Evaluation of CAPM Using American Stock Market Data - Dissertation Example

? Evaluation of CAPM using American stock market data Table of Contents Table of Contents 2 Introduction 3 of CAPM 3 Assumptions of CAPM 4 Economic Rationale behind CAPM and its Consistency with the regulatory and the economic standards 4 Role of CAPM in estimating Cost of Equity 6 Implications of empirical Tests of CAPM 6 Regression Analysis- A tool for employing the CAPM 6 Critique of CAPM 7 Evaluation of CAPM using the US Stock Market 7 Conclusion 9 References 14 Introduction Description of CAPM William Sharpe (1964) and John Lintner (1965) have contributed to the origin of asset pricing theory in the Capital Asset Pricing Model (CAPM). The CAPM was built on the model of choice of portfolio developed by Harry Markowitz (1959). According to the model of Markowitz, an investor opts to select a portfolio at time t-1 which would generate a stochastic return at time t. The model assumes that investors are generally risk averse, and at the time of choosing their portfolio they are concerned only about the mean and variance of their return at the end of the period of investment. So investors prefer to choose mean-variance-efficient portfolios that would either minimize variance with a given expected return or would maximize expected return given variance. Thus, CAPM is a theory that defines the relationship between risk and the expected return of a security or a portfolio of securities. The theory is based on the assumption that the security market is generally composed of risk-averse investors and the type of investors who prefer and will to take more risk only when they expect to earn a higher return in commensuration with that risk. The return from an asset varies through successive periods and an asset which has a fluctuating return is considered to have greater risk. So, the tendency of investors is to diversify their investment portfolio so that they could minimize the effect of risk volatility, i.e. the unsystematic risk attached to the portfolio. Thus due to diversification only market related or systematic risk is relevant in the risk-return trade-off. The portion of risk volatility which is systematic, i.e. measured by the extent to which return varies with respect to the overall market, is measured by the parameter ? (Beta). Beta is a measure of risk contributed by individual securities to a well-diversified portfolio, and measured by- rA = return of the asset rM = Return of the market ?2M = variance of the return of the market cov(rA, rM) = covariance between the return of the asset and the return of the market. Beta is calculated with the help of historical returns for both the asset and the market. Assumptions of CAPM The assumptions of CAPM are- Investors in the market are concerned only about the expected return and the volatility of risk involved with their investment All investors have homogeneous idea about the concept of risk and return associated with an investment. Systematic risk factor is common to a broad-based market portfolio as systematic risk brings volatility which is non-diversifiable. So, if a securities beta can be identified, then the expected return from that security can be calculated. Economic Rationale behind CAPM and its Consistency with the regulatory and the economic standards The relationship in risk and return in CAPM is measured using- Where, Rt = the expected return on a security or a portfolio Rf = Risk-free rate of return ?i = Beta of the security or portfolio i Rm = expected return on the equity market performance The rationale behind the CAPM equation is to persuade the investors to shift their money from riskless assets to risky assets such as equity security. The usefulness of CAPM lies in the measurement of the expected return premium appropriate for an investment with respect to the risk involved relative to the market index risk. The economic explanation of the equation brings out that how risk-free rate of return (Rf) and market-wide risk premium (Rm- Rf) aid to persuade investors from investment in risk-free securities to risky securities. Beta measures the impact of the benchmark market index over the business cycle on the returns of the investment by the investor, i.e. the relativity of risk involved in a security or portfolio to the overall market benchmark. The CAPM is consistent with the economic standards and the public utility regulatory, especially the regulatory principle set forth in the Hope case and the regulatory standard that aroused from the Bluefield decision. According to the economic standards, the return estimates produced by CAPM must satisfy the demands of the risk-return tradeoff, meet the opportunity cost of the investors, and must maintain consistency with the empirical evidence which aims to bring a high degree of efficiency in the U.S. financial market. Role of CAPM in estimating Cost of Equity CAPM is a conceptual tool that relates return to risk systematically. The model requires market-based data as inputs that are objective and easier to obtain. The limitation of CAPM as derived from the empirical evidence states that beta may not be always capable of capturing all the sources of risk present in a market. Thus, the estimates of cost of equity based on CAPM should be supplemented with alternative approaches that use other measures of risk, i.e. DCF model and the risk premium approach. Implications of empirical Tests of CAPM With respect to the relation between expected return and market beta, the empirical tests of CAPM are based on three implications. They are- The expected returns on all assets are linearly related to their beta If the beta premium is positive, it indicates that the expected return on the market portfolio is greater than the expected return on the assets, which are not correlated with the market return. According to the model version by Sharpe and Linter, assets which are not correlated with the market have expected returns equal to the risk-free interest rate. The beta premium for such assets is the expected market return minus the risk-free rate. Regression Analysis- A tool for employing the CAPM Fund Managers aim to outperform the market by selecting stocks in a portfolio on the basis of research and informed opinions. Therefore, so as to determine whether a manager should be credited for the performance, the portfolio formed is analyzed using the CAPM and Regression. For calculating