CAPM (Capital Asset Pricing Model) - Essay Example

?Capital Asset Pricing Model Introduction CAPM (Capital Asset Pricing Model) The CAPM model has emerged to be one of the most important tools in making a fundamental decision related to the investment management. It measures the relationship between the expected rate of return and the risk involved in a particular investment The CAPM tool signifies the linear relationship between the non diversified systematic risks which is measured by beta ? and expected returns which is denoted as r. The ? is used as a measure of non diversified risk and implies that the expected return is the return on a risk free asset in addition to a risk premium (Laubscher, 2002). The risk premium will be equivalent to the market return in surplus of the risk free rate which is multiplied by the share portfolio. This is the reason that ? is regarded as the difference between the returns on various share portfolio. The formula for CAPM model is denoted below: R = Rf + ?(Rm - Rf) R = Expected return on the share/portfolio. Rf = Risk-free rate of return. ? = Beta (volatility of the share/portfolio relative to the market portfolio). Rm = Expected return on the market portfolio. Rm - Rf = Market risk premium (Laubscher, 2002). In the CAPM model risk is defined as the extent to which returns on share portfolio have covariance and variance with the market returns. ? is used for measuring risk and the basis for expected market returns. It is used as a measure for non diversified risk and is a relative measure of risk relative to the market portfolio. ? measure the volatility in the share price or share portfolios which are relative to the movement to the returns on the market portfolio. ? is used widely in the investment management as a standard measure of risk. As mentioned before that the relationship between ? and market returns signifies that the investors expect a market return to be equal to the risk free rate in addition to the risk premium. Implementation of the CAPM model requires the parameters to be assumed. The various components of the CAPM model are as follows: 1. Risk free rate of return: It is known as the return on asset has no risk and has no variance/ covariance with the return on market. Instruments like these are very difficult to find and usually does not exist in the market. Government bonds and Treasury bills are used instead of this instrument (Laubscher, 2002). 2. Return in the market: The market portfolio constitutes of all kinds of risky assets and is one of the most available diversified portfolios. After the valuation of portfolio is done then it will be difficult to diversify the risk. The market return is the return on the market portfolio which constitutes of all risky assets. The rate of return is actually measured by the approximation of the stock indices which is used a proxy to the market. However, the problem arises regarding the choice of the index to be used as a proxy (Laubscher, 2002).The expected rate of return depends upon the market risk but it also depends upon the nature of the benchmark of the portfolios. However, investors are satisfied in investing in a limited number of benchmark portfolios. 3. Beta (?): This is one of the most crucial aspects of the CAPM model; as it helps in determining the difference between the expected market return and the actual market rate of return. Portfolio betas are usually derived from the historical data and are useful in the measurement of the betas of the future (Rai University, n.d.). According to economic analysts the high beta shares tend to have a higher returns and lower betas shares tend to have low returns. The relationship between the average returns and beta is linear but the slope of risk and return relationship is not as steep as estimated by the CAPM model. Beta measures the relationship based on past returns and the derived results are more accurate than the standard deviation used to measure the relationship between risk and returns (Laubscher, 2002). Figure 1: Relationship of risk & return as per CAPM Model (Source: Myers, 2003) From the above diagram we can observe that the beta of treasury bill is 0 and risk premium of 0 and the beta of market portfolio is 1 and the beta of risk premium is rm- rf. Therefore there would be two benchmarks for the expected risk premium which is 1 and 0. As per the CAPM Model formulated by William Sharpe, Jack Treynor and John Linter in the 1960 the solution for dilemmas like this could be solved by the CAPM model. As per the CAPM model the riks premium would be in direct proportion to the beta. All the investmenst in the portfiolio will be plotted along the sloping line which is known as security market line. The expected risk premium with a beta of 0.5 signifies that it is half the expected risk premium on the market. The expected risk premium with a beta of 2 will be twice the expected risk premium on the market. The relationship will be signified as Expected risk premium on the stock value = Beta * expected risk premium on market ( r- rf = ? ( rm-rf) (Myers, 2003). The basic assumpytion of CAP Model would be: 1. There is a perfect capital market, there are no transaction costs and the assets are fixed in supply and are infinitely divisible. It is assumed that all the investors can borrow and lend at the same interest rate. There is minimum risk associated with borrowing. 2. Th investors are risk averse and tend to maximize the utility of wealth at the end of the planning period. The portfolios are analyzed by the expected rate of return and the standard deviation of the expected return. 3. The planning periods will be same for all the investors and the decisions related to the portfolio is made at the same time. 4. All the investors have the same kind of estimation standard deviation and expected rate of return (McDonald, 2002). Practical Usage of CAPM Model 1. Hurdle rates: In reality an average investor gets higher returns for stocks with high risks and is more concerned with the company related risks than the market related risks. CAPM is used by the management of the company to determine the cost of equity of the company, hurdle rates for the corporate investments and to forecast the required rate of return. The cost of equity of a company is used in capital budgeting analysis which is used for investment appraisal and valuation of equity (Rai University, n.d.). Hurdle rate of return are the required rate of return and the management analyzes the past performance of the company by using Beta as a measurement tool. For example let us assume that the beta of expected rate of return is 1.4, rf is 6 percent and E (rm) is 11 percent. The expected rate of return or hurdle rate of return would be E(r) = 0.06 +1.4 (0.11 – 0.06) = 13 percent. This calculated expected rate of return would be used by the managers in the NPV calculation (Shapiro, n.d.). 