Capital Asset Pricing Model - Essay Example

Capital Asset Pricing Model Introduction CAPM stands for capital asset pricing model (CAPM) which is used for relating the risk and the associated trade-offs with market returns. The security price is associated directly with cost of the capital. However the interest rates can be used in relation to the cost of capital while beta is used as a proxy for the level risk. These calculations are popular among investment practitioners. CAPM is a sub-division of finance which is used for determining a theoretically suitable rate of return of an asset. CAPM Model If a certain asset is aimed to be included with a well-diversified portfolio then that particular asset’s non-diversifiable risk is required to be calculated on the basis of return of an asset. But if that asset is aimed to be included in an already well-diversified portfolio then the required asset possesses non-diversifiable risk. This model takes into consideration the asset sensitivity to a specified and diversified portfolio provided that the assets are present in a non-diversifiable ratio. Moreover this model can be optimized to include asset sensitivity to non-diversifiable risk which can also be termed as systematic or market risk. In financial industry this sensitivity measurement of diversifiable risk is represented using a symbol regarded as beta (β). This quantitative measurement value can also be related with expected return of the market and the expected return of a theoretical free risk. In short, CAPM is used for suggesting or determining an investor’s cost of equity which can then be summarized as beta value (Sigman, 2005). The underlying theme associated with CAPM is investor’s relationship and the advantages which an investor can attain by the application of this model. The investors are linked in two ways with this technique; one is the time value of money and the other is the risk factor involved in a project. The time value of money can be depicted using the risk free (Rf) rate in the formula which can then be compensated with the investors for placing money in any investment after a certain period of time. The risk part of CAPM formula is used for representation of risk and calculates only the amount of compensation which any investor can undertake for facing any additional risk. These financials can be calculated using the risk measurement tool i.e. beta, which has the ability to compare the returns of the asset towards the market after a certain period of time having definite market premium (Rm-rf). According to the CAPM tool the expected return of a security calculated on a portfolio is equal to the rate of a risk free security, which is further raised by including a risk premium. If this is expected return is not able to be ascertained or is not able to even beat the expected return then the required return and the investment will not be undertaken (Fama & French, 2004). Practical Implementation of CAPM This pricing model which is regarded as CAPM was put forwarded in the year 1960 and since then it is under deep influence of criticisms. The argument of such critics involves hypothesis that CAPM does not put forward realistic market conditions. It can only be regarded as a mechanism through which investors can predict the return of an asset by making assumptions associated with level of systematic or market risk. Here are some practical implementations of CAPM: Intrinsic Value The biggest challenge faced by security agencies is to properly calculate the intrinsic value of a certain project. Hence the first most work of CAPM is to determine the asset pricing. Moreover the analysts and the investors can make use of this wonderful technique for comparing accounting value and market value of a stock. CAPM can also be utilized for gauging the intrinsic value of an asset. In this particular situation a certain asset which is trading low in comparison to its intrinsic value, then it is a good deal (Brown, et al., 2013). NPV CAPM is a significant tool which can be used for appraising projects and other valuation requirements. This technique of CPM is used for calculation of projects having different types of risks involved in them. The end result is regarded superior to Net Present Value (NPV) valuation in many ways. CAPM makes use of only one discount rate for all projects as opposed to project’s own consent. It must be left on the discretion of the project or finance manager for calculating individual risks for different accompanied projects. Empirically Testable CAPM model is used in empirical studies which are used for finding out individual assets by overlooking the inaccuracies which can be produced. The CAPM was invented by William Sharpe in collaboration with his friends. CAPM has been tested and gone through positive and negative criticism over the years. Moreover it has been tested empirically by researchers by using proxies for different variables. Proxies are used while making calculations by investors, which helps them in making comparison against their investment. They also use some indexes, such as S&P 500, for representing the market and the corresponding monthly rates for the three month Treasury Bills are used for the approximate risk free rate. Despite numerous applications of this technique it is observed that CAPM does not predict asset prices, and the corresponding factors associated with stock indexes, which are poor proxies for CAPM variables. The CAPM is not ascertained to be true in many situations as it does not have the ability to predict asset prices correctly along with some corresponding factors such as firm size which are bound to be reliable measures for systematic risk. Still on the other hand CAPM is found to have produced compelling results which can further be improved through application of statistical methods and by the induction of proxies assigned with variables (icsa.org.uk, 2012). Advantage of using CAPM If other methods are compared with CAPM, it has been found that it will lead towards better investment decisions. Similarly weighted average cost of capital (WACC) is another investment tool which helps in calculation of discount rate for making investment appraisals. The assumption which is associated with WACC is that the investment projects do not change the business risk or the corresponding financial risk of the investing organization. As opposed to CAPM, when WACC is applied in connection with discount rate, it will produce incorrect investment decisions for a project which will further direct towards rejection. The Internal Rate of Return or the measure of the value of an investment is computed to less than that of the WACC. If CAPM is based on the project’s IRR it lies above the Security Market Line and provides a return greater than that of required to offset the systematic risk (Sharifzadeh, 2010). Not Viable in Reality The argument against CAPM emanates mainly from the pre-suppositions about it. Several of these are removed from reality. While some of them may seem to be plausible, e.g. investors wanting to maintain well-diversified stock portfolios that fairly represent market conditions and to derive the benefits of taking smart risks, the other assumptions are arguable. Real world capital markets are far from being perfect and the price of assets may be incorrect. Following is a list if the pre-suppositions about investors, in the CAPM model. 