Capital asset pricing model (CAPM) - Essay Example

Capital asset pricing model (CAPM) Developments in the Capital Asset Pricing Model (CAPM) Sometimes due to lack of knowledge, the opportunity to invest in profitable investments is lost. The foundation of Capital asset pricing model was established in an article of a finance journal in the year 1963 named, Capital Asset Prices: A theory of market equilibrium under conditions of risk. The CAPM model was first proposed by Sharpe during 1964 and Lintner during 1965 in which they recommended about a single risk (or beta factor) which is associated with a portfolio of investment and this formed a simple and convincing theory of asset market pricing (Sharpe, 1964). This theory has also forecasted that the expected return on an asset beyond the risk-free rate is in equal relation to the systematic risk. In this regard, the higher the beta of a security, the higher will be the expected return of that particular asset (Sharpe, 1964). In the following years, economists have critically reviewed the published theory of CAPM and its application in reality after comparing the actual returns with the expected returns. The CAPM model is still widely used by companies as an efficient model for computing cost of capital (Ko) on the basis of explanation that securities with higher betas offer higher return. CAPM has numerous applications; it is used in capital budgeting, for analysis of merger and acquisitions, valuation of convertible securities and warrant and to value the equity of a firm. William Sharpe made several assumptions for investors in creating market equilibrium in order to validate the CAPM model (Sharpe, 1964). The model develops the price of an asset which it must hold in order to satisfy the investors for holding the current market portfolio. According to CAPM, everybody bears the same risk in different quantity. As the systematic risks is removed and the investors hold diversified portfolios, they will have a need for return and according to the utility function, the investor will rank the portfolio. All the investors will tend to buy the market portfolio as everybody possesses the same portfolio comprising of risk bearing assets. Furthermore, by purchasing several other assets, it is possible for the investor to diversify a part of the risk. The riskiness of a security is not entirely based on the unpredictability of its return. If one investor puts all his money in a single asset, then variability would be a suitable measure. In reality, the riskiness is diversified by purchasing many different assets. Macroeconomic factors influence the systematic or market risks, for example, large number of companies faced negative cash flows and low profits during credit crunch (Hill, 2010). Though the assumptions of CAPM focus on the correlation between non-diversifiable risk and return, in practical world, the situation is different where companies and individuals take the investment decisions. The accuracy of CAPM is affected to the extent of which the assumptions of the model are not realized (Hill, 2010). The assumptions of CAPM are a part of the classical economic principles. Sharpe (1964) has emphasized that these assumptions are highly unrealistic and restrictive. In real world the market is not perfect and there are fair chances of securities being mispriced. CAPM assumes that there are no transactions costs, in reality there are many investments such as, merger and acquisitions involve noticeable amount of transaction costs. Moreover, CAPM considers trading in investment as tax free and are unaffected by taxes, though in real situation, return on dividend and capital gains is taxed. In real scenario, individuals are also taxed according to their status such as, through pension plans or individual tax. Furthermore, the assumption that investors possess diversified portfolio or market portfolios is also unrealistic (Elton, et al., 2010). An asset having certainty of return in future is called a risk free asset, such as government securities. According to CAPM, a risk free rate prevails at which the investors can borrow money, but in reality, it is not possible for investors to borrow at this rate because risk connected with individual investors is much more than the risk associated with government (Pandey, 2005). William Sharpe proposed that all investors have similar expectation about risk and return, investing strategies and risk of available investments as long as they stay risk averters. However, in real scenario, the situation is different as investors possess different risk preferences, opinions, expectations and investment horizons because homogeneity in expectation leads to inefficient market with predictable and periodic booms and crashes (Pandey, 2005). In 1995, George Soros, Manager of Quantum Group Fund proposed classical economic theory which assumes that the participants of the market act on the basis of perfect knowledge. However, this assumption is not correct as it is impossible to obtain perfect knowledge about market. Investors will have different expectation and diversification strategies depending on their way of gauging the market through numerical data or prediction through time series trends (Soros, 2003). The CAPM model has been widely accepted over the years because it eliminates the unsystematic risk and considers the systematic risk for diversifying the portfolios of the investors (Chavas, 2004). The model also creates a relationship between systematic risk and required rate of return which is frequently considered for testing and empirical research (Sheeba, 2011). As the CAPM model clearly takes into account the volatility of an investment without considering the dividend growth rate or the size of the dividend, it is widely used by the firms to determine the cost of equity (Fama and French, 2002). As the CAPM model gives the internal rate of return of the project which is higher than the security market line, this model is preferred over weighted average cost of capital model. CAPM model also portrays a return which is required to counterbalance the systematic risk. It is inferred that CAPM approach is superior to WACC for calculating the discount rates which is used for investment appraisal (Barucci, 2003). In 1973, Fama and McBeth countered the concept of beta (β) in CAPM and proposed that beta (β) does not matter in portfolio diversification and that the standard deviation of the return of any asset is also irrelevant for explaining its excess return since it does not