Foundations of Finance - Term Paper Example

Table of Contents Introduction 2 Description and Usefulness of the Capital Asset Pricing Model (CAPM) 3 The CML and the SML 4 CML 4 SML 5 Usefulness of CAPM 5 Explanation of Variables of the CAPM equilibrium equation 7 Explanation of Beta Factor 8 Advantages of Beta 8 Weaknesses and Limitations of CAPM 10 Conclusion 11 References 12 Bibliography 14 Introduction The research paper is an in-depth analysis of the Capital Asset Pricing Model and the discussion will relate to various intricacies of the model. The objective of making such an in-depth analysis is to validate the model and represent whether it can be stated as an appropriate model to explain return on a security or not. The discussion will start with a general explanation of concept underlying CAPM; and the areas or fields where it is useful will be determined. Subsequently, with respect to the ultimate equation of the model, each variable will be explained. The followed discussion will be on in-depth explanation of the β factor in the equation of the model. The purpose of the paper will hopefully be fulfilled by discussion on these related issues to the model. Description and Usefulness of the Capital Asset Pricing Model (CAPM) CAPM was developed during the mid 1960s with several assumptions about the market and the behaviour of investors, giving certain equilibrium conditions which allow an investor to calculate the return of an asset for a given level of systematic risk. CAPM makes use of a measurement of systematic risk which can be used to make a comparison of other assets in the market. In order to arrive at the equilibrium condition of CAPM, certain assumptions have to be defined: Investors tend to maximise expected value of assets All investors have homogenous expectations and invests on the same optimum portfolio Market is free from friction where the borrowing and lending rate are equal Many investors are there in the market and the individual endowment on investment is small compared to the entire endowment of all the investors All the investors hold money for the same period of time There are no transaction costs and taxes in the market (Taylor, 2005). CAPM is a model by which the relationship between the risk and expected return on an asset can be determined and this is widely used in pricing of risky securities. The equilibrium condition of the CAPM is as follows: Ei = Rf + (Em – Rf) βi Where Rf is the rate of risk-free asset Βi is the beta of the security Em is the expected return on the market portfolio The concept of CAPM starts with a risk-free rate (may be yield on a 10 year government bond). With this concept, a premium is added which is equity investor’s demand for compensation on holding an extra risk. This premium is also known as the equity market premium which is calculated as expected return from the market less the return on risk-free asset. This premium is then multiplied by a coefficient called ‘beta’ (McClure, 2010). The CML and the SML CML (elgingroup.com) In the above figure, the efficient frontier is the line which consists of optimal portfolios and is created from the risk-return graph. The Capital Market Line (CML) is a tangent drawn from the intercept point on efficient frontier to the point where the risk-free rate of return is equal to the expected return. The CML is better than the efficient frontier because it considers risk-free asset in the portfolio (Investopedia, 2010). SML (duke.edu) The SML is a line that shows the systematic risk and whole market return at a certain point of time and this line shows the entire risky assets. The SML is very useful in evaluating the expected return on an asset for a specific amount of risk that is involved (Investopedia, 2010). Usefulness of CAPM The CAPM is a very useful tool in stock pricing. Through SML, a fair return and thus the price of a stock can be measured for a given level of risk, beta. Plotting securities on the graph with standard deviation or risk on the x-axis and expected return on the y-axis, security’s prices can be evaluated. If an asset is plotted above the SML, the security is considered to be underpriced that gives a higher expected return that is anticipated by SML. Again if the security is plotted below the SML, then it is considered to be overpriced because it would yield a lower return than what has been predicted by SML. CAPM also proves very useful in budgeting decisions because it provides the required rate of return on an asset. The asset can be an investment project and given its level of risk, investors can use CAPM for evaluating the project’s acceptability (University of Maryland, n.d.). CAPM is also useful in establishment of an appropriate return for a regulated monopoly. The expected rate of return, in a monopoly market, is the equity cost of capital and thus it affects the price which is charged in the market (Shapiro, A., 2010). Explanation of Variables of the CAPM equilibrium equation The equilibrium equation of the CAPM is: Ei = Rf + (Em – Rf) βi Or, Expected return on security = Return on risk-free asset + (Expected market risk premium) * Beta The term in the left side of the equation is the ultimate rate which the investor expects to earn on a security which is actually measured by the three term sin the right hand side of the equation. The first term is the rate of return that is earned by the investor by investing in