Capital Asset Pricing Model - Essay Example

? Capital Asset Pricing Model and Table of Contents Introduction 3 The Background of Companies4 Woodside Petroleum 4 Santos Limited 4 Oil Search Limited 4 Aurora Oil & Gas 5 Beach Petroleum Limited 5 Literature Review 5 Methodology 7 Specification of the Model 7 References 10 Capital Asset Pricing Model Introduction Financial managers use the capital asset pricing model (CAPM) to determine a theoretically required rate of return of an asset. This model considers the asset’s sensitivity to systematic risk and the expected rate of return of a theoretical risk-free asset (Malz, 2011). The capital asset pricing model is founded on the assumption that beta (?) determines the investor’s cost of equity capital. Jack Treynor introduced the concept of the capital asset pricing model to build on diversification and modern portfolio theory introduced by Harry Markowitz (Levy, 2011). Capital asset pricing model is simple to use; this has made it possible to retain popularity despite the modern approaches to asset pricing and portfolio selection. This financial project aims at analyzing a given equally weighted portfolio, which constitutes five types of stocks listed in the Australian Stock Exchange. The project will measure the rate of return on securities of Woolside Petroleum, Santos, Oil Search, Aurora Oil & Gas and Beach Petroleum. The systematic risk will be determined using Beta as the basis of measurement. The project will also evaluate the performance of the selected stock using the capital asset pricing model. The result from the analysis is beneficial to both current and prospective investors when making investment decisions. The analysis will also enable investors to decide whether to add their investment assets to the existing portfolio by finding non-diversifiable risk in the investments. The project will consider thirty-six observations consisting of monthly rates of return between January 2010 and December 2012. This will act as a representative sample for estimating the risks involved in each class of stock. Prior to estimating the capital asset pricing for the selected portfolio, the model will be tested for each stock. The Background of Companies Woodside Petroleum Woodside Petroleum Limited explores and produces petroleum in Australia (Roth, 2011). Woodside is Australia’s largest independent and dedicated oil and gas company with headquarters in Perth, Western Australia. The company is listed on the Australian Securities Exchange. Woodside focuses on the exploration, assessment, development, processing and supplying relative products and services. Santos Limited Santos limited produces and supplies oil and gas to its Australian and Asian customers. The origin of Santos is traced back to Cooper Basin since the year 1964 (Roth, 2011). The company is one of the largest suppliers of oil and gas to the domestic and foreign markets. Presently, Santos has an exploration-led Asian portfolio focusing on three countries including Papua New Guinea, Indonesia and Vietnam. Santos focuses on explorations, exploiting, processing, transportation and marketing of hydrocarbons. The company has over 3,000 employees in Australia and Asia. The foundations of Santos are based on sustainable operations and collaborating with host communities, business partners and shareholders. Oil Search Limited Oil Search Limited is Papua New Guinea’s largest oil and gas producer, which was incorporated in the year 1929. The company has a 29% interest in the world scale Papua New Guinea (PNG) LNG project (Roth, 2011). Oil Search Limited is a public listed company on the Port Moresby and Australian stock exchanges. The Independent State of Papua New Guinea holds 15% of the company’s interest, and this is the largest shareholder in the company. Oil Search Limited has launched exploration activities in Papua New Guinea, Kurdistan, Tunisia and Yemen. Aurora Oil & Gas Aurora Oil & Gas Limited, founded in 2005, is an Australia based oil and gas exploration and production company, which explores and produces in North America. The company is listed in Australian Stock Exchange as ASX: AUT and TSX: AEF in Toronto Stock Exchange. Aurora Oil & Gas Limited produces oil and gas for its markets in Texas, North America (Roth, 2011). Beach Petroleum Limited Beach Petroleum Limited is an oil and gas exploration company based in Adelaide in South Australia. The company has oil and gas reserves amounting to 77 million barrels with contingent resources of 467 million barrels of oil equivalent (Roth, 2011). Beach Petroleum Limited has an active program for drilling within a well balanced portfolio of tenements. Literature Review The capital asset pricing model is founded on two-parameter portfolio analysis, which was developed by Markwitz in the year 1965. Other later independent developers of the CAPM include Sharpe William in 1964, Linter John in 1965, Mossion Jan in 1966 (Ausma, 2008). The capital asset pricing model is a centerpiece of the modern financial economic and accounting. The model offers a precise prediction of the relationship between the risk and the expected rate of return. This relationship is crucial since it provides a benchmark rate of return for evaluating prospective investments. The model enables investors to make independent predictions regarding the expected return on assets that have not been traded in the market place. Historically, the capital asset pricing model has been used for pricing initial public offering of stock, effects of a new investment on the expected rate of return and investors’ required rate of return. The capital asset pricing model does not fully withstand the empirical test. This model is, however, popular among financial managers and investors because of