Capital Asset Pricing Model - Assignment Example

?Corporate Finance Table of Contents Capital Asset Pricing Model (CAPM) 3 Parameters of CAPM 5 Application of Capital Asset Pricing Model in Corporate Decision making 6 Outline of Three Factor Model by Fama and French 7 Assessment of CAPM 9 Reference List 11 Capital Asset Pricing Model (CAPM) After Markowitz (1952) had constructed the Modern Portfolio Theory, a large number of models have been developed, which related the excess return of the portfolio with the excess market portfolio returns. In this respect, a popular model designed by Sharpe (1964) and Lintner (1965) had explained this relationship as Capital asset Pricing Model (CAPM). The main idea of this model involves only one risk factor, the excess market portfolio return. In this model, the variation in the excess portfolio return is explained by the covariance of the market portfolio return with the portfolio return. Blume (1993) had suggested that CAPM provides a model of equilibrium risk/return relationship. The CAPM also denotes that there exists a linear relationship between expected return and non-diversifiable systematic risk which is denoted as beta. This linear relationship is denoted as security market line (SML). In SML, the systematic risk of a share is compared with the risk and return of the market as well as the risk free rate of return for estimating the expected return of a particular share (Arnold, 2008; Pike and Neale, 1999). Figure 1 Source: (Ogilvie, 2008) CAPM defines risk as an extent to which the return of the portfolio of shares or a single share has a covariance with the return in the market. If it is assumed that CAPM correctly defines the capital market, then the risk/return relationship can be established for an efficient market strategy. The CAPM equation represents this relationship and expected return is seen to be a function of the following equation: R = Rf + ? (Rm – Rf) Where: R = Expected return on the portfolio or share. Rf = Risk-free rate of return. ? = Beta. It signifies the volatility of the portfolio or the share relative to the market portfolio. Rm = Expected return on the market portfolio. Rm – Rf = Market risk premium (Harrington, 2001; Jones, 1998). Parameters of CAPM The risk-free rate of return: It signifies the return on the asset that has no risk. This indicates that it neither has covariance nor variance with the return on the market. In reality, it is difficult to find an asset of this kind and doubts prevail regarding the actual existence. Various proxies like, treasury bills and government bonds, are used in this stead. However, these proxies are also subjected to inflation and uncertainty and cannot be considered as entirely risk-free (Harrington 2001; Watson and Head, 1998). Return on the market: For CAPM, one of the most important implications is the existence of optimally efficient market portfolio. In theoretical approach, the market portfolio consists of risky assets that are diversified among the portfolios available. Once this portfolio is held, it is not possible to diversify the risk any further. The market return is the return on the market portfolio, including all the risky assets. Unlike risk-free rate, the market return is difficult to estimate. It is approximated by using the indices of the stock exchange as the proxy for the market. However, issues exist regarding the selection of index to be used as proxy. Beta: It is the measure of non-diversifiable risk and relative measure of risk. It is the risk estimation relative to the market portfolios. In simple words, it measures the price volatility of the share or a portfolio of shares and also, how the expected return of the portfolio or the share will react in consideration to the movement of return in the market portfolio (Moyer, McGuigan and Kretlow 2001; Jones 1998). Hence, beta is the measure for the difference between the return of the various portfolios of share or shares (Ward, 2000; Jones, 1998). Application of Capital Asset Pricing Model in Corporate Decision making CAPM argues that total risk is measured by standard deviation and can be segregated into two parts such as, specific risk, which is the risk that can be reduced by diversification and market risk or systematic risk, which cannot be diversified by any means. Specific risk can be reduced by diversification and pertains to a single investment. On the other hand, market risk originates from the economic environment in which an entity operates. CAPM can be used for the estimation of discounting factor required to decide about investment project, based on the systematic risk or market risk of an investment. CAPM is a superior project appraising techniques as compared to WACC. The use of WACC may lead to sub-optimal decision making within an entity, since a single WACC is applied to the entire investment project regardless of the risk associated with the projects (Ross, Westerfield and Jaffe, 2005). A similar situation is illustrated in the figure below: Figure 2 Source: (Ogilvie, 2008) In this case, if WACC would have been considered to accept or reject a project, then project A would have been rejected and project B would have been accepted, incorrectly. For capital budgeting decision, CAPM has proven to play an important role. The rationale here is that the return of the project is linked to the return of the industry or the total asset of the firm, similar to that of the market portfolio or the stock. Therefore, the beta of the firm is used as the beta of the project. After identifying the required rate of return of the project, the next step calculates the NPV. Using the required rate of return, the expected cash flow is discounted and the total NPV is subtracted from the initial investment made towards the project. Finally, this NPV is used to accept or reject a project. It is seen that a project with zero or positive NPV is accepted. In case of multiple projects, one with higher beta is considered to be risky (IMA, 2012). Outline of Three Factor Model by Fama and French