a risk-free asset. The risk free asset can be any kind of government bond on which the return is certain and thus the investor calculate it as the amount that is mentioned as a percentage of return during initial investment. The second term in the first bracket is a premium which the investors hope to earn as an additional amount for holding a risky asset. It is calculated as difference between the expected return on a market portfolio and the risk-free asset. This is calculated in this way because it is the additional amount which the investor earns by investing in the risky portfolio. The third term is the beta that appears as a multiple to the premium. It is the overall risk that investors bear for investing in a large market. Beta is that risk of a stock which is arrived at by comparing the risk of the overall market (Sharpe, 2010). Explanation of Beta Factor Beta is the measurement of a security’s explosive nature in the market or rather it is the systematic risk associated with a security. It is considered that the beta of market is 1 and stocks are ranked according to their deviation from the market. If the movement of a stock is more than the market, then its beta is considered to be more than 1 and if the movement is less, then beta is considered to be less than 1. Beta is used as a useful component for calculating cost of equity. For higher beta, the company’s cost of capital will also be higher. Advantages of Beta For the investors who follow CAPM for investment, beta is a very useful measure. For assessment of risk associated with a stock, it is very essential to measure its variability and beta offers a comprehensive approach towards measuring the variability. Beta provides a quantifiable measure with which evaluation of stocks become easy. This is because it can be directly used for calculating cost of equity in a valuation method that provides the discount rate for cash flows. The assets that have higher beta are termed to be more sensitive to the market and thus by calculating beta, investors can effectively take investment decisions (Wang, 2003). Weaknesses and Limitations of CAPM There are certain flaws of the model as well, besides being accepted as an appropriate model for expected return. Firstly, it is criticised on the ground that it ignores those investors who are ready to earn a lower return for taking higher risk. The assumption that investors favour higher returns to lower and lower risk to higher is not realistic due to ignorance of the other category of investors. CAPM is also criticised on the ground that it cannot explain variation in stock returns. In 1969, a paper was presented by Myron Scholes, Michael Jensen and Fisher Black that suggested stocks with low beta may offer increased returns than what would be predicted by the model. In the CAPM, beta is calculated based on the past historical data. The market in the present world is dynamic and the stocks that demonstrated less volatility can become extremely volatile due to certain changes in the market conditions. Conclusion From the various discussion made on the CAPM, it can be stated that the model, over the years, has been able to provide fruitful results for the investors. Most of the factors considered during calculation of the expected return are realistic except a few. Moreover, its popularity itself measures the amount of validity it holds. In the paper, almost all the factors of the model have been taken up and adequate discussions have been made. The discussions are related to the aspects considered by investors for taking investment related decision based on the CAPM. The findings of the research on this paper state that CAPM is a valid model and can be effectively used for explaining expected return on a security. References Investopedia, 2010. Capital Market Line. Terms. [Online] Available at: http://www.investopedia.com/terms/c/cml.asp [Accessed December 14, 2010]. Investopedia, 2010. Security Market Line. Terms. [Online] Available at: http://www.investopedia.com/terms/s/sml.asp [Accessed December 14, 2010]. McClure, B., 2010. The Capital Asset Pricing Model: An Overview. Investopedia. [Online] Available at: http://www.investopedia.com/articles/06/CAPM.asp [Accessed December 14, 2010]. Shapiro, A., 2010. The Capital Asset Pricing Model. Foundations of Finance. [Online] Available at: http://pages.stern.nyu.edu/~ashapiro/courses/B01.231103/FFL09.pdf [Accessed December 14, 2010]. Sharpe, W. F., 2010. Capital Asset Pricing Model CAPM. Value Based Management. [Online] Available at: http://www.valuebasedmanagement.net/methods_capm.html [Accessed December 14, 2010]. Taylor, B., 2005. An Empirical Evaluation of the Capital Asset Pricing Model. Fundamental of Finance. [Online] Available at: http://economics.fundamentalfinance.com/capm.php [Accessed December 14, 2010]. University of Maryland, No Date. The Capital Asset Pricing Model. Department of Economics. [Online] Available at: http://econweb.umd.edu/~trandafi/econ435/Chapter_09_4spp.pdf [Accessed December 14, 2010]. Wang, J., 2003. Capital Asset Pricing Model. Lecture Notes. [Online] Available at: http://web.mit.edu/15.407/file/Ch11.pdf [Accessed December 14, 2010]. Bibliography Arnold, G., 2002. Corporate Financial Management. Prentice Hall / Financial Times. Bromwich, M., 1979. The Economics of Capital Budgeting. Pitman. Sharpe, W. F., 1970. Portfolio Theory and Capital Markets. McGraw-Hill. Read More