2. Pricing Application: The CAPM model when applied to pricing individual risk indicates the risk required to be maintained in a desired risk and return relationship in the total portfolio value. If the actual value of the risk is equivalent or almost same to the desired risk then the necessity for management of the risk of the portfolio through reinsurance or diversification is not required. The risk of the total portfolio would be self managed through the process of pricing. In the similar way the methodology of market equilibrium when applied to pricing an individual risk indicates the fair premium risk that the competitive market would permit. If the actual price of the individual risk is equivalent to the indicated risk then the aggregate premium would not arise in a expected portfolio through Return On Equity (RoE) without the management of the portfolio risk through reinsurance or diversification. Thus, we can observe that CAPM is used for evaluation of performance and construction of a rational portfolio value which is used for investment analysis. 3. Fair Remuneration: The CAPM model helps in establishing a fair remuneration in a regulated monopoly. For example rf = 6 percent, E(rm ) = 12 percent and beta is 0.5 therefore, it would be calculated as E( r ) = 0.06 + 0.05 ( 0.12 – 0.06)= 0.063 or 6.3 percent (Shapiro, n.d.). Investment value= $300 million. Required annual profit would be 300 * 0.063 = $18.9 million. 6.3 percent is known as cost of equity capital and affects the price the monopoly company will charge. 4. The use of Beta in companies: The beta is used by the investment analyst who refers to variety of resources for determining beta. Beta is used by all the investment analysts working in channels like Bloomberg, McGregor BFA and other financial risk service. However the various investment analyst use different equity valuation approaches (Nel, 2002). 5. Use of proxy for risk free rate: Risk free rate is one of the important components of CAPM model. Although, many proxies can be used for risk free rate as per the survey conducted by the Price Waterhouse Coopers, South Africa majority of the surveyed respondents preferred instruments like government bonds and Treasury bill (Nel, 2002). Limitations of CAPM Model The limitations of this model are as follows: 1. The CAPM model is very unrealistic for an average investor as they are more interested in the company related risk and not market related risk. Data like past performance of the company, dividend, equity valuation model etc is more important to the average investor (Rai University, n.d). 2. The assumptions in the CAPM model are not relevant because the transaction costs and taxes are not taken into consideration. Factors like 1) Share returns are not evenly and normally distributed 2) investors are interested in the mean, covariance and variance of the market return is not entirely true. However, these assumptions might be untrue to a certain extent but does not have negative implications on the portfolios. Although the calculation of beta is not based on valid explanations as historical betas may not reflect the future market returns of risks. There has been evidence that future projections on the basis of betas have found to be faulty and inaccurate (Laubscher, 2002). 3. As per some analyst the Arbitrage pricing theory holds more relevance than the CAPM theory because the assumptions based on market return are real. Arbitrage pricing theory (ABT) states that market returns are the result of function of various macroeconomic risk factors and not one risk factor as assumed in the CAPM model. However in the ABT theory also there are some limitations like 1) it does not identify the risk factors 2) ABT is descriptive in nature. However, ABT cannot be regarded a s an alternative investment model as CAPM model regards the relationship between the risk and return whereas ABT explains the current situation of the investment market (Laubscher, 2002). 4. A true market portfolio does not exist hence the practice of CAPM model to evaluate investment performance is futile (Laubscher, 2002). Conclusion We can observe that the CAPM is instrumental in the assessment of the relationship between risks and return and helps in estimating the investing performance, cost of capital and portfolio evaluation. The CAPM model may exist in a perfect market but without this tool the knowledge on capital markets and market conditions would be limited. However, the modified version of CAPM model reflects that security risks affect the sensitivity of returns to changes in the investor’s consumption. If the manager follows the principle of higher risk and higher returns, the manager will keep the risk level at the optimum level while performing an investment function keeping in mind that the shareholder’s return will be at the expected rate of return. References Laubscher, E., 2002. A capital asset pricing model with variable asset supply. University of South Africa, 10, p.131- 146. McDonald, J.F., 2002. A capital asset pricing model with variable asset supply. University of Illinois, 02 (4), p.07. Myers, B., 2003. Principles of corporate finance [pdf] Available at: [Accessed 20 April 2013]. Nel, W.S., 2002. The application of the Capital Asset Pricing Model (CAPM): A South African perspective. Stellenbosch University, 05 (13), p.5336-5337. Rai University, n.d. Capital asset pricing model (CAPM) [pdf] Available at: < http://psnacet.edu.in/courses/MBA/sapm/lecture-28.pdf> [Accessed 20 April 2013]. Shapiro, A., n.d. The Capital Asset Pricing Model (CAPM) [pdf] Available at: < http://pages.stern.nyu.edu/~ashapiro/courses/B01.231103/FFL09.pdf> [Accessed 20 April 2013]. Read More