The Relative Merits of the Capital Asset Pricing Model - Case Study Example

Critically analyse the relative merits of the capital asset pricing model (CAPM) and empirical approaches to asset pricing (such as the Fama and French model). Table of Contents 1. Introduction 2. Capital Asset Pricing Model (CAPM) – overview, characteristics 3. Strengths and weaknesses of CAPM 4. CAPM compared to Fama and French asset pricing model – empirical approaches 5. Conclusion References Appendix (Words 2037) 1. Introduction The increase of complexity of finance activities worldwide have led to the need for updating the practices used for the estimation of risk involved. Theorists worldwide have tried to identify the methodologies that would be most appropriate for measuring the performance of financial products of various types; the theoretical frameworks resulted from these efforts have been related to a series of advantages and weaknesses. The Capital Asset Pricing Model (CAPM) is one of these theoretical models; as most of other theoretical frameworks of this type, CAPM has been based on rules and principles that can be met only in ideal markets – which do not exist. The specific fact has been also used as a justification for doubting this model’s value; the model of asset pricing developed by Fama and French is among those theories that most oppose CAPM. The conflict developed between CAPM and other theories of this type has helped not only to identify the weaknesses of CAPM but also to understand its potentials under severe market pressures. Moreover, the research made on CAPM has revealed its ability to be transformed being aligned with the market conditions – a potential which does not exist in traditional theoretical models, which are based on common market conditions. 2. Capital Asset Pricing Model (CAPM) – overview, characteristics The Capital Asset Pricing Model (CAPM) is used in order ‘to calculate the required rate of return of an investment’ (Pahl, 2009, p.18); CAPM is the result of the work of the following theorists: W. Sharpe, J. Mossing and J. Lintner (Pahl, 2009, p.18). CAPM is mainly based on the following strategy: the portfolio diversification; through this strategy, the risk for high losses in regard to a particular investment is decreased: investment is distributed among portfolio of different investment characteristics; in this way, the risk for investors is reduced. CAPM has been developed for helping the investors to identify the level of risk of their investment – based on the fact that the main scope of investment is to result to profits for the amount invested (Pahl, 2009, p.18). In accordance to Fabozzi et al. (2006, p.209) CAPM is based on a series of assumptions, which can be indicatively described as follows: a) the investment decisions are influenced by the level of the return expected; this means that each investment decision is expected to result to a profit which is estimated in advance, b) investors accept the diversification of their portfolio; this diversification is based on the relevant methodology developed by Markowitz, c) the investment period is the same for all investors, d) the investors share the same perceptions in regard to the return that their investment is expected to achieve, d) investors ‘can borrow or lend any amount at the risk free-rate asset’ (Fabozzi et al., 2006, p.209), e) ‘capital markets are (perfectly) competitive and frictionless’ (Fabozzi et al., 2006, p.209); another principle on which CAPM is based is the fact that shares can lead to higher profits compared to government bonds which can have quite low return (Chisholm, 2009); in the context of CAPM government bonds are useful in order to identify the minimum return guaranteed to investors. The forms of CAPM can be differentiated – apart from the standard forms of CAPM there are also the complex forms of CAPM which can be used in case that alternatives need to be set in regard to a particular investment project (Elton et al., 2009, p.284). The point at which CAPM is differentiated from other asset pricing methods is the following one: - which is also considered to be its advantage: CAPM can help investors to estimate the return of their investment even regarding ‘the risks that cannot eliminate through diversification’ (Pahl, 2009, p.19). On the other hand, CAPM has also common characteristics with other asset pricing models; a key characteristic of this type is the fact that ‘CAPM is an abstraction of reality’ (Lasher, 2007, p.405). The value of CAPM compared to the other asset pricing methods can be related to the following facts: a) CAPM is the most effective tool for assessing the relationship between risk and return; b) through CAPM assumptions can be developed on ‘how market risk is priced and how idiosyncratic risk is not priced’ (Constantinides et al., 2003, p.624), c) the CAPM can be used in order to assess the future performance of an investment – even if at that point its effectiveness is often doubted, d) the mathematical forms developed in the context of the CAPM are easy – compared to other, similar, asset pricing methods (CTG, 2008, p.152), e) risk-free assets are available to the investors – the latter can choose to invest on these assets eliminating the risk of their investment (CTG, 2008, p.154). The potential used of CAPM in practice is presented through two graphs in the Appendix section – the example refers to the co-existence of three available projects and the use of CAPM for estimating their return. 