Portfolio Theory and Capital Asset Pricing Model - Term Paper Example

Portfolio Theory and Capital Asset Pricing Model (CAPM) Introduction The kind of investments made evaluates the amount of risk on investments to an investor. Since investors averse risk they always like to be on the safer side by making more payment for safety but getting less in return. Actually risk taking is connected to a greater amount of earnings and to attract investors risky investments offer greater returns. James Bradfield (2007, p167) defines portfolio as an assortment of securities. Portfolio theory actually is nothing but a traditional analysis of the association between risk and returns on risky securities. The theory is useful for investors. It assists them to determine and apportion their funds in securities which are risky thus generating a portfolio. The Capital Asset Pricing Model (CAPM) is a liaison involving risk and return on a portfolio of investments. Sharpe, William F (1964, pp. 425-442) formulated the CAPM hypothesis. It is the groundwork of modern finance which puts forward that the risk premium of a single asset is equal to its beta times the risk premium of the market portfolio on the whole. Beta computes the level of inter-movement of the asset's return and the total return on the entire market portfolio of an investor. Put differently, beta measures the organized risk of an asset which is nothing but the quantity of risk and it cannot be spread. This risk is referred to as "market risk" and the expression for CAPM is as follows: E (Ri) = Rf +i [E (RM) - Rf] Where E (RM) = expected return on a market portfolio i = measure of systematic risk of asset i when compared to market portfolio. Frank J. Fabozzi and Harry Markowitz (2002, p.67) define CAPM as "The anticipated return for an asset according to CAPM is equal risk free rate plus a risk premium". They further state that "even though the idea is not true it does not mean that the constructs introduced by the theory are not important. Constructs introduced in the development of theory include the notion of a market portfolio, systematic risk, diversifiable risks and beta." For computing the beta of an asset, the following market model is applied: Rjt = j + j RMt + ej Where Rjt = return of security j in period t = intercept term alpha j = regression coefficient beta RMt = return on market portfolio in period t ej = random error term The entire movement of the market is enlarged with stocks which possess betas greater than 1.0. Stocks which have betas between 0 and 1.0 are inclined to go in the same route as the market. Certainly, the market is the collection of all stocks, and hence the standard stock has a beta of 1.0 Risk is best adjudicated in the context of a portfolio of securities. Part of the ambiguity about a sureties return is branched out when security is sorted with other assets in a portfolio. It can be said that diversification is the best for the investors undoubtedly. This does not entail that business firms have to diversify. Corporate variegation is superfluous if capitalists can broaden on their personal account. Frank J Fabozzi and Pamela P Peterson (2003, p 299) state that "Though it lacks realism and is difficult to apply, the CAPM makes some sense regarding the role of diversification and the type of risks we need to consider in investment decisions." When an asset does contain a factor of market risk, CAPM submits that it should make a risk premium impartial to the sum of market risk mused in the asset. If the fundamental market has an amount of return vagueness, it can be assumed that the market return will be greater than the risk gratis return. This is the surplus market return. To obtain the additive surplus return, the marked is levered with the market return either up or down by the level of market risk disclosure intrinsic in the asset (Bruce J Feible, 2003, p. 192). The most frequently used gauge of risk or unpredictability in finance is standard deviation. This is because 'the return on a portfolio is a weighted average of the returns of individual assets' (Lawrence J Gitman, 2006, p.238). For instance if 50% of collection of assets is committed in 'A' a stock of a firm with anticipated rate of return of 20% and the balance is committed in 'B' anticipated to render 17% on investment; then the anticipated return on the portfolio of shares an stocks is merely a weighted mean of the anticipated return on the item-by-item assets computed as under: Expected portfolio return = (0.50 * 20) + (0.50 * 17) = 10.85% It is crucial to mention that when there are 2 assets in the collection then there will be the same number of variances and covariance when computing standard deviation. When the number of assets in the portfolio is large then the number of covariance is greater than the number of variances. Thus the unpredictability of a well distinct portfolio ponders chiefly on its covariance. Shrewd capitalists never always place all their eggs into a single basket: they try to decrease their risk by variegation. They are concerned about the impact that each asset might have on the risk in their portfolio. Thesis Statement The fundamental judgment is that the capitalists approximate generally the risk of the savings in the