The CAPM Model - Report Example

Finance Contents Contents 2 Introduction 3 Discussion 3 CAPM Assumptions 3 Applications of CAPM 5 Conclusion 8 References 8 Introduction The CAPM model was developed in order to explain how the risky securities are priced in the market and it was developed by experts known as Lintner and Sharpe. But Markowitz looked at CPAM from a more practical approach to stock valuation. The main attraction point of CAPM is that it is powerful and offers intuitively pleasing predictions on how to measure the risk and provides the relations between risk and expected return. But the empirical record of CAPM model is very poor and it is poor enough to invalidate the way it is used in the applications. The empirical problems of CAPM reflect the theoretical failings because of many simplifying assumptions. But still CAPM has wide applications in the practical aspects of financial systems. This report will take a look at the assumptions of CAPM model, the model itself and the practical applications of the model. Discussion CAPM Assumptions CAPM is based on the number of assumptions. These are The investors look to maximize the utility of his wealth instead of wealth. The difference is that individual preferences are taken in account in the utility concept. For example some individuals are low risk takers while others have high risk appetite that will have increasing marginal Utility for wealth for others. The second preference is that the investors have similar expectations of Return and Risk. This assumption is important because without this the estimates of variance and mean will lead to different forecasts with the result. It will result in many efficient frontiers each depending on the set of preferences of individual return and risk. The third assumption is that the investors make their decisions on a rational basis depending on their risk and return appetite. Here the rational investors tries to diversify away their unsystematic risk and only systematic risk remains which depends on the Beta of the security. The fourth assumption is that investors will have free access to available information at no loss of time and no cost. In case the information is not same for all the party, then there will be no common efficient frontier line. The fifth and final assumption is that the investors should have same time horizons. Investors which have different time horizons will have different stock estimates. According to CAPM the risk and return follow a linear model Here is the expected return on security j. is the risk free return. is the beta of the security j and E (RM) is the expected return on the market portfolio. The above relationship is referred to as security market line. The required return on a security consists of two parts. One is the risk free return ( ) and the risk premium. Figure 1: Relationship between CAPM and SML (Source: Hill, R.A. 2002, p. 26) The intercept in the above figure represents the nominal rate of return on the risk free security. The intercept is expected to be equal to risk free rate of return plus the inflation rate. The slope in the above figure indicates the price per unit of risk and is a function of the risk aversion of investors. If the inflation or real risk free rate of return changes the intercept of the security market line changes. Again if the risk aversion of the investors changes then the slope of the security market line will change. The slope of the CAPM model indicates the beta. It indicates the portfolio premium to the market risk premium. If the value of beta is one then they are all the same (Damodaran, 2008, p. 28). Applications of CAPM There is extensive use of Capital Asset Pricing Model (CAPM) which assists in a focusing on a particular sector where the potential opportunities appear. For example there are firms with small capitalization which have increased price fluctuations while having both the highest expected risk and return. In between the two extreme points lie bonds and stocks. CAPM model is used to determine whether an individual stocks deviate from this relationship. In case a stock have high potential return but has low expected risk those stocks are termed as undervalued stocks. This technique is used to find good companies which are worth investing. Such companies are usually run by high quality management but with low market prices in comparison to current values. Thus it is the duty of the investment managers to select such sound companies which are selling at low P/E ratio with little or no debt (Elton, Gruber, Brown and Goetzmann, 2009, p. 121). For example in case an investor gets a return of 8% p.a. by investing in riskless US treasury, and then he will not accept anything less than 8% when investing in a riskier security. There is a concept of beta which varies from one share to another. For example financial stocks are very sensitive to the interest rates and changes with every movement of either US Fed Reserve, Bank of England monetary policy and it experiences huge fluctuations. Hence