the time series data for regression analysis two kinds of data is required. Firstly, the stock returns for the period for which Beta is to be calculated. Secondly, the overall market index for the same period. Regression is denoted with the help of the following- Alpha (?) denotes the potential value added by the fund manager. Thus with the help of the above equation regression helps to detect the excess fund realized against the excess market returns with the help of alpha. Furthermore, from the view of statistical perspective, it can be said that the explanatory power of a model improves with the addition of independent variables to a regression. Critique of CAPM Several criticisms which have aroused from academic research for the concept of CAPM are- The true predictive power of CAPM is doubted. Incorrect predicting results when compared to the effect of other risk factors and realized returns have lead to the support of the criticism. The influence of CAPM in estimating the impact of it on the expected returns have been questioned and criticized by many critics. Evaluation of CAPM using the US Stock Market Fama and French in 1992 presented one of the major empirical arguments about CAPM. In their study they found that in the US stock market the cross section of the average equity returns show a minute statistical relation to the Beta of the original CAPM. They evaluated the joint roles of the firm size, market beta, earning per share, ratio of firm’s book-value to market equity and financial leverage in the cross section of average returns on the stocks of American Stock Exchange, National Association of securities Dealers Automated Quotations, and New York Stock Exchange, and concluded that the propositions of CAPM is violated in the prediction of a cross sectional relationship between exposures to market factor and mean excess returns. Fama and French in 1993 found from their study that there are five common risk factors that explain the returns in both stocks and bonds. They found two factors, i.e. firm size and ratio of firm’s book-value to market equity, which would help to explain the differences in the average cross-section returns in stocks. Fama and French in 1996 observed that the abnormal patterns of asset returns experienced during the 1980s and 1990s could not be explained through the CAPM. So they found if two new variables, i.e SMB and HML, including the market factor are introduced in the model, it would be able to explain the abnormal patterns of asset returns. SMB would measure the additional returns received by the investors by investing in stocks of the companies which have small market capitalization, and HML would measure the value premium that the investors would receive for investing in stocks of companies with high book-to-market values which will suggest high risk exposure of an investor. Thus the Three Factor Model (TFM) was coined by the researchers Fama and French in 1996 which used the multiple regression approach and combining the original market risk factors and newly developed factors. Where, SMB = Small minus Big (proxy for company size) HML = High minus Low (proxy for the ratio of firm’s book-value to market equity) ?A = Measure of exposure of an asset to market risk sA = measure of the extent of exposure to size risk hA = Measure of the extent of exposure to value risk The coefficients of the TFM had similar representations as that of the CAPM. Conclusion The versions of CAPM developed by Sharpe (1964) and Lintner (1965) was never able to attain empirical success in the US market. But late in the 1970s research by some researchers, for example, Research by Fama and French, found the drawbacks of the CAPM model and introduced some additional variables such as firm size, market beta, earning per share, ratio of firm’s book-value to market equity and financial leverage, that if introduced would help to overcome the limitations of CAPM and provide a better and accurate value of ? (Beta) as per the benchmark market index. Several researchers and economists have identified the use of CAPM by various officers and directors of the management so as to predict the return from a stock investment to be received in future and its effect on either selling or holding the stocks. The desire to be in a beneficial position often motivates the direction to undergo insider trading which will generate higher return than the average. The study conducted analyses the fact that if trading conducted by the managers, though being materialistic, if conducted by not informing the public, is considered to be illegal. The directors of an organization are exposed to various forms of internal information of the organization related to industry conditions, operational capability, competitive advantages and disadvantages, demographic advantages and disadvantages, and other general economic conditions. With a proper access to these information’s the directors can make forecast about the rise or fall of the prices of shares of the organization in future which would be beneficial in undertaking several decisions. Directors hold a position of great responsibility in an organization which highlights the significance of corporate governance in an organization. The directors take the advantage of this responsibility and attempt to involve in some malpractices so as to reap their own benefits. The study conducted for over 50companies listed in the NYSE (New York Stock Exchange) compared the relationship between directors’ insider gain and CAPM. The analysis of the study suggested that 40 out of the 50 selected companies have shown that the directors of the companies were generating abnormal profits through insider trading, i.e. by sale of the shares of the companies. & companies out of the selected companies did not report about any abnormal profits generated by their directors from insider trading, such as sale transactions. The abnormal gain generated by the directors led to the rise in their own profits by 46.44% as compared to what a normal shareholder would have earned from the same sale transactions. According to study of Nelson (2006) an asset pricing model should regard two areas of concern in its analysis. Firstly, whether the model is well specified in random samples, and secondly, the model is powerful enough to explain stock returns. In the above analysis of the study it is found that the analysis have considered the two areas of study, i.e. the