marketplace. Their inclination is in the direction of portfolio of investments and not on a single investment. The underlying theory which links risk and returns is the CAPM theory. The CAPM serves to perceive the key risk-return trade-offs involved in all events of financial decisions (Lawrence J Gitman, page 246). CAPM theory and Portfolio management CAPM formulated by Sharpe (1964) and Lintner (1965) broadened the Markowitz average-variance portfolio choice standards in the capital asset pricing model. They equated an individual surety's returns proportional to the returns on the market portfolio which included all the assets so invested. The implication of the CAPM is that the variance of a benefit's returns, and the ensuing risk degree, can be deduced from two sources: (1) Market (or) systematic risk which in reality has its impact on all assets; (2) Specific firm risk can be done away with by an investor by way of portfolio diversification. The CAPM model functions on some suppositions. Some of these assumptions have been keyed out as being either unrealistic or irrational (Roll, 1977; Akintoye & Ashaolu, 2008 and Palmitar, 2003). The CAPM model portrays the market value which has already being anticipated. It also depicts the rate of return prevalent in the market for a certain stock with regard to its predictable risk which cannot be diversified. The model is based on mathematical and economical models and the one which can be availed to compute stocks and relate it to the anticipated risk and the awaited return. Based on the model capitalists admit added risk when they are sheltered under additional returns. The anticipated risk is actually split into two: i. Those risks which are diversifiable and hence known as unsystematic; ii. Those risks which is not diversifiable and hence known as systematic. The unsystematic risk is of micro nature affecting a specific firm or industry only. This kind of risk can be ignored by the capitalist by not investing in such stocks and shares of the firm. But with regard to the systematic risk which is macro in nature lays its impact on all the firms operating in the economy. This kind of risk cannot be annulled by the investors as they form the anticipated risk part of the capitalist. Thus these type of securities will have to attract the investors by paying high rate of return which would make good the risk taken (Sadowsky, 2006). In fact the assumptions of CAPM are not realistic. For instance the model assumes that the market is a perfect one. Information flow is not obstructed and every investor can avail the same information simultaneously. Such market prices cannot be overcome by the investor. In reality the market is never a perfect one. This actually makes the model an unsuitable one. Also this model will not work under any market conditions where absence of effective information prevails. Quite a few studies disagree that the model is not tested by trial and error (Engle, 1982; Bollerslev, 1986 & Palmitar, 2003). The competent boundary The (Markowitz, 1999) efficient frontier, CAL stands for the capital allocation line. The CAPM presumes that the risk-return feature of a portfolio may be maximised. In reality the best portfolio exhibits the least possible degree of risk for its point of return. Moreover, since each supplementary asset brought into a portfolio further broadens the portfolio, the best portfolio must include every asset. All such best portfolios, one for every stage of return, involve the efficient frontier (Markowitz, 1999). Irregularity of information in Asset Pricing The CAPM method has many blemishes in it and one among them is theory of information homogeneity available to all investors. But this can never take place in real life experiences. Investors are not able to access same info at the same time which means that they have access only to heterogenic information. Since the investors in a market have access to a varying level of info regarding the quantity of even the quality of info then such information is known as asymmetry. This situation entails the investors to recognise the same product in different ways (Lensink & Sterken, 2000). In fact the rating of an asset is a dual function. It in reality relates to the ask-bid cost offerings. The marketer or the emptor establishes an offer subject to the available information with regard to the asset and the market for such securities. The amount of info available to the investor or the seller helps in deciding the quality of the asset price. This also helps them to take a decision. The importance of asymmetry information in the financial market is also important to an investor (Rothschild & Stiglitz, 1976; Leland & Pyle, 1977). A conjectural and observational research was conducted to find out about the implications of imbalance in the information available for the rates of the same kind of assets in a portfolio. This research was undertaken by Biais, Bossaerts and Spatt (2005). They revealed that capitalists' portfolios are an expression of the info at their disposal. The investors who are not informed get their information from the prices prevailing in the market. The discovery of Biais, Bossaerts and Spatt (2005) that uninformed capitalists inferred information from