Capital Asset Pricing Model - Assignment Example

? Capital Asset Pricing Model (CAPM) and Capital Asset Pricing Model (CAPM) CAPM is a financial theory that aims at calculating the yields of a stock while taking into consideration the risk of the asset. The hypothesis argues that the expected return on an asset is linearly related to the systematic risk and the risk free rate of return, multiplied by the hazardous premium (Ma, 2011). Thus, CAPM predicts that the risk that faces businesses is the market or systematic hazard, which is unavoidable. The market risk in unavoidable because it affects all businesses simultaneously, meaning that companies cannot diversify their products and services to avoid the hazard. CAPM has theoretical limitation, which include impractical assumptions and instability of the beta values. The Arbitrage Pricing Model and Rolls have criticized the theory indicating that it may be unreliable and invalid. This study will examine the theoretical limitations and criticisms of the theory. Theoretical Limitations of the Theory The theory argues that all investors are risk avoiders and that the returns are normally distributed (Ma, 2011). This is not the case because investors are normally risk takers who are willing to make huge returns when their predictions favor them and lose when they fail. Assuming that returns are normally distributed is also unfounded because investors are not usually sure of the yields on their assets (Ma, 2011). The assumption that assets are free from risk is also unrealistic because it is hard to find such stocks in the real world. The theory argues that short-term securities offered by the government are free from hazards because the state assures investors certain returns on the assets. This is not the case because the risk on the assets is in the form of inflation, which is the instability of prices in the market (Ma, 2011). Inflation leads to the loss of value of money, and this means that, assets also lose their worth when prices rise in the economy. Since money loses its value then it means that investors face the risk of lower returns when their stock matures. For example, when the state pays 10% on its short-term bonds then inflation rises in the country by 2%, investors get 8% returns on their securities in real terms. This means that investors face the risk of inflation, which reduces their earnings. This also indicates that the CAPM model is applicable in an ideal world, an occurrence that is impossible (Ma, 2011). Roll’s Critique of CAPM Roll criticizes the validity of the Capital Asset Pricing Model equation. The equation is as indicated below: E(Ri) =RF +?i [E(RM) - RF] Where E(Ri) represents the yield on security i. RF is the risk free rate of return. Bi is the market risk that security i faces. Roll’s first critique was that the model could not be tested using current data because it is constructed based on historical data. The impossibility of testing the model arises from the fact that it is based on market values of stocks, real estates, jewelers, and labor. Rolls argue that it is impossible to find the market value of this portfolio because no accurate data of these factors exists in reality. Thus, Roll argues that the CAPM cannot be proven right or wrong because of the impossibility of getting accurate data (Ma, 2011). Roll argues that economic models should be easy to test using future data because they simplify the real life. However, according to him, CAPM is complex because of the inability of being tested using future data, and this makes it unreliable. Roll also postulates that it is impossible to get efficient stocks whose values and rates of return have linear relationships ideally (Ma, 2011). Therefore, Rolls argument generally argues that CAPM is unreliable because it has never been tested using real data, and it is still impossible to do so because of uncertainty of prices, which is common in the real world. Arbitrage Pricing Model (APM) The APM addresses the weaknesses of CAPM by doing away with the assumption that the value of assets is determined only by the risk free rate of return. APM argues that stock values depend on numerous factors, and as such, the hypothesis introduces an error term in the formula for determining the value of assets. The theory argues that the factors that affect the value of an asset include inflation and level of gross domestic products in a country (Ma, 2011). The error term takes care of the unobservable effects of these factors on the price of assets. This makes the theory more realistic and reliable than CAPM in the real world. The hypothesis also eliminates the vague assumptions of normality in the distribution of asset returns. Investors are also risk takers in that their choice of asset depends on numerous factors rather than only the return on asset. This is because APM assumes that rational investors chose their investments depending on returns and level of risk of each stock. This assumption is in line with the economic assumption that rational consumers aim at maximizing their utility (Ma, 2011). This makes the theory to be based on the real world more than CAPM, which is applicable only in an ideal planet. The fact that APM is testable using future data also eliminates the criticisms of the theory, which Roll puts forward. APM is tested using regression analysis, a forecasting technique that takes into account human errors using the error term. The consideration of the error term makes the model more accurate, hence reliable than CAPM (Ma, 2011). CAPM is a financial model that measures the value of portfolio by assuming that it depends on the risk free rate of return only, and that investors are risk averse meaning that they avoid hazardous portfolio. The main weaknesses of the model are its assumption, which are unrealistic in the real world. Roll criticizes the model on the basis that it is impossible to test because of the consideration of market assets that are hard to value. The APM model eliminates the weaknesses of vague assumptions and untestability by assuming that investors are risk takers, the value of assets depend on numerous factors that affect the economy, and that the returns on assets are not usually normally distributed. APM is testable using regression analysis that takes care of the errors, meaning that it is more realistic and reliable than CAPM. Reference Ma, C., 2011. Advanced asset pricing theory. London: Imperial College Press. Read More