The Capital Asset Pricing Model - Term Paper Example

The Capital Asset Pricing Model (CAPM) Introduction The Capital Asset Pricing Model is widely used in the industrydespite the fact that it is based on very strong assumptions. CAPM is a capital budgeting model used to price an individual asset or a portfolio of assets. It was developed in the early 1960s by William Sharpe in order to determine how an investment risk affects its expected return. Risk has been a key consideration when dealing with assets since the 1960s (Shefrin and Statman, 2000). Several models have been developed to calculate risks; but CAPM has received the largest support among many financial experts. Like any other capital budgeting model, CAPM has its own weaknesses and strengths. In order to improve its usefulness, the standard capital asset pricing model has undergone various developments and modifications in the recent past. Since its conception about four decades ago, the Capital Asset Pricing Model has been used widely in applications to estimate cost of capital of firms and evaluate the performance of asset portfolios in companies. This report argues that CAPM has received such a wide support and use in the industry despite its strong assumptions because it provides powerful and reliable predictions about risk measurements and the relationship between risk and expected return. CAPM has several problems which are considered by many as the results of theoretical failures emanating from the strong assumptions of the model (Rubinstein 2006). However, they could also be caused by the difficulties of its empirical implementation. Although these problems are common, it is also understood that other models have their problems too. Therefore, the best model is the one which has proved to be successful in its application. Capital Asset Pricing Model is the model with such wide and successful application because it provides powerful and reliable predictions about risk and returns of a given portfolio of assets. Main Concepts behind the Problem and Discussion The Capital Assets Pricing Model (CAPM) suggests that the equilibrium rates of return of risky assets in the market have a linear relationship with the market portfolio. CAPM is used to establish a theoretical value of required rate of return of an asset in a diversified portfolio. This takes into consideration the systematic and market risks which are non-diversifiable risks (Rubinstein 2006). The model also considers the markets expected return and the theoretical risk-free assets expected return. CAPM draws from the portfolio theory developed by Harry Markowitz (1959). The formula of calculating expected return of an asset portfolio using the CAPM model is given as: E(Ri) = Rf + β(E(Rm) – Rf) where, E(Ri) is the expected market return; Rf is risk-free rate of return; β is the sensitivity of the excess returns of the assets to the excess market returns; E(Rm) is the expected market return; E(Rm) – Rf is the market premium which represents the difference between expected rate of return in the market and the risk-free rate of return; and E(Ri) – Rf. In terms of risk premium, this formula can be restated as E(Ri) – Rf = βi(E(Rm) – Rf). This means that the individual asset premium is equal to the market premium multiplied by β. There are various theories, empirical studies and developments which explain Capital Asset Pricing Model. Fama and French (2006) suggest that CAPM is attractive because it provides powerful and pleasing predictions about measurement of risk and clearly explains the relationship between risk and return of assets. According to Perold (2004), the price of a highly risky asset should be low in order to earn high payoffs in future relative to the initial price of the asset (Ross 1976). However, this faces difficulties when the risk of the asset results from how the asset is held. Diversification is used by firms to reduce risk (Kothari et al, 1995). The essence of diversification is that one is able to spread his/her wealth across several independent risks so that they can cancel each other when held in sufficient number (Sharpe 1964). This results in the investment in diversified portfolio in order to minimize risk in the firm. CAPM enables investors to find the correlation among individual security returns and how such returns affect portfolio risk (Graham & Harvey 2001). According to Markowitz, diversification relies on imperfect correlation of individual risks, and the reduction of risk through diversification depends on the extent of correlation between individual asset returns. According to CAPM, non-diversifiable risks are rewarded by linking the required return to its portfolio riskiness rather than considering only a stand-alone risk (Mehrling 2005). The expected return compensates for the risk taken in the portfolio. The portfolio’s beta defines how the investor is rewarded in a systematic exposure to risk (Mullins 1982). CAPM predicts the relationship between expected return and risk by identifying a portfolio so efficient that its asset prices can clear the market (Fama and French 2004, p.26). The developments of CAPM over the past few years have contributed to a better application of CAPM in determining the performance of a portfolio of assets and estimating the cost of capital for investors. Due to these developments, new models usually result in more effective interpretation of market conditions in various portfolios and economic units (Raei 2011, p.139). In 1974, Hogan and Waren introduced the Downside Capital Asset Pricing Model (D-CAPM) which argues that lower or higher returns than the expected returns are taken into consideration because return distributions may not always be normal. The standard CAPM model was adjusted by Pastor and Stambaugh (2003) to include liquidity risk factor resulting in Adjusted Capital Asset Pricing Model (A-CAPM). In this case, the expected return is predicted considering liquidity risk factor. The beta is