3. Strengths and weaknesses of CAPM CAPM is one of the most important models for measuring the performance of investments within a particular period of time; as noted above, the specific model can be used both for the current period and for the future, i.e. estimations can be made in regard to the future performance of a financial product – but only under specific terms. No similar theoretical model exists in the specific field – a fact that makes CAPM unique in regard to its role and its potentials. On the other hand, the findings retrieved through CAPM may be confirmed using different – similar – theoretical models – even using different hypotheses. This fact should be noted when handling the critiques against CAPM. However, the above model has not managed to avoid the oppositions of theorists and researchers studying the particular subject. Moreover, the structure and the theoretical rules of CAPM have certain weaknesses, which are used for justifying the opposition towards the specific theoretical model. Despite its value for identifying the level of risk and return involved in assets, CAPM has been related to a series of problems; in accordance with Kurschner (2008) the empirical tests that have been developed in regard to CAPM showed its inability to retrieve precise estimations on the future performance of assets – it is noted that weaknesses have been ever identified regarding the identification of the past performance of assets. One of the majors problems of CAPM is the fact that it can lead to unrealistic assumptions; this problem results because of the following reason: through the CAMP the performance of investment is measured in regard only to the next period (Kurschner, 2008, p.6); when returns are estimated by referring only to the next period – even for investments that are going to last for many years – this automatically leads to severe failures – referring to the estimated performance of the investment at the end of the investment period. By considering the performance of investments as standardized for the whole investment period – even if the specific investment is going to last for many years – this results to false indications regarding the performance of the investment at the end of the investment period. The fact that CAPM is not related to the real world – as also other similar theoretical models – is considered to be one of its major weaknesses; since the hypotheses used in CAPM reflect ideal market conditions – which does not exist in practice – this means that the findings of this model are not credible (Lasher, 2007, p.405). 4. CAPM compared to Fama and French asset pricing model – empirical approaches CAPM has been often compared to other asset pricing models; through this comparison the advantages and the weaknesses of CAPM have been identified. One of the most known asset pricing models used for evaluating CAPM is the Fama and French theory. The French and Fama three - factor model is used along CAPM for measuring ‘the cost of equity capital’ (Pratt, 2002, p.37); the three – factor model of Fama and French (1992) is based on the following factors: a) the market risk premium; up to this point, the Fama and French model are similar with CAPM, b) the second factor is developed by ‘gathering all active traded stocks and diving them into two portfolios’ (Brigham et al., 2009, p.99); it is necessary that the two portfolios include stocks of different size: small stocks should be included in one portfolio and the big stocks should be included in the other, c) the third factor is developed by ‘ranking all stocks according to their book-to-market ratios’ (Brigham et al., 2009, p.99). The second and the third factor are the points at which the Fama and French theory is differentiated from CAPM. Fama and French have been strongly doubted the value of CAPM justifying their view by the following argument: ‘no historical relationship has been proved to exist between the returns on stocks and their betas’ (Lasher, 2007, p.405). In practice, the model of Fama and French can be characterized as more efficient than CAPM especially at the following point: the principles on which the Fama and French model is based are mainly these two: a) the use of time-series market betas when trying to identify the differences in the performance of US equities should be avoided – as it often results to misleading information (Connor et al., 2009, p.130) and b) ‘market capitalization and book-to-price ratio are strongly correlated with the difference in mean returns across securities’ (Connor et al., 2009, p.130); the above rule emphasizes on the potential effects of size and value in the performance of stocks of different characteristics (value and size) (Cochrane, 2005, p.216). It is through the above rules that the difference between the Fama and French model and CAPM becomes quite clear. The Fama and the French model sets a series of criteria for the evaluation of performance of stocks – these criteria are based on figures related to a particular market – they are not imaginary; however, CAPM is based on ideal market conditions and leads to findings that cannot be tested analytically neither evaluated – as in Fama and French model where findings can be verified at the end of each of the model’s phases. The use of three factors in the theory of Fama and French should not lead to the assumption that the above model is more complex than CAPM; in fact, the theory of Fama and French has been regarded as having a key role in the limitation of the power of statistics in measuring equity; the simplicity of the theory of Fama and French – compared to other theoretical models of similar form – is a characteristic common with CAPM. 5. Conclusion The examination of the characteristics and the performance of CAPM has led to the assumption that the role of this theoretical model is quite specific: to help identifying the potential performance of financial products (investments of various types) within a particular period of time. However, it has to be noted that the principles and the assumptions/ hypotheses on which this model is based can be doubted as of their credibility. Investment decisions are part of a market’s operation – in terms that the specific actions are not imaginary. Therefore, their evaluation by referring to the conditions of an ideal market may lead to the following controversy: the return of investment expected can be lower or higher compared to the actual return of this investment – at the end of the investment period. This fact is made clearer when using the Fama and French approach for evaluating CAPM; it is revealed that CAPM can be appropriate only under specific terms especially when there is no need for accurate measurement of performance but just an estimation of the expected return on investment – again, at an average level; in accordance with Chandra (2008) the empirical tests that have been developed for evaluating CAPM prove the value of CAPM for measuring equity performance. In any case, it is important to have in mind that the findings of CAPM are valuable only under standardized market conditions – where the distance between the ideal market and the current market is not too long; otherwise, i.e. in markets that suffer from severe turbulences the findings of CAPM would not help to estimate the performance of an investment – even at an average level. References Barucci, E. (2003) Financial markets theory: equilibrium, efficiency, and information. Springer Brigham, E., Daves, P. (2009) Intermediate Financial Management. Cengage Learning Chisholm, A. (2009) An Introduction to International Capital Markets: Products, Strategies, Participants. John Wiley and Sons Cochrane, J. (2005) Financial markets and the real economy. Now Publishers Connor, G., Goldberg, L., Korajczyk, R. (2009) Portfolio Risk Analysis. Princeton University Press Constantinides, G., Harris, M., Stulz, R. (2003) Handbook of the economics of finance, Volume 1. Elsevier Damodaran, A. (2008) Strategic risk taking: a framework for risk management. Wharton School Publishing Danthine, J., Donaldson, J. (2005) Intermediate financial theory. Academic Press Dash, A. (2009) Security Analysis And Portfolio Management. I. K. International Elton, M., Gruber, M., Brown, S. (2009) Modern Portfolio Theory and Investment Analysis. John Wiley and Sons Fabozzi, F. (2007) Robust portfolio optimization and management. John Wiley and Sons Fabozzi, F., Focardi, S., Kolhm, P. (2006) Financial modeling of the equity market: from CAPM to cointegration. John Wiley and Sons Chandra, P. (2008) Investment Analysis 3/E. Tata McGraw-Hill Corporate Training Group, CTG (2008) The Investment Bankers Handbook: Accounting, Valuation and Modelling. ILX Group Islam, S., Watanapalachaikul, S. (2005) Empirical finance: modelling and analysis of emerging financial and stock markets. Springer Kevin, S. (2006) Portfolio management. PHI Learning Pvt. Ltd. Kurschner, M. (2008) Limitations of the Capital Asset Pricing Model (CAPM): Criticism and New Developments. GRIN Verlag Lasher, W. (2007) Practical Financial Management. Cengage Learning Magill, M., Quinzii, M. (2002) Theory of incomplete markets. MIT Press Mercer, C., Harms, T. (2007) Business valuation: an integrated theory. John Wiley and Sons Pahl, N. (2009) Principles of the Capital Asset Pricing Model and the Importance in Firm Valuation. GRIN Verlag Pratt, S. (2002) Cost of capital workbook. John Wiley and Sons Schon, D. (2007) The Relevance of Discounted Cash Flow (DCF) and Economic Value Added (EVA) for the Valuation of Banks. GRIN Verlag Shim, J., Siegel, J. (1998) Schaums outline of theory and problems of financial management. McGraw-Hill Professional Van Horne, J., Wachowicz, J. (2008) Fundamentals of financial management. Pearson Education Appendix 1. Example of CAPM in practice – as retrieved through the following source: (source: http://www.palisade.com/articles/motta_preftheory.asp) Projects A, B, C and D are available to an investor; three are the characteristics of these projects: development costs, return and risk are given in millions of US$ dollars – first graph. The estimated return is presented in the second graph. Read More