model has been used in the analysis of the random samples in the study with the help of regression, and the model has efficiently explained the results using the American Stock market data. This study also helps to expose the misconception attached with the concept of ? (Beta) in measuring the sensitivity of the price of a security with respect to market movements. In the study regression analysis has been used to analyze the stock market data of the companies and derive the results. The shares of financial institutions and companies in the in the technological sector are exposed to several risks which is represented by their value of ? that is always high among all the other companies. Several types of financial intermediaries such as insurance companies, banks, credit unions, building societies, pension funds, etc perform their activities in the economy. The primary function of a financial intermediary is to bring 2 parties in contact, i.e. one person having a surplus of funds and is looking for a venture where if the investor invests his surplus funds will be beneficial and would yield positive assured returns, and one person who is in need of funds and is in search for an investor who will agree to invest in his venture and the person will be able to borrow funds from him. It is the financial institution with the help of which a lender and a borrower comes in contact with each other and are able to meet their requirements. A financial intermediary, such as a bank, acquires the excess fund of the lender and reconciles it to the borrower at a specified rate of interest. Since this transaction of a financial intermediary is linked to the interest rate, and is thus affected by the interest rates changes in the economy, and faces interest rate risk. Due to this very reason the shares of banks in the stock market are subject to more speculation as compared to the shares of other organizations in the stock market. Speculation in the prices of shares introduces the stock market to volatility, which also leads to the rise of various other types of risks. The presence of insider trading, as an illegal transaction undertaken by the directors of the companies and financial institutions so as to avail personal benefits out of it, can be also partly blamed for the interest rate fluctuation and the volatility present in the stock market. The study shows that the investors who invest in value stocks will be more beneficial as they will receive higher returns as compared to the investors who hold growth stocks. Thus the results were consistent to the findings of the researchers, such as the findings of Fama and French based on the US Market. The study depicts the variation of ? (Beta) over the period of study. The results drawn from this will have its implications on portfolio managers and investors who used to maintain the use of traditional full period CAPM. As ? (Beta) relates to the systematic risk and return, this study would give an opportunity to the portfolio managers of the organizations to recognize the time varying concept of ?. The sensitivity is generally a varying aspect in the in the results of the study. The results in relation to varying ? with respect to time emphasizes the limitation of ? calculated using the ordinary least square method. All securities do not respond equally to the changes in the market index. Some securities are more sensitive to the situation when market index reaches its peak, and less sensitive when the market index is at a moderate level. The expected rate of return varies with time due to the change in ?. Therefore, so as to estimate the expected rate of return in correspondence to the market return the use of regression analysis would be considered appropriate. In 1992 Fama and French proposed that the performance of managed portfolios can be evaluated by comparing their average returns with the returns of benchmark portfolios in the market which are similar in their book-to-market equity characteristics and their firm size. The evidence in the study provides support for the evaluation to clarify the value premiums and returns. These findings will have its implications on the investment strategies and portfolio performance adopted by the portfolio managers of the American companies that are listed in the New York Stock Exchange. Some areas of research have also been kept unanswered in this study. The study did not examine the effect of industry classifications on CAPM, i.e. whether the additional pervasive factors affect the performance of the stock market as per the models. The research of the study was limited to the examination of data based on specific models, i.e. CAPM, and failed to consider other complicated versions of the CAPM, such as Inter-temporal models and its ability in terms of explanation of the returns of the American Stock Market in the US. Future study may be done so as to overcome the limitations of this study. A modest level of disappointment have emerged with the concept of CAPM after the origin of several theories as a result of study of different researchers, which also have questioned on the validity of CAPM as a scientific theory. Inspite of such criticisms and controversies CAPM continues to hold a primary and central place in the works of the practitioners, such as investment advisors, portfolio managers and security analysts, and the researchers of finance. CAPM plays a central role in helping managers of organizations to undertake crucial decisions depending on the stock market conditions in America as well as other countries. CAPM holds a place of durability in the stock market and explains the linear functional relationship of the effects of return due to the variability in the risk factor. Thus the study, inspite of some of its limitations, has been successful in bringing out the objective and the purpose of conducting the research. References 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: August 24, 2013]. Fama, E.F. and French, K.R., 2003. The CAPM: Theory and Evidence. [Pdf]. Available at: http://efinance.org.cn/cn/fm/The%20CAPM%20Theory%20and%20Evidence.pdf. [Accessed on: August 24, 2013]. Bhatnagar, C.S. and Ramlogan, R., no date. The Capital Asset Pricing Model versus The three Factor Model: A United Kingdom Perspective. [Pdf]. Available at: http://sta.uwi.edu/conferences/09/finance/documents/Riad%20Ramlogan%20and%20C%20Bhatnagar.pdf. [Accessed on: August 24, 2013]. Read More