1. They aim to optimize economic utilities, i.e. the quantity if assets is already given and fixed. 2. They tend to be logical and averse to risk 3. Their demographics are widely dispersed across a wide spectrum of investments 4. They cannot influence prices and take whatever is the market rate 5. Under the risk-free interest rate, they can borrow infinitely 6. They trade without any transaction or tax costs 7. They are more keen about securities that can be divided into smaller parcels 8. Their assumptions are mainly alike 9. They expect that all investors have access to the all the information at the same time. Fama and French, in their 2004 review, put forth the notion that ‘the failure of the CAPM in empirical tests suggests that most applications of the model are unacceptable.” We take an analytical look at this claim below: According to the CAPM model, the variance of returns is ample to gauge the amount of risk involved. In reality however, risk in financial investments does not differ by itself, but it involves the likelihood of loss. According to some research conducted by Barclays Wealth, the more risk averse the investors are the more cash must they hold than is recommended by CAPM (Butt, 2013). CAPM pre-supposes that all active and prospective shareholders are privy to the same information and are in concurrence about the anticipated return of all assets. CAPM also assumes that provided a particular anticipated return, active and prospective shareholders will favor lesser risk as compared to a greater one, and vice versa. The model makes no provision for those active and prospective shareholders who will accept lower returns on for greater risks! Further, the CAPM model implies that there are costs of taxes and transactions. Even though this may not really be the case, there is a chance that this particular assumption may be relaxed with its more intricate versions (Dickie, 2006). The market portfolio comprises all assets prevailing in every market, and each is valued according to market capitalization. This implies that all active and prospective shareholders opt for assets based singularly as a function of their risk-return potential. CAPM also assumes that all assets may be divided innumerably as per the amount which can be withheld or transacted. Theoretically speaking, the market portfolio should encompass all kinds of assets that are possessed as investments by anyone. Realistically speaking, however, this phenomenon cannot be gauged and people usually replace a stock index for its true market value. Such a substitution can prove to be misleading about the legitimacy of the CAPM and it has also been said that owing to the fact that the true market portfolio cannot be gauged, the CAPM cannot be emphatically tested (Vernimmen & Quiry, 2009 ). Contrary to another assumption about the horizon of economic representatives, investors with long term thinking would ideally opt for long-term inflation linked bonds rather than settling for short term rates. Finally, the CAPM also assumes just two dates, and hence, according to its claim, there is no chance to consume and adjust portfolios numerously over the course of time. Investor and Financial Manager Behavior Attempting to encourage investors about something that does not exist is unquestionably a problem. There's more to raising money than simply just requesting income. Most traders wish to invest in currently set up companies with negligible risk. When constructing a small business from scratch, raising cash will certainly become business enterprise problem which an entrepreneur must face. To overcome this problem, it is required to create the flexibility to provide an idea and a vision to likely investors. Inside the competition of increasing cash, the person should use a very good tale backed by a strong organization strategy (Murthy & Latha, 2009). Conclusion Developing any business surely takes time. The extent of an effort that is put in is instantly equivalent to the amount of consequence an individual is going to get but we cannot expect a right away final result. It can be like planting a seed; it takes time to develop into a tree. Entrepreneurs with their influential bias for action often circumvent thinking about the big issues of goals, strategies and capabilities. They must sooner or later structure such inquiry into their companies and their lives, which will eventually assist them in making influential decisions. The best tool which is applied for assessing the related risk and the associated trade-offs with market returns in concluded to be Capital Asset Pricing Model. References Brown, P., Emeritus & Walter, T., 2013. The CAPM: Theoretical Validity, Empirical Intractability and Practical Applications. The Capital Asset Pricing Model, 49(1), p. 44–50. Butt, H. A., 2013. Asset Pricing In Small Sized Development Markets. [Online] Available at: https://helda.helsinki.fi/bitstream/handle/10138/41329/261_978-952-232-209-8.pdf?sequence=1 [Accessed 29 March 2014]. Dickie, R. B., 2006. Financial Statement Analysis and Business Valuation for the Practical Lawyer. s.l.:American Bar Association. Fama, E. F. & French, K. R., 2004. The Capital Asset Pricing Model. Journal of Economic Perspectives, 18(3), p. 25–46. icsa.org.uk, 2012. The Capital Asset Pricing Model. [Online] Available at: https://www.icsa.org.uk/assets/files/pdfs/BusinessPractice_and_IQS_docs/studytexts/cfm2/l_CFM_6thEd_StudyText_Chapter8.pdf [Accessed 29 March 2014]. Murthy, L. & Latha, K., 2009. Problems of small-scale entrepreneurs. Journal of Chinese Entrepreneurship, 1(3). Scowcroft, A., 2003. Advances in Portfolio Construction and Implementation. s.l.:Butterworth-Heinemann. Sharifzadeh, M., 2010. An Empirical and Theoretical Analysis of Capital Asset Pricing Model. s.l.:Universal-Publishers. Sigman, K., 2005. Capital Asset Pricing Model (CAPM). [Online] Available at: http://www.columbia.edu/~ks20/FE-Notes/4700-07-Notes-CAPM.pdf [Accessed 29 March 2014]. Vernimmen, P. & Quiry, P., 2009 . Corporate Finance: Theory and Practice. s.l.:John Wiley & Sons. Read More