Use of Capital Asset Pricing Model in Valuing Securities and Related Risks - Literature review Example

Introduction Capital Asset Pricing Model (CAPM) Capital asset pricing model refers to the framework used in determining the appropriate rate of return for the asset and whether the asset can be added to the diversified portfolio given the non-diversifiable risks of the asset(Perold 2004, p. 3). The model was developed in 1964 by William Sharpe and it marks the beginning of asset pricing theory. This takes into consideration the sensitivity of the asset to the non-diversifiable risk. The model describes the relationship between the expected rate of return and risk in risky securities. CAPM is based on the idea that there should be compensation for the investors through time value for the money and risk. Time value for the money is equivalent to risk-free rate (rf) and it compensates the investors in their placement of money to investments within a certain period. The formula represents the risk and calculates amount of compensation required by an investor when considering for an additional risk. This is achieved through taking the risk measure as beta for comparing the asset returns to those in the market in a certain period (Rm-rf). According to the model, expected rate of return on security is equivalent to the rate on risk free security combined with the risk premium. When the expected return fails to meet the required level, the investment is not viable. The market line for the security lines up the plot for the results for the different types of risks (Morelli 2007, p. 257). However, the model assumes that all investors aim at maximizing their economic utility and remain risk-averse and rational. The model also assumes that investors are price takers, can lend and borrow in unlimited manner under risk-free interest rates, deal with the securities that can be divided into smaller portions and assumes that all the information remains the same at all time for all investors (Morelli 1997, p. 257). Use of CAPM in valuing securities and related risks The graph above shows the security market line describing relationship between beta and expected rate of return of the asset. The CAPM provides a model for pricing a security or portfolio. For security, the model makes use of security market line (SML) and the relationship to systematic risk (beta) and expected rate of return. This shows how the market is expected to price the individual securities relative to the security risk class. Therefore, SML is critical in calculating reward-to-risk ratio for the security relative to the overall market price (Lally & Tony 2003, p. 187). Therefore, when expected rate of return for securities are deflated by the beta coefficient, reward-to-risk ratio for the securities in market is equivalent to ratio of market reward-to-risk represented by The ratio of market reward-to-risk represents the market risk premium. Rearranging above equation and substituting for E(Ri), the capital pricing model is obtained as In this case, E(Ri) represents expected excess return on capital asset, E(Ri) represents risk-free rate for the interest like the interest from government bonds. The beta coefficient βi represents the sensitivity of expected excess return assets to expected returns on the market. E(Rm) represents the expected excess market returns, while E(Rm) − Rf is the risk or market premium expressing the difference between expected rate of return on markets and the rate of return on risk-free rate (Johnston 2007, p. 35). Pricing of the Assets After calculation of expected rate of return, E(Ri), using CAPM, future cash flow for the asset can then be discounted to give their present value in order to establish the correct asset price. Theoretically, an asset can be said to be correctly priced if the observed price is equivalent to the value calculated using CAPM derived rates for the discount. When observed price becomes higher that valuation price, then the asset is said to be overvalued, or the asset can be undervalued when observed price remains below the valuation price by the CAPM (Graham & Harvey 2001, p. 25). Alternatively, the discount rate can solved for observed prices for a particular valuation model so as to compare the CAPM rate with the discount rate. When the discount rate for the model is lower than CAPM rate, then asset is therefore said to be overvalued. However, when the discount rates are higher than CAPM rates, then the asset is said to be undervalued (Fama & French 2003, p. 550). The Asset-specific required return The CAPM returns represent asset-appropriate returns required or the discount rates. These are the rates through which the future cash flows by an asset are discounted given the relative risk of an asset. The betas that exceed one indicate a ‘higher than average’ level of risk, while betas below one represent a ‘lower than average’ risk. Therefore, more risky stock have a higher beta, hence will be discounted at lower rates. For a given accepted concave utility function, the investors must use a higher rate of return for holding a risky asset. Beta reflects the asset-specific sensitivity of non-diversifiable assets; therefore, the overall market has a beta value of one. The stock market indices are used most frequently as local proxies for the market; in this case, the beta value is equals to one. Therefore, an investor in a diversified portfolio must expect a performance in line with market (Faff et al. 2002, p. 1). Risks and diversification The risk for securities encompasses both systematic risks or undiversifiable risk, and unsystematic or idiosyncratic risk. Systematic risks entails the risks that are common to market risks or all securities while the unsystematic risks refers to risks associated with the individual assets and can be diversified to smaller levels through inclusion of large number of assets within the portfolio. However, this is not possible for the systematic risks in a single market. Based on the type of market, a portfolio with approximately 30-40 securities within the developed markets may render a portfolio as sufficiently diversified to ensure that the risk exposure remain limited to the systematic risks only. For developing markets, a higher number is needed as a result of the increased asset volatilities (Schubert et al. 1999, p. 381). For investment, a non-diversifiable risk is more preferable to enable the linking of the required return on asset within a portfolio context. Within a CAPM context, the portfolio risk results in a higher variance with less predictability. Therefore, the beta for the portfolio is equivalent to the defining factor for rewarding systematic exposure by an investor (Desierto & Desierto 2013, p. 405). The market portfolio An investor may chose to invest in a portfolio comprising of risky assets with rest remaining in cash or may borrow money in funding the purchases within a risky asset with a negative cash weighting. This shows a clear linear relationship, and it is possible to achieve a