Capital Asset Pricing Model - Essay Example

The Capital Asset Pricing Model Introduction Since the coming of the CAPM, there have been several researches and literature which have criticised its usefulness in the modern business environment. This is because most such commentators believe that the model heavily rely on assumptions rather than laws (De Brouwer, 2009). The current paper therefore seeks to examine some recent developments in the area of corporate finance and the use of the CAPM to see how the model responses to existing criticisms. The paper take the approach of comparing the weaknesses and limitations of CAPM with its usage in recent developments to see if it can be considered a credible and reliable model for asset pricing and forecasting for today’s dynamic business environment. Overview of CAPM The CAPM is seen as an asset pricing method which gives a theoretical determination of the required rate of return of an asset, given the condition that the asset is being added to an existing well-diversified portfolio (Berk, 1995). This means that estimating the rate of return of an asset based on the CAPM requires that the asset in question will not be an independent asset being invested but part of a portfolio considered to be well-diversified. Again, Fama & French (2002) stressed that the use of CAPM in asset pricing must be based on the use of assets which are considered non-sensitive to non-diversified risks which come as either systematic risk or market risk. In short, the asset must be a risk-free asset which guarantees the repayment of interest and principal with absolute certainty (Banz, 1981). There are several determinants and variables used in the calculation of CAPM and hence the CAPM formula. There are generally traditional and modified formulas for CAPM but this paper is limited to the use of the traditional formula. Fama & French (1992) stressed that for CAPM usage, it is important that the expected return on the capital asset E(Ri), which can only be known when the risk-free rate of interest Rf, sensitivity of the expected excess asset or beta ßi, expected return of the market E(Rm), and market premium E(Rm) – Rf are all known. With these known, it is possible to obtain the CAPM given as E(Ri) = Rf + ßi (E(Rm) – Rf) From the equation given above, CAPM argues that in equilibrium, which is a state of acceptability for asset investment to take place, only the systematic risk should be priced and not the total risk. CAPMs Assumptions For the actual applicability of the equation and SML to function, there are very important assumptions that must hold. In all, CAPM makes use of nine assumptions which are briefly analysed as follows. The first is that investors aim to maximise economic utilities. Based on this assumption, investors would only want to go into investments that have asset quantities that are known and fixed so that the margin of utility can be easily determined. Secondly, there is the assumption that investors are rational and risk-averse. Relating this to the first, Banz (1981) noted that risk minimised the extent of utility within the market and so investors resort to risk aversion by staying away from practices that add high risk. Thirdly, CAPM assumes that every investor is broadly diversified with the use of a large range of investments. To many, such diversification is done to avoid the situation of putting all eggs in one basket and losing them all when there is market shock (Graham & Harvey, 2001). In the fourth assumption, it is stated that investors are price takers rather than people who influence prices. CAPM does see the market to be free and fair, putting all investors at the same level of taking what the fair market presents to them. What is more, it is assumed that investors can borrow and lend any desired amount that comes under the risk free rate of interest. This assumption is deemed necessary to ensure that investors do not become bound by the initial capital with which they begin their investment (Kothari et al., 1995). The sixth assumption sees investors as trading with no taxes considered as part of transaction cost. Together with the seventh assumption that says that investors deal with assets that are perfectly divisible and liquid, Roll (1977) explained that these provisions are there to ensure that in the real determination of expected returns, investors will only focus on their actual initial amounts invested. Once this is done, they will not have to look to external deductions or additions as factors causing either valuation or devaluation to their capital. In the eight assumption it is stated that investors have the same expectation, which makes them care only about the expected return. By applying this assumption, investors are made to focus very specifically on the tenability of their investment so that they can avoid any forms of distractions. Finally, it is assumed that there is fairness with the availability of information and thus all investors get the information at the same time (Sharpe, 1964). Limitations Several economists of recent times have criticised the CAPM as having major limitations that make its usage and applicability to the modern business environment suspicious (Fama & Macbeth, 1973). First, the CAPM has been said to have assumptions that are completely market oriented. Meanwhile, such market-oriented assumptions tend to shift the possibility of having a good expected return from what the investor can do to what the market holds for the investor (Lintner, 1965). It is also said that CAPM focuses on the use of homogeneous expectation assumptions when in actual fact, most modern investors diversify their portfolios so much that they do not have homogeneous expectations. Graham & Harvey (2001) also noted that the fact that CAPM assumes that interest rate is constant hampers the credibility of its usage when avenues of borrowing are there for investors and such borrowings come with changing interest rate. Again, based on the assumption that investors have homogenous expectations which are based on the expected return, Loughran and Ritter (1995) criticised the CAPM by stating that this assumption paints the picture that rate of return is constant when in reality different assets guarantee different rates of return. What is more, using CAPM in modern portfolio management has been noted to neglect human assets even though there is sufficient evidence to suggest the important role of human assets in the determination of the investment value for investors and organisations (Fama & Macbeth, 1973). Again, the beta which is given so much emphasis in CAPM has been said to represent change in past volatility but actual fact, investors base their decisions on future price differentiations. Lastly, Kothari et al. (1995) questioned the existence of risk-free assets and market investment portfolio which is highly emphasised in CAPM, stressing that these two only exist in theory. As far as limitations are concerned therefore, the CAPM has been criticised as been highly theoretical instead of practical. Recent Developments and the use of Security Market Line Recent developments are focused on the use of CAPM to addressing issues of asset-pricing