asset costs is logical and is in agreement with general reason that asset prices are fixed established on accessible info about the asset. According to Frank J Fabozzi and Pamela P Peterson (2003, p.299) "CAPM is not testable. The market portfolio is theoretical and not really observable, so we cannot test the relation between expected return on an asset and the expected return of the market to see if relation specified in CAPM holds." Only exceptional risks are considered by CAPM and market dangers are not at all covered. John Ogilvie (2007, p.185) states that CAPM presumes that risk can be covered in a solitary figure and that is beta. Critics disagree with the fact that it is not essentially logical to gauge risk merely in terms of inconsistency of portfolio returns (Peter J Booth, 1998, p97). Conclusion CAPM as initially formulated was merely an idea and it was not developed as a perfect technique for best asset prices. This model has paved way for further research work. The future research work has to formulate a perfect pricing technique which can be tested by a trial and error method. The prefaces on which the CAPM was dependant were impossible. This model of pricing of assets were actually formulated where the information in the market were not effective. Where the asset pricing environs for asset pricing were incompetent the allotment of resources for the investors were not optimized. The reason being, that the suppliers of finance will not be willing to accept return which is not in proportion to the associated organized risk. It is as a result, desired that the changed model would furnish an improved technique for integrating all market info linked to the asset prices. It is pragmatic that variegation decreases risks and consequently logical for capitalists. John Mauldin (2005, P 93) states that "If an investor is diversified in accord with the theory, then CAPM indicates that the percentage of returns that is due to the market should be 100 per cent. As a result, effective diversification under CAPM should provide investors with investment returns that are consistent with market returns." The unpredictability of stocks demonstrating distinctive risk can be annihilated by variegation, but variegation will not help in eliminating market risk. Reference 1. Akintoye, Ishola Rufus and Taiwo Ashaolu, "The Effect of Misinterpretation on Trading Volume in an Informational Efficient Market", European Journal of Social Sciences, Volume 5, Number 4, 2008 2. Biais, B. Peter Bossaerts and Chester Spatt, "Equilibrium Asset Pricing and PortfolioChoice under Asymmetric Information", Institut d'conomie Industrielle (IDEI), IDEI, 2005; Working Papers, 474. 3. Bollerslev, T. "Generalised Autoregressive Conditional Heteroscedasticity" Journal Of Econometrics 1986; 31. 4. Bruce J Feible, Investment Performance Measurement, John Wiley and Sons, 2003, page 192 5. Engle, R. F. "Autoregressive Conditional Hetroscedasticity With Estimates of UK Inflation" 1982; Econometrica 50 6. Frank J Fabozzi and Pamela P Peterson, Financial management and analysis, John Wiley and Sons Inc., 2003, page 299 7. James Bradfield, Introduction to the economics of financial markets, Oxford University Press S, 2007, page 167 8. John Ogilvie, CIMA Learning System 2007 Management Accounting Financial Strategy, Elsevier, 2007, page 185 9. John Mauldin, Just One Thing: Twelve of the world's best investors reveal with one strategy, John Wiley and Sons, 2005, Page 93 10. Lawrence J Gitman, Principles of Managerial Finance, Pearson Education, 2006; page 247 11. Lensink, Robert and Elmer Sterken, "Capital Market Imperfections, Uncertainty and Corporate Investment in The Czech Republic", Economic Change and Restructuring, Springer, 2000; vol. 33(1-2). 12. Leland, Hayen E. and David H. Pyle, "Informational Asymmetries, Financial Structure, and Financial Intermediation", Journal of Finance, 32, 1977. 13. Lintner, J., The valuation of risk assets and selection of risky investments in stock portfolios and capital budgets, Review of Economics and Statistics 47 1965: 13-37. 14. Markowitz, Harry M. The early history of portfolio theory: 1600-1960, Financial Analysts Journal, Vol. 55, No. 4, 1999. 15. Palmitar, Alan R. "Capital Asset Pricing Model", Law & Valuation, School of Law, Wake Forest University, 2003; www.wfu.edu/-palmitar/Law&Valuation. 16. Peter J Booth, Modern Actuarial Theory and practice, Part I, CRC, 1998, page 97 17. Roll, Richard, "A Critique of the Asset Pricing Theory's Tests. Part 1: On Past and Potential Testability of the Theory," Journal of Financial Economics, Vol. 4, 1977. 18. Rothschild, M. and J. Stiglitz, "Equilibrium In Competitive Insurance Markets: An Essay on The Economics of Imperfect Information", Quarterly Journal of Economics, 90, 1976. 19. Sadowsky, J.R. "Learning By Investing With Market And Technical Uncertainty: A Real Options Approach" 2006; A Dissertation Submitted to The Department of Management Science And Engineering And The Committee On Graduate Studies Of Stanford University In Partial Fulfillment Of The Requirements For The Degree Of Doctor Of Philosophy. 20. William F. Sharpe, Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risks; Journal of Finance (September 1964); pp.425-442. Read More