The Capital Asset Pricing Method (CAPM) - Essay Example

 THE CAPITAL ASSET PRICING METHOD (CAPM) Key words: Rate of return, Asset pricing Introduction The model is an important advancement in financial economics because it is used to for the purpose of investment since it clearly illustrate the relationship between an asset’s rate of return and its beta while also being used in the world of corporate finance due to the fact that a project’s discount rate as a function of a project’s beta (Dempsey 2010). The model calls for empirical tests like any other model in order to give analysis and insight into the actual outcomes and relationships. This is because the CAPM model does not wholly explain the returns on investment portfolios. A number of assumptions have to be identified for CAPM equilibrium to be achieved (Madanoglu 2013). The assumptions include the fact that investors must have the same expectations and also apply similar input list, they also have to maximize their estimated utility of wealth, the investors have to plan for a homogenous holding period, no transaction costs or taxes are incurred, the rate of borrowing equals the rate of lending and that there exists an environment where there is availability of numerous investors each having an endowment of wealth that is small in comparison to the whole endowment. Concepts When the model was developed, a variety of empirical tests were conducted on the model by using proxies and a number showed that the model was unsuitable and inaccurate when predicting the prices of assets and in many situations did not hold. However it was later asserted that the model was theoretically probable but was very hard, by using empirical tests to prove because stock indexes coupled with other market measures were not adequate proxies for the variables of the CAPM model. The Capital Asset Pricing Method makes use of a variety of assumptions regarding the behavior of the investor and market in order to provide a group of equilibrium conditions which enable people to estimate the expected return of an asset I compare to its non-diversifiable risk. The model makes use of systematic risk measure in order to facilitate a comparison between the assets in consideration and other assets in the market. Theoretically, by using the systematic measure of risk it enables managers to calculate their needed rate of return while also assisting investors to better their portfolios (Andriotto 2013). The CAPM model is based on assumptions that have been regularly criticized and are discussed in depth. The assumption that there are no transaction costs is completely erroneous because no investments are free of charge and their pricing does not rely on the capital market line. This is because some investments are priced above and below the market line and transaction costs play a major role in discouraging shift in pricing mechanism to fall on the market line (Hopkinson 2002). It is common knowledge that a lot of investments especially those involved in buying small businesses incur heavy transaction costs. It has been asserted by commentators that the capital market line is probably a band width that reflects costs of trading. CAPM erroneously assumes that investors possess the same beliefs regarding risks of the investments and their expected returns. This is however misleading because there are massive trading bonds and stocks by investors and they are attached varying expectations coupled with the fact that investors have differing risk preferences. The model is based on the assumption that there are no taxes levied on investments and that the resultant returns are not affected by taxes. In today’s financial world, a lot of the investment transactions are levied capital gain taxes which have the effect of increasing the transaction costs. The taxes also decrease the investors’ expected returns coupled with the fact that a variety of returns such as dividends and capital gains are differently taxed which result to investors preferring portfolios where assets are tax favored. It is of worth to note that pension plans and individuals are differently taxed meaning that homogenous assets are priced differently. Another assumption is that beta is a whole measure of risk meaning that CAPM takes the assumption that risk is calculated by the standard deviation of the systematic risk of an asset relative to the fluctuations of the whole market. However, investors are faced by a number of risks such as liquidity risk, inflation risk. The liquidity risks occur when investors require funds for the purpose of changing their portfolio profile risk but are not able to sell in the current market prices (Grauer 2013). Additionally, the volatility levels are not a good measure of risk particularly in cases where returns are unevenly distributed. The uneven distribution experienced is highlighted in current financial times where major corporations record positive returns in the past decade while others experience high negative returns. Borrowing cannot be achieved at risk free rates as the model assumes. Investors cannot borrow at risk free rates in order to improve the percentage of risky assets contained in their portfolio even for lesser non-institutional investors (Pedersen 2006). Commentators have noted that it is possible to estimate the capital market line and it shows a kinked downward movement for portfolios where the beta function is bigger than 1.This shows that the risk free borrowing is higher than risk free lending. CAPM is based on the assumption that there exist risk free assets that have varying maturities and adequate amounts that can enable for adjustments on the risk of portfolios (Clare 2005). This is however incorrect because even treasury bills have a number or risks ranging from risks associated with re-investments where investors set their expectations beyond the maturity date of the T-bill, currency risk where the fixed returns’ purchasing power is reduced in comparison to other currencies (Levy 2012). Additional risks are in the form of inflation where fixed returns risk being devalued by inflation in the future. The method applied assumes wrongfully that by reducing risks associated with the portfolio investment, no additional costs will be incurred and short term ability of an investor is unlimited. One of the more recent critics of the model was through the work of Farma and French who conducted empirical tests that were inconsistent with the previous work conducted by other economists who supported the model regarding the positive correlation between the beta of the portfolio and the average rate of return regarding the equities of a portfolio (Praetz 2011). From their study it was concluded that the relationship between beta and the average return was