anomalies such as book-to-market and momentum. This is because Fama & French (2002) noted that unlike earlier stages with the introduction of the CAPM, stakeholders of companies such as their shareholders are more concerned about having a real balance between a company’s current market price, as against what is known to be the company’s book value. As a result of this and other credibility related decisions that shareholders need to take, they have now become more inclined about having answers to market anomalies. Meanwhile, Markowitz (2002) saw CAPM’s overly dependence on the security market line (SML) as being a reason such anomalies are yet to be answered vividly to suit recent developments and concerns, particularly of shareholders. This situation has forced those who want to remain stack with the use of CAPM to only focus on individual securities. Most modern corporate financiers are known to use CAPM in cases where individual securities or portfolios are involved. This is because of the ability of such portfolios to meet the requirements given earlier to make the usage of CAPM possible. Whiles using such individual securities or portfolios, Markowitz, (2009) stressed that making use of the security market line (SML) is very important in the determination of how the market must price individual securities. By implication, SML is used as function of systematic, non-diversifiable risk that helps to display the expected rate of return of the individual security or portfolio (Treynor, 1962). In effect, the SML is used to describe the relationship between the beta, which is the sensitivity of the expected excess asset and expected return. But as stated earlier, it is important that equilibrium be reached to consider an investment return assured. Rubinstein (2006) posited that because of this, when using SML, it is expected that the beta will cross out in its relation with the expected return. In the long run therefore, SML can be said to be a representation or statement of the expected returns Er. This means that in practice, low beta portfolio will guarantee high return because the equilibrium will favour the SML, which is a statement of expected return (Markowitz, 2009). In the same manner, high beta portfolio could have low return. Use of CAPM in finance and strategic-decision making Notwithstanding the major limitations of CAPM, most of which are based on the model’s overreliance on theoretical assumptions, Markowitz (2002) said that there are still merits with the use of the model that makes it workable in finance and strategic decision making. In the first place, CAPM is extensively used in corporate finance and strategic decision making when it comes to capital budgeting. This is because Bodie, Kane & Marcus (2008) observed a situation where the outcomes of CAPM can be used for decisions on the establishment of hurdle rates for a company’s projects. This is often done by working out the beta from traded firms that are considered to be stand-alone and basing on the beta to work out expected rate of return as the hurdle rate for the company (Rubinstein, 2006). Secondly, CAPM is known to have been used extensively when corporate financial decisions are to be made on the establishment of fair compensation for a regulated monopoly (Berk, 1995). To do this effectively, the entire regulated project specification ought to be known from the investment and required annual profit. Then because CAPM assumes that there is a homogenous expectation, the compensation can be decided for the monopoly based on the single rate of return expected at the end of the yield period (De Brouwer, 2009). Lastly, Fama & French (1992) found the CAPM as a very ideal and necessary model for strategic-decision making that focus on getting objective estimated costs of equity. This can be assured from the assumption that all assets are perfectly divisible and liquid and thus permitting a single form of return that stockholders for a company (Bodie, Kane & Marcus, 2008). Conclusion The corporate finance sector of business has constantly been concerned with the need to engaging in asset and portfolio investments that guarantee best returns for increasing the value of organizations. The paper has however shoed that most of the investment efforts put in by experts in corporate finance have not yielded the desired wish of aiding with the rising of funding and capital structure for corporations. This is largely because of lack of proper forecasting of the possible returns associate with the investments in which these investors find themselves in. It is for such reason as forecasting the returns involved with investments in assets and portfolios which modalities such as the capital asset pricing model (CAPM) was introduced. The CAPM has however had its own limitations, mainly because it is based on several assumptions rather than laws. Going into the future, it is expected that the emphasis on the effectiveness of the CAPM will be based on what the model is able to achieve in the real world. This is because CAPM has been used in the corporate world and has already yielded several strategic decision making outcomes. References Banz, R (1981). “The Relation between Return and Market Values of Common Stock”, Journal of Financial Economics, 9, 3-18 Berk, J.B (1995). “A Critique of Size Related Anomalies”, Review of Financial Studies, 8, 275-286 Bodie, Z.; Kane, A. & Marcus, A. J. (2008). Investments. McGraw-Hill: Boston De Brouwer, P. (2009). "Maslowian Portfolio Theory: An alternative formulation of the Behavioural Portfolio Theory". Journal of Asset Management Vol. 9 No. 6: pp. 359–365. Fama, E & French, K (1992). “The Cross Section Of Expected Stock Returns”, Journal of Finance, 47, 427-465 Fama, E & French, K (2002). “The Equity Premium”, Journal of Finance, 57, 637-659 Fama, E & Macbeth, J (1973) Risk Return and Equilibrium: Some Empirical Tests, Journal of Political Economy, 8, 607-636 Graham, J & Harvey, C (2001). “The Theory And Practice Of Corporate Finance: Evidence From The Field”, Journal Of Financial Economics 60, 187-243 Kothari et al. (1995). Another Look at the Cross Section Of Expected Stock Returns, Journal of Finance, 50, 185-224 Lintner, J. (1965). “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics. 47:1, pp. 13–37. Loughran, T. and Ritter J. R. (1995). “The New Issues Puzzle.” Journal of Finance. 50:1, pp. 23–51. Markowitz, H. (2002). “Portfolio Selection.” Journal of Finance. 47, pp. 77–99. Markowitz, H. (2009). Portfolio Selection: Efficient Diversification of Investments. Cowles Foundation Monograph No. 216. New York: John Wiley & Sons, Inc. Roll, R (1977). “A Critique of the Asset Pricing Theory Test”, Journal of Financial Economics, 4, 129-176 Rubinstein, M. (2006). A History of the Theory of Investments. Hoboken: John Wiley & Sons, Inc. Sharpe, W.F (1964). “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk”, Journal of Finance 19, 425-442 Treynor, J. L. (1962). Toward a Theory of Market Value of Risky Assets. Unpublished manuscript. A final version was published in 1999, in Asset Pricing and Portfolio Performance: Models, Strategy and Performance Metrics. Robert A. Korajczyk (editor) London: Risk Books. Read More