its accuracy and insight. Asma (2008) carried out a study with the objective of empirical evaluation of the capital asset pricing model. The general objective of the study was to measure the return on securities of technology companies including HCL Technologies, Tata Consultancy Services Limited, Wipro and Infosys. The researcher evaluated the performance of stock using the capital asset pricing model. The sampling for this study included historical closing values of S & P Nifty index value between March 3, 2005 and March 3, 2010 (Ausma, 2008). Data from the study was analyzed by using Beta, expected market return, and security market line. The researcher calculated Beta using SPSS and represented the findings as shown in the table below. Firms Expected Return Beta Wipro Technologies Limited 16.4424 0.4351 HCL Technologies Limited 18.672 0.5289 Tata Consultancy Services Limited 9.4848 0.1452 Infosys Technologies Limited 19.5072 0.5628 Source: (Asma, 2008) The researcher found out that most investors are risk averse. They thus attempt to maximize their wealth at the minimum risk possible. The investors strive to understand the various pitfalls in the investment opportunities. Financial analysts ensure the convenience of investors by measuring risks (Levy, 2011). This enables them to be able to combine securities and reach the portfolio that that most appropriate for investors’ risk measured by Beta test. The capital asset pricing model uses the concept of Beta to risk to study the expected rate of return to investment. A risk is associated with the possibility of realizing lower returns than the expected returns. Investors are risk taking since no one can define the outcomes investments due to prevalence of external and internal constraints. There are two types of risks that are considered under the concept of the capital asset pricing model. These include systematic risk and unsystematic risk (Levy, 2011). Systematic risk is non-diversifiable, meaning that the risk is common to the entire class of assets and liabilities. Systematic risk is usually associated with economic, legal, political and sociological consideration in relation the market for securities. Unsystematic risk is unique to a firm or industry and does not affect the average investor. Methodology Specification of the Model This research paper used the capital asset pricing model to estimate the return on assets of five selected Australian limited companies. The assumptions of the model include: 1. The aim of the investors is maximizing economic utilities. 2. Investors can lend and borrow unlimited amount of money under the risk-free rate of interest. 3. All investors access the same information simultaneously. 4. Investors cannot influence prices since they are price takers. The basic equation for CAPM is: R i= R f+?i (Rm-Rf) The variables included in this model are R I, R f, ?i , Rm and Rf, where: R i=the expected rate of return R f=the risk-free rate of return ?i =the sensitivity of the excess returns on assets to the excess market returns Rm= the market return on portfolio Rf= the risk-free rate of interest Beta represents the ratio of the covariance of return of a risky portfolio to the market return variance. Beta also measures the sensitivity of the portfolio to the overall market movements. This equation can be re-written as: R i= R f+?i (Rm-Rf) R i= R f + ?i Rm- ?i Rf R i- R f = ?i Rm- ?i Rf R i- R f = ?i (Rm- Rf) ?i = R i- Rf/(Rm- Rf) (R i- R f) represents individual excess returns and (Rm- Rf) represents the market excess return. This indicates that the excess returns are contingent upon the risk free rate and the market return. Testing the model empirically using econometric techniques requires the equation to be re-written as (Ri- Rf) = ?+ ?(Rm- Rf) + E. This will make it possible for transformation of the equation into ri = ?0 + ?i?i + E, where: i) ri = Ri - Rf (the excess return of the risky portfolio in relation to the risk-free asset) ii) ?0 = the point of intersection of the regression model iii) ?i = Rm- Rf (the excess return of the market portfolio also called the market premium) iv) ?i= the gradient of the corresponding regression lines v) E = error term The expected significant of the coefficient ? is positive, which implies that the excess return on stocks of a portfolio is directly proportional to the excess return of the market. The process of evaluating the capital asset pricing model on the given portfolio requires the researcher to follow the steps below: 1. Test whether the model is supported by the data. 2. Calculate the excess demand and premium for the five selected stocks. 3. Estimate the Betas and test their statistical significance using the P-value and the T-tests 4. Use the R-squared and the F-test to determine the statistical significance of the model as a whole 5. Test normality of the data since all the hypothesis tests are based on the assumption that errors are normally distributed. The capital asset pricing model will pass the test if the P-value of the T-test values are greater than 0.05. Passing the 95% confidence level implies that it is not possible to reject the null hypotheses. References Asma, S. J., 2008. A study on Empirical Testing of the Capital Asset Pricing Mode: a case study of Five Technology Companies. Hassan: Haranahalli Ramaswamy Institute of Higher Education. Levy, H., 2011. The Capital Asset Pricing Model in the 21st Century: Analytical, Empirical, and Behavioral Perspectives. Cambridge: Cambridge University Press. Malz, A. M., 2011. Financial risk management: Models, history, and institutions. Hoboken, N.J: Wiley. Roth, M., 2011. Top Stocks 2008: A Sharebuyer's Guide to Leading Australian Companies. Milton, QLD: Wiley. 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