investments in such stocks will result in adding more risk to the market portfolio (Hill, 2002, p. 24). As discussed above the investors are faced with systematic and unsystematic risk. Unsystematic risk is within the control of a company and investors can eliminate this risk by diversification of the stocks. These unsystematic risks are specific to individual stocks for example the risk that managers will not look into the interest of the shareholders. But systematic risk includes risks like global recession which can’t be eliminated by diversification. Hence it is not possible to eliminate systematic risk. Hence investors must be rewarded for investing into such risky basket and earning above average returns. The market’s risk contribution is measured by beta which is the rate of change of asset price with respect to change in overall market changes (Fama and French, 2004, pp. 25-30). In real world, the investors are more concerned about getting higher return for higher risk and are more interested with the company risks rather than with market related risk. Firm uses CAPM to find out the cost of equity of the firm and it is used to estimate the required return for various lines of business and helps to determine the hurdle rates for corporate investments and to calculate the performance of the investment division in terms of returns and costs. The hurdle rates of return are actually the required rates of return and companies assess the past performance of the return and costs for each of the divisions. The CAPM can be used to estimate the rates and costs which is to be charged to cover the costs for public utilities. Thus it is quite evident that from the point of view of costs CAPM is used to regulate the public utilities (Chavas, 2004, p. 121). Again the historical betas and return are used to select the proper risk in investments in the portfolio. It is used to select the securities and form a portfolio and assess the performance of the portfolio. Thus it is a useful tool for portfolio management and investment analysis. Investments in treasury securities have a beta value close to zero and economists term it as risk free. In case of investments into riskier securities it should generate premium more than risk free rate. The amount of risk premium for a particular risky security is calculated by the average premium for all assets multiplied by beta of the asset. Thus it is helpful for calculation of risk premium (Giovanis, 2010, p. 127). Again there are many limitations to the theory. For an average investor this theory is not practical. Such kinds of investor go by the fundamental factors which influences the company, its dividend, and earning and bonus record. Many empirical tests have been conducted on the model and it has not proved to be useful. CAPM model is built on ex-ante factors though actually the expectations of the future are different from person to person. The CAPM model is not testable with the same composition of market. The use of proxies and surrogatives has not proved the CAPM as really practical and useful. Thus though CAPM model is a very good theory but in actual practice it does not follow real world risk-return trends and the same result have been obtained from the empirical test. Research has found that there are many non-beta factors which have influenced the returns. Again few critics have doubted the validity of beta as the historical betas may not reflect the returns or risk in the future. In the short run, the risks and returns calculated on the basis of betas have found out to be unreliable and contrary to the CAPM theory. Hence the CAPM is a good theoretical model abut it has practical limitations. Conclusion CAPM model was used to describe how the risks return trade off of a security and how the assets are priced in the market. The model has a number of assumptions in place which are not practical in real life. CAPM is used to understand the undervaluation or overvaluation of a stock and whether the investors should invest in the stock. CAPM is used for study the beta value of a security which can be used in the diversification of a portfolio. But there are many limitations to the model like critics argue about the validity of the beta value. Hence CAPM model has both practical usability but it is not without limitations. References Chavas, J.P. 2004. Risk Analysis in Theory and Practice. London: Elsevier Damodaran, A. 2008. Strategic Risk Taking: A Framework for Risk Management. London: Pearson Prentice Hall. Elton, E.J., Gruber, M.J., Brown, S.J. and Goetzmann, W.N. 2009. Modern Portfolio Theory and Investment Analysis. New Jersey: John Wiley & Sons. Fama, E.F. and French, K.R. 2004. “The Capital Asset Pricing Model:Theory and Evidence”, Journal of Economic Perspectives. Vol. 18(3), pp. 25-30 Giovanis, E. 2010. Application of Capital Asset Pricing (CAPM) and Arbitrage Pricing Theory (APT) Models in Athens Exchange Stock Market. Berlin: GRIN Verlag Hill, R.A. 2002. The Capital Asset Pricing Model. London: Bookboon Read More