measure risk when return are not evenly distributed around the mean (Fama and Macbeth, 1973). In 1977, Richard Roll, an American economist through a significant analysis stated that the CAPM model is not testable due to certain aspects such as the unfeasibility of testing the true market portfolio and benchmark error using an inefficient market proxy (Roll, 1977). The economist stated that the CAPM model is mathematically not sound as other economists consider other variables of risk which leads to misspecification of the CAPM model. In 1981, Rolf Banz in his article named “The Relationship between Return and Market Value of Common Stocks” stated that smaller firms have higher risk amended returns than larger firms. CAPM is being “misspecified” due to the size effect (Banz, 1981). Pursuing the article of Banz, in 1995 Berk published an article named “A Critique of Size related Anomalies” in which he stressed on the fact that firms posing high risk will expect high returns but will have low market value (Berk and DeMarzo, 2007). From the article of Berk, it was inferred that the empirical size effect is not a confirmation of the relation between risk and size of the firm. The CAPM is based on several unrealistic assumptions. In reality, it is very difficult to find a security which is absolutely risk free (Barucci, 2003). Though a government security is often considered as a risk free security, but when it is coupled with inflation, it causes high rate of uncertainty in the real rate of return of the security. The assumption of parity in lending and borrowing rates is also unrealistic as in real scenario these rates are quite different (Kothari, 1995). Further, if the portfolio of the investor is not well diversified then beta may be unsuccessful in capturing the risk involved in investment (Fouque and Langsam, 2013). Though beta measures the future risk of a security, investors do not possess any future data in order to estimate beta and they have to rely on historical data (Manuel, 2008). For measuring future risk, investors may use historical beta if it shows stability over time. According to a number of researches, the beta of individual securities is not stable over time which implies historical betas are not appropriate indicators of the future risk of securities (Fouque and Langsam, 2013). In the multi factor model proposed by Fama and French (1992), the market index and book to market ratio are considered which states that these variables generate systematic risks or non-diversifiable risks with respect to returns which is not captured by market return and prices independently from the beta of the market. In brief, according to this model, as the systematic risks are not related to the beta factor, they are not exposed in the CAPM. Fama and French proposed a theory named “Three Factor model” which is more comprehensive as it studies the performance of security prices in relation to the size of the firm and book to market equity. The professors concluded that this model could be used for rational pricing (Fama and French, 1993). Importance of CAPM model CAPM remains a popular model for computing the cost of capital in spite of its apparent invalidity. Graham and Harvay (2001) had stated that CAPM is the most commonly accepted method of measuring the cost of equity capital in companies as more than 70% of the company preferred CAPM model. In addition, as the actual results almost match with the expected results, concluding that the projects having high risk provide higher return reinforces the explanation of the use of CAPM in corporate finance (Vernimmen, et al., 2014). The foundation of CAPM is built on strong assumptions regarding the actions of the investors which are quite unrealistic in practical application; the model rationally evaluates the behaviour of investors regarding diversifying risk. The deviations in the security market line indicated by the presence of alphas denote that CAPM cannot be completely relied upon (Pahl, 2007). Since CAPM computes expected returns and not actual return, it is widely used as an accurate method for calculating the cost of capital of a firm. Reference list Banz, R., 1981. The relation between return and market values of common stock. Journal of Financial Economics, 9, pp. 3-18 Barucci, E., 2003. Financial markets theory: equilibrium, efficiency and information. London: Springer-Verlag London Limited. Berk, J. and DeMarzo, P., 2007. Corporate finance. New York: Pearson Education Chavas, J., 2004. Risk analysis in theory and practice. California: Elsevier Academic Press Elton, E., Gruber, M., Brown, S. and Goetzmann, W., 2010. Modern portfolio theory and investment analysis. Danvers: John Wiley and Sons, Inc. Fama, E. and French, K., 1992. The cross section of expected stock returns. Journal of Finance, 47, pp. 427-465 Fama, E. and French, K., 1993. Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33, pp. 3-56 Fama, E. and French, K., 2002. The equity premium. Journal of Finance, 57, pp. 637-659 Fama, E. and Macbeth, J., 1973. Risk return and equilibrium: some empirical tests. Journal of Political Economy, 8, pp. 607-636 Fouque, J. and Langsam, J., 2013. Handbook on systemic risk. New York: Cambridge University Press. Graham, J. and Harvey, C., 2001. The theory and practice of corporate finance: evidence from the field. Journal of Financial Economics, 60, pp. 187-243 Hill, R., 2010. The capital asset pricing model. London: Robert Alan Hill and Ventus Publishing ApS Kothari., 1995. Another look at the cross section of expected stock returns. Journal of Finance, 50, pp. 185-224 Manuel, K., 2008. Limitations of the capital asset pricing model (capm). Norderstedt: Drunk und Bindung Pahl, N., 2007. Principles of the capital asset pricing model and the importance in firm valuation. Norderstedt: Grin Verlag Pandey, I., 2005. Financial management. Noida: Vikas Publishing House Pvt Ltd. Roll, R., 1977. A critique of the asset pricing theory test. Journal of Financial Economics, 4, pp. 129-176 Sharpe, W., 2000. Portfolio theory and capital markets. New York: McGraw Hill. Sharpe, W.F., 1964. Capital asset prices: a theory of market equilibrium under conditions of risk. Journal of Finance,19, pp. 425-442 Sheeba, K., 2011. Financial management. Noida: Dorling Kindersley (India) Pvt. Ltd Soros, G., 2003. The alchemy of finance. New Jersey: John Wiley and Sons, Inc. Vernimmen, P., Quiry, P., Dallocchio, M., Fur, Y. and Salvi, A., 2014. Corporate finance: theory and practice. West Sussex: John Wiley and Sons Read More