital Asset Pricing Model: Theory and Evidence. [Pdf]. Available at: http://www-personal.umich.edu/~kathrynd/JEP.FamaandFrench.pdf. [Accessed on April 18, 2013]. Read More