return through complete investment in a risky portfolio or investment in both cash and in risky portfolio. For a certain level of return, one of the portfolios must be optimal. Since risk free asset is uncorrelated with all the assets, the market option will have a lower variance, hence the most efficient. This relationship remains true for the portfolios on efficient frontier resulting in high return portfolios and cash. For a certain risk free rate, only one portfolio that can be combined with the cash so as to attain the lowest risk level for the possible returns. This represents the market portfolio (Chang 2011, p. 23). Comparison of CAPM with Dividend Valuation Model (DVM) While CAPM is used in determining the appropriate rate of return for the asset, the Dividend Valuation Model, is a framework used in valuing the stock price. This means that DVM values stocks based on net present value of future dividends. In price appreciation, the CAPM can be used in calculating the probability of growth of an investment while the DVM enhances the dividend appreciation. Stocks that pay dividend attract investors. Therefore, the investment in securities must focus on income received from dividends with slight appreciation in stock prices. For CAPM, the risk can be run to determine the level of risk while for DVM, the risks can be run do determine the money that cannot be afforded by the company through cutting down the dividends. Also, the CAPM the stocks can be held up for quite a long time to allow for the increase in prices while for DVM, the dividends can be received quarterly which must be owned throughout the period (Elton & Martin 1997, p. 1743). Drawbacks of CAPM The model assumes random normal distribution of the variables. It is observable that returns on other markets and equity are not distributed normally. As such, large swings occur more frequently in such markets than for normal distribution as assumed by the model (Calomiris & Doron 2012, p. 45) . The CAPM assumes variance for the returns is an appropriate measurement for the risk. Nevertheless, this is justifiable under normally distributed assumption for the returns. For general return distribution, other risk measures have high likelihood of reflecting the preferences of the investors in a adequate way. According to the model, all investors are assumed to have the access to same information and seem to agree on expected return on assets and associated risks. This homogeneous expectation of the assumptions is inappropriate. The CAPM model assumes the matching of probability of the investors’ beliefs with true return distribution. However, a different possibility is that the expectation by the investors is normally biased, and this makes the market prices to be inefficient informationally. The CAPM never gives adequate explanation of the variation of the stock returns. According to the empirical studies, low beta stocks offer higher returns than the predictions by the model. Such a possibility portrays a volatility arbitrage strategy for reliability beating in the market. The assumption by the model of the expected return investors preferring low variance risks to the high variance risks conversely given a particular risk level prefers higher returns to the lower ones. This prohibits investors from accepting lower returns for higher risks. According to the model, there is assumption of non availability of transaction costs and taxes. This may, however, be relaxed with other complicated versions by the model. The market portfolio comprises of assets in all markets, with every asset weighed by the market capitalization. However, this assumes lack of preference between the assets and the markets for the investors who chose the assets as a function of the risk return profile. This assumes that all assets are divisible indefinitely as to amount that can be easily transacted or held (Coën 2001, p. 497). Theoretically, the market portfolio is supposed to include the different assets held by most people as an investment. Practically, such portfolio is impossible and remains unobservable. This calls for substitution of the stock index as proxy for true market portfolio. This is unfortunate as substitution is innocuous and may result in false inferences regarding the validity of CAPM. Therefore, CAPM may not be empirically testable due to inobservability. The CAPM assumes only two dates. This makes it hard to rebalance and consume the portfolios repeatedly. Finally, the assumption by the model that all investors consider their assets in order to optimize on one portfolio presents a sharp contradiction with the portfolios held by the investors since human possess fragmented portfolios most of the time (Viebig et al. 2008, p. 45). References List Calomiris, C., & Doron, N. (2012). Crisis-Related Shifts in the Market Valuation of Banking Activities. Cambridge, MA: National Bureau of Economic Research. Chang, M. (2011). Reexamination of Capital Asset Pricing Model (CAPM): An Application of Quantile Regression. African Journal Of Business Management 5(33), pp. 23-6. Coën, A. (2001). Home Bias and International Capital Asset Pricing Model with Human Capital. Journal of Multinational Financial Management 11(4-5), pp. 497-513. Desierto, D. A., & Desierto, D. (2013). Investment Pricing and Social Protection: A Proposal for an ICESCR-adjusted Capital Asset Pricing Model. ICSID Review 28(2), pp. 405-19. Elton, E., & Martin, J. (1997). Modern Portfolio Theory, 1950 to Date. Journal of Banking & Finance 21(11-12), pp. 1743-759. Faff, R., Brooks, R., & Ho, Y. (2002). New Evidence on the Impact of Financial Leverage on Beta Risk: A Time-series Approach. The North American Journal of Economics and Finance 13(1), pp. 1-20. Fama, E. F., & French, K. (2003). The Capital Asset Pricing Model: Theory and Evidence. Tuck Business School Working Paper No. 03-26, pp. 550. Graham, J., & Harvey, C. (2001). The theory and practice of corporate finance: evidence from the field . Journal of Financial Economics 23(2), pp. 25-30. Johnston, M. (2007). Extension of the Capital Asset Pricing Model to Non-Normal Dependence Structures. ASTIN Bulletin 37(1), pp. 35-52. Lally, M., & Tony, V. (2003). Capital Gains Tax and the Capital Asset Pricing Model. Accounting and Finance 43(2), pp. 187-210. Morelli, D. (1997). Beta, size, book-to-market equity and returns: A study based on UK data. Journal of Multinational Financial Management Volume 17 (3), pp. 257-272. Morelli, D. (2007). Beta, Size, Book-to-market Equity and Returns: A Study Based on UK Data. Journal of Multinational Financial Management 17(3), pp. 257-72. Perold, A. (2004). The Capital Asset Pricing ModeL. Journal of Economic Perspectives 18(3), pp. 3-24. Schubert, M., Gysler, R., & Brachinger, H. (1999). Financial Decision-Making: Are Women Really More Risk Averse? Papers and Proceedings:American Economic Review 89(2), pp. 381-385. Viebig, J., Armin, V., & Thorsten, P. (2008). Equity Valuation: Models from Leading Investment Banks. Chichester, England: John Wiley & Sons. Read More