Capital Asset Pricing Model and its Practical Use - Essay Example

CAPM and its Practical Use Definition of CAPM: Measuring costs and returns is an essential task of any finance manager at any organization.The proposed model for all these calculation is CAPM i.e. Capital Asset Pricing Model. This is the best and the easiest model for making such calculations. At first the model of CAPM was introduced by Jack Treynor. The acronym for CAPM is Capital Asset pricing Model. In finance the Capital Asset Pricing Model is used widely for determining required rate of return on the assets. Though currently many models are also introduced for this purpose which may include Arbitrage Pricing Theory and Mentor’s portfolio Problem, but still many investors use this old CAPM because of its reliability. CAPM is popular because of its simplicity and utility at various problems. CAPM is used to quantify the risk associated with the assets and then translate it into the returns associated with the securities (Mullins 2012). CAPM is actually used to make calculations of a single security. The formula is very simple which is used in calculations. It includes the expected return on the capital assets, risk free rate of interest, market risk which is denoted by beta, market premium and the risk premium. Now the description of all of these components is given as follow; Risk free rate of interest is the rate applied on Government securities Beta is the sensitivity of the expected asset returns Market premium is the difference between expected market return and risk free rate of return. Risk premium is actually the market reward to risk ratio. The formula of capital asset pricing model is E (Ri) =Rf + βi (E (Rm) – Rf) Here beta or the market risk is very important. Every company also has its own beta value which is useful for every type of calculations. A specific company’s beta value means the risk associated with the company but in comparison with the whole operational market. But when we talk about beta in capital asset pricing model i.e. CAPM then it means the market risk which any company must face during their cost and return calculations. By definition the value of beta is equal to 1.0. Assumptions of CAPM: Usually we have to set certain assumptions while observing any theoretical model in the real life matters. Same is the case with capital asset price model; these are given as All the investors are rational and risk averse. The portfolio is fully diversified across a wide range of securities. Investors are price takers always. No taxation or trade cost will be applied. All the investors in the market are well informed about available information. The assets are perfectly liquid in the market. The application of CAPM gives its best results when all of the above assumptions are met in an appropriate environment. These assumptions are made regarding a generalized conditional environment. Whenever any specific different situation may come and the investor may feel any difficulty then the researchers start their duty and find any other way to solve the problem. Therefore we may see certain modified versions of theories and models. The basic theme and assumptions of these theories and models is same only the operational side may be modified according to the situations. Some critics are of the opinion that CAPM assumptions are totally unrealistic, but still there are many supporters of this model of capital asset pricing model. Advantages: From the very beginning (i.e. just after introducing CAPM), the financial companies are using this model for their calculations. The results of the CAPM model truly depict their portfolio performance and the cost of capital. There can be various other methods or ways to calculate the riskiness of the assets but CAPM is usually preferred over others. The reason behind the extensive use of CAPM might be that there were no models or theories before this capital asset pricing model. Managers and companies really face problem for the calculation of the market risk, cost of their equities and the most important the associated rate of returns along with the CAPM has many advantages and popularity over many other return calculative models and formulas. CAPM include only systematic risk in its calculations because diversification of portfolio is an essential assumption for the investors therefore it is also pre-assumed that all the un-systematic risk will be diversified and then eliminated. A relationship is built between return and systematic risk. It can also act as a model used to calculate cost of equity. Investors are mostly concerned with the market risk calculation and our CAPM show the calculation of market risk accurately. On the basis of all of the above and many other advantages CAPM is always a better tool for decision making during making investments for any security. Limitations of CAPM: Anything in this world which is advantageous at one side must have some dark sides also. These dark sides are also called limitation of that theory. Having limitation in the practicality is not an unusual thing, because usually theories are designed by considering a general set of assumptions and conditions whereas they might be not applicable in any specific situation. Similarly in case of CAPM, there are also some limitations which it faces in the real practical world. Many investors are of the opinion that the assumptions of the model CAPM are not practical. Just because of their unrealistic nature and impracticality the results may not be valid for those investors who still believe on the effects of using CAPM theory. Another limitation of the CAPM is that the value of Beta is not constant and thus changes over time which may create confusion in the calculations. It is also pre-assumed that all the investors have equal availability of information regarding market fluctuations but if we see practically it is not possible and thus another assumption may go in vein. Another limitation of the Capital Asset Pricing Model is also highlighted by the critics that it does not give a clear concept or the view of average stock returns. Despite all of the listed benefits and advantages the model i.e. CAPM is still unable to answer the question that why small shares are better traded as compare to large shares or stocks. It is also a questionable statement that why the high profitable businesses are always at top positions as compare to low profits when the profit earned is not a measure to calculate the ranking of a firm. We can say that CAPM is still unable to answer some questions. Practical Uses: The capital Asset Pricing Model i.e. CAPM is widely used in real life investment decisions so we can have practical examples of its use in many cases. The most salient feature of CAPM is the calculation of its intrinsic value. This intrinsic value is then used to calculate the asset price. A measure can be used to check the trade that might occur up or below then that specific intrinsic value. Another use of CAPM is to compare different projects just for the sake of finalizing the investment decision. This use of CAPM is also termed as the project appraisal. The NPV of the project will help the investors to make their final decisions. But most of the people are of the opinion that CAPM is a far better tool to compare the investment project as compare to the calculation of net present value. Capital budgeting is an issue for the organizations and it is quite obvious from the research that managers usually use CAPM as their capital budgeting tool. Most of the regulatory authorities or agencies use this CAPM theory for price setting. This model is a suitable and best fit tool for price estimation and the exact calculation of it. Here it is to be noted that CAPM can only be used when the portfolio is well diversified and the considered risk is completely diversifiable. It is already mentioned that Capital Asset Pricing Model can be used for calculation of prices of the assets but in addition to that it can also be used to making cost of the equities which are other than investment projects. In short words we can say that Capital Asset Pricing Model i.e. CAPM is the easiest and a useful tool for making those tough calculations. All the empirical tests of this model CAPM show positive results. Anyone can understand the formula and its components just with simple description. The risk plays a very important role here. All the calculations are dependent on the risk present in the market. So we can say that the calculation of expected rate of return on a particular security of a well diversified portfolio is fully dependent on the measure of beta that is risk present in the market. Though all the assumptions cannot be accurate at a single time but still we can consider them as a general market conditions which may present in the market at any point of time. Reference: Mullins, D 2012, ‘Does the Capital Asset Pricing Model Work?’, Harvard Business Review, viewed 27th Mar, 2014 http://hbr.org/1982/01/does-the-capital-asset-pricing-model-work/ar/10 Read More