The research conducted by Fama and French shows that, the stock of the small firms and those with a high book-to-market ratio have provided returns that are higher than the average return. This can be regarded as simple coincidence, but these factors seem to relate to the profitability of the organization and recognize the risk factors that are omitted in the CAPM model (Hillier et al., 2010). If the investors demand extra return for being exposed to these factors, then the equation below can be referred: r – rf = bmarket (rmarket factor) + bsize (rsize factor) + bbook-to-market (rbook-to-market factor) This model is known as the Fama-French three factor model. By using this, estimated expected return is exactly similar to the arbitrage pricing theory. Step 1: Three factors have been identified by Fama and French that helps in determining the expected return. The return of these three factors is as follows: Factors Measured by Market factor Risk-free interest rate subtracted from return on market index. Size factor Return on the stocks of large-firm subtracted from the return of the stock of the small firms. Book-to-market factor Return on stock with low book-to-market ratio subtracted from return on stocks with high book-to-market ratio. Step 2: This step deals with the estimation of risk premium related to each factor, which highly relies on the history. Step 3: This step deals with the estimation of the factor sensitivities. Some of the stocks are more sensitive than the others due to the fluctuations in the returns from the three factors (Brealey and Myers, 2011). Assessment of CAPM Many of the research scholars have identified that the assumptions in the CAPM model are unrealistic and do not hold true in reality. They are the main cause of flaws in this model (Watson and Head, 1998; Harrington, 1987). The assumption that there is no transaction cost or taxes does not exist in reality. Moreover, the assumption of homogeneous expectations have also raised new doubts since the investors are interested in divergent expectations, which can be applied to varying investment periods that differs in respect to the decision-making process (Levy, Levy and Solomon 2000). Apart from this, the assumptions related to the normally distributed return of share or to the fact that investors are not looking at the downside risk and upside potential and only interested in the variance and mean of the return, is unsatisfactory. Therefore, beta is considered to be an incomplete measure of risk (Ward, 2000; Leland, 1999). Hence, CAPM model has established a connection between expected returns and market covariance risk, with its inherent simplicity. However, the simplicity in its assumptions has limited the ability of the model to predict or explain the actual returns. The Three Factor model of Fama and French has extended the capability of the model by incorporating two company specific risk factors like, the Small minus Big (SMB) and High minus Low (HML) factor. The SMB factor was designed for measuring the additional historical return of the investors that they have received for investing in the stock, which is commonly referred as size premium. On the other hand, HML measures the value premium that is provided to the investors for investing in the firms with high Book-to-market value (Fama and French, 1995). Similarly like, CAPM, the Three Factor model describes the expected return on the assets, resulting from the relationship between the three risk factors like, value risk, size risk and market risk. rA = rf + ?A (rM – rf) + SA SMB + hA HML The coefficient in the Three Factor model has a similar interpretation as the beta of CAPM. ?A is the measure for the exposure of an asset towards the market risk, SA measures the exposure to size risk and hA measures the exposure to value risk. Reference List Arnold, G., 2008. Corporate financial management. New Jersey: FT Pitman Publishing. Blume, M.E., 1993. The Capital Asset Pricing Model and the CAPM literature, in The CAPM controversy: Policy and strategy implications for investment management. New York: AIMR. Brealey, R.A. and Myers, S.C., 2011. Principles of corporate finance. 10th Ed. New York: McGraw-Hill. Fama, E. F. and French, K.R., 1995. Size and book-to-market factors in earnings and returns. Journal of Finance, 50(1), pp. 131-155. Harrington, D.R., 1987. Modern portfolio theory, the Capital Asset Pricing Model and Arbitrage Pricing Theory: A user’s guide. 2nd Ed. New Jersey: Prentice-Hall. Harrington, D.R., 2001. Corporate financial analysis in a global environment. 6th edition. Cincinnati: South-Western. Hillier, D., Ross, S.A., Westerfied, R., Jaffe, J. and Jordan, B., 2010. Corporate finance. 1st. Ed. New York: European Edition. IMA, 2012. Wiley CMA learning system exam review 2013, financial decision making, online intensive review + test bank. New Jersey: John Wiley & Sons. Jones, C.P., 1998. Investments: Analysis and management. 6th edition. New York: Wiley. Levy, M., Levy, H. and Solomon, S., 2000. Microscopic simulation of financial markets – from investor behavior to market phenomena. California: Academic Press. Lintner, J., 1965. The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. Review of Economics and Statistics, 47(1), 12-37. Markowitz, H., 1952. Portfolio selection. The Journal of Finance, 7(1), pp. 77-91. Sharpe, W., 1964. Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19(3), pp. 425-442. Moyer, R.C., McGuigan, J.R. and Kretlow, W.J., 2001. Contemporary financial management. 8th edition. Cincinnati: South-Western. Ogilvie, J., 2008. CIMA official learning system management accounting financial strategy. Massachusetts: Elsevier. Pike, R. and Neale, B., 1999. Corporate finance and investment. London: Prentice Hall Europe. Ross, S.A., Westerfield, R.W. and Jaffe, J.F., 2005. Corporate finance. New York: McGraw-Hill. Ward, M., 2000. The CAPM in an options pricing framework. Investment Analysts Journal, 52, pp. 35-44. Watson, D. and Head, A., 1998. 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