weak in the periods between 1941 to 1990 and was almost completely non-existent between 1963 to 1990.They also disproved previously held assumptions regarding the positivity of the relationship between average return of a portfolios security and the price earnings of a firm and its market-to-book ratio. They concluded that the relationship was actually negatively related (Ross 2011). In my opinion, the CAPM model is a very useful model even though it is based on flawed assumptions. One of the criticisms that I can add to the model is the fact that it fails to factor the role played by liabilities because a lot of the investors in institutions delegate their decisions to agents on their behalf and additionally, they are keen on investing in service liabilities. The model is essentially a specialized scenario of a relative asset pricing model in general criteria. It should be noted that when liabilities are added to the CAPM model, the asset becomes risk free. Further research by others such as Grauer and Janmaat showed compelling evidence against the model through demonstrating how well securities had performed in the near past and how they tended to experience greater returns in the future (Grauer & Janmaat, 2013). This was further shown that equities that experienced higher sensitivity to fluctuations in the market returns were prone to yield lower returns in comparison to other firms in the same market. This was conducted in the United States but there is proof that the same conditions are applicable in other parts of the world. In recent times, following new developments in experimental economics and behavioral finance, variables related to the psychology of the investor should be used in the CAPM model to evaluate and assess assets because the assets are what bind investors in their interactions. By basing the argument on Keynes in 1936, most of the decisions made by investors are geared towards achieving a positive result and the whole consequences drawn out over a number of days can only be assessed in light of primal instincts and spontaneity to act rather to remain inactive (Ang 2002). The actions are in essence not due to qualitative benefits that are weighted averagely and are multiplied with quantitative probabilities. Recent analysis by Zhang and Meng suggests that it is important to institute primal instincts and urges to the CAPM model so that one can be able to comprehend how the market and assessment of returns of assets works. Simply, the CAPM fails to incorporate the psyche of the investor in its assumptions (Zhang and Meng 2014). Others have recently cited that the using the expected returns of investments as parameters when deriving the CAPM model is erroneous (Winker 2010). They argue that the parameters cannot be classified as decision variables meaning that the optimal portfolio relies on the expected rate of return coupled with other covariance parameters and not the other way round. Mathematically speaking, the assumption that expected rate of returns is reliant on the optimal or market portfolio is impossible. Furthermore, in order to compute the covariance, the expected value must be provided concluding the fact that statistically, the CAPM model assumption that the expected rate of return is dependent on the covariance has no bearing (Bornholt 2013). Conclusion Regardless of the criticisms put forward regarding the CAPM, it is still to date, one of the most accepted and used pricing models. The model has been criticized for having assumptions that are unrealistic especially for investors in the present times. Empirical studies have been conducted to try to disprove the model by basing it on factors like price momentum, size and a number of ratios for the purpose of providing a clear diversion from the premise of the model (Liu 2009). However, they ignore very many asset classes that are viable options. Some empirical studies have been conducted and they have concluded that the CAPM model has had its fair amount of success in predicting individual asset prices and that of the three mandatory stipulations for a valid model; none was rejected at a fairly high certainty level. The model is not perfect but it gives a reasonable explanation of prices of assets by arguing that systematic risk of assets is proportional to their expected return which is also proportional to expected surplus return related to the market. The inaccuracies can only be improved by better market proxies and more superior econometric techniques. References Andriotto, M., & Teti, E .,2013. Beyond Capm: An Innovative Factor Model To Optimize The Risk And Return Trade-Off. Journal of Business Economics and Management, 1-17. Ang, A., & Chen, J .,2002. CAPM over the long run 1926-2001 . Cambridge, Mass.: National Bureau of Economic Research. Bornholt, G. (n.d.).,2013.The Failure of the Capital Asset Pricing Model (CAPM): An Update and Discussion. Abacus, 36-43. Clare, A. (n.d.).,2005. The Capm, The Apt And A Contingent Claims Model Of A Securities House. Journal of Business Finance & Accounting, 1147-1168. Dempsey, M. (n.d.).,2010. The Capital Asset Pricing Model (CAPM): The History of a Failed Revolutionary Idea in Finance? Abacus, 7-23. Grauer, R., & Janmaat, J. (n.d.).,2013. Cross-sectional tests of the CAPM and Fama–French three- factor model. Journal of Banking & Finance, 457-470. Hopkinson, G., & Lum, C.,2002. Valuing customer relationships: Using the capital asset pricing model (CAPM) to incorporate relationship risk. Journal of Targeting, Measurement and Analysis for Marketing,220-232. Levy, H.,2012. The capital asset pricing model in the 21st century: Analytical, empirical, and behavioral perspectives . New York: Cambridge University Press. Liu, J., Su, T., & Yi, R. (n.d.).,2009. Value-at-Risk Model based on Switching Regime CAPM. Energy Procedia, 1862-1867. Madanoglu, M., Olsen, M., & Kwansa, F. (n.d.).,2013. Empirical Investigation of the CAPM vs. Fama- French Model: Evidence from the Lodging Industry. The Journal of Hospitality Financial Management, 127-127. Pedersen, C. (n.d.).,2006. Separating risk and return in the CAPM: A general utility-based model. European Journal of Operational Research, 628-639. Praetz, P. (n.d.).,2001. The Market Model, Capm And Efficiency In The Frequency Domain. Journal of Time Series Analysis, 61-79. Ross, S. (n.d.).,2011. The Current Status of the Capital Asset Pricing Model (CAPM). The Journal of Finance, 885-885. Winker, P., Lyra, M., & Sharpe, C. (n.d.).,2010. Least median of squares estimation by optimization heuristics with an application to the CAPM and a multi-factor model. Computational Management Science, 103 123. Zhang, P., & Meng, X. (n.d.).,2014. The Market Application Analysis of CAPM Model. 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