obtained by including the liquidity risk coefficient given as Cm in the CAPM formula (Graham &Harvey 2001). Conditional Capital Asset Pricing Model takes into consideration possible challenges and changes that occur in investments so that they may cause bankruptcies. The Revised Capital Asset Pricing Model is also another development of CAPM. It determines the relationship between financial and operational risk, and Earnings before interest and tax. This takes into account the financial risk in the calculation of expected returns. These developments indicate how the Capital Asset Pricing Model has evolved since it was conceptualized. The developments attempt to solve some of the problems associated with CAPM in order to enhance effective prediction of expected risk and return of an asset portfolio (Fama & French1996). Some of the risks that various developments have included in the CAPM method include liquidity risk, financial risk, downside risk, and inter-temporal risk. This leads to a better prediction of the relationship between risk and return of assets and the determination of the best price of assets that can clear the asset market (Lintner 1965). However, there are still problems and assumptions that undermine the practicality and application of this model. One of the assumptions is that return variance can adequately measure risk – that is, the method assumes returns to be normally distributed (Lintner 1965). This means that investors who are risk-aversive should retain a lot of cash. The problem of this assumption is overcome through the Downside Capital Asset Pricing Model, which is one of the developments of CAPM in estimating prices of asset portfolios that can clear the market and the expected risk and returns of such assets. Secondly, CAPM assumes that there are no taxes or transaction costs. However, these costs are usually common in various transactions including acquisition and disposal of assets. The model also assumes that stakeholders have sufficient and uniform information about the risk and return of the assets (homogenous expectations). In reality, information asymmetry normally exists. Furthermore, the model assumes that shareholders’ expectations reflect the true distribution of returns (Roll 1977). However, there is always the possibility that the expectations of shareholders are biased; causing inefficiencies in market prices of assets. The model also assumes that all investors are rational and risk-aversive (Ross 1978). In reality, some investors such as casino gamblers prefer high risk for low returns. Under risk-free interest rate, investors are also assumed to lend and borrow unlimited funds under CAPM. As my own independent thought, I think various developments of CAPM can provide solutions to the assumptions of the model, making it to remain the widely applied, most applied, and most successful method of measuring asset prices in the market and determining the relationship between risk and return. As it is already known, higher risk leads to higher returns, and diversification reduces risks. CAPM should be used to determine which portfolio will produce the highest returns given the prices and risks involved in the assets within the portfolio. Based on the principle that higher risk leads to higher returns, and the reality that there are usually high and low returns among assets, CAPM should combine the low and high risk to come up with a market clearing price level of assets. The assets with high risks and potentially high returns usually carry lower prices while the assets with low risks and potentially lower returns carry high prices. People may prefer low prices in order to earn higher returns, but they often have to put up with high risks (Berk 1995). On the other hand, investors who wish to avoid risks choose to invest in high priced assets. These two groups of people can be brought to a market clearing price level or market equilibrium through modified CAPM which takes into account various risks and expected returns in portfolio of assets (Fama & French 1993). Assets with low risks and high expected returns are combined with assets with high risks and low expected returns in the same portfolio. Different portfolios should then be evaluated to determine the portfolio that yields the highest returns using modified CAPM. In conclusion it is clear that CAPM is the measure of asset prices based on the relationship between risk and return in a portfolio of assets. It is calculated by taking into account non-diversified (systematic) risk and unsystematic risk as well as expected returns of each asset in a portfolio. This model is used to measure the cost of capital to be used by an investor, market clearing asset prices, and the relationship between return and risk. Various assumptions of the model lead to some problems associated with the model. However, the development of CAPM has resulted in different considerations that may overcome the problems of such assumptions. With a bit of modification to CAPM, such as inclusion of liquidity risk, financial risk, downside risk, and inter-temporal risk; the Capital Asset pricing Model will provide powerful and reliable predictions about risk measurements and the relationship between risk and expected return. References Berk, J.B. (1995) “A Critique of Size Related Anomalies”, Review of Financial Studies, vol. 8, pp. 275-286 Fama, E.F. & French. K.R. (1993) “Common Risk Factors in the Returns on Stocks and Bonds”, Journal of Financial Economics, 33, 3-56 Fama, E.F. and French, K.R. (1996) “The CAPM is Wanted, Dead or Alive”, Journal of Finance, vol. 51, no. 5, December, pp. 1947-1958. Fama, E.F. and French, K.R. (2004) “The Capital Asset Pricing Model: Theory and Evidence”, Journal of Economic Perspectives, vol. 18, no. 3, pp. 25-46. Fama, E.F. and French, K.R. (2006) “The Value Premium and the CAPM”, Journal of Finance, vol. 61, pp. 2163-2185. Graham, J. & Harvey, C. 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