The Practical Use of Capital Asset Pricing Model - Essay Example

The Practical Use of Capital Asset Pricing Model (Camp) THE PRACTICAL USE OF CAPITAL ASSET PRICING MODEL (CAMP) Camp is a model that is used to determine the relationship between risk and the return expected and that is used to price risky securities. This model takes into account the sensitivity of an asset to market risk or systematic risk, often in the financial industry represented by the quantity beta (β) as well as the expected return of the risk-free asset and the expected return of the market. John Lintner, William Sharpe, and Jan Mosin simultaneously and independently developed CAMP. In the period of 1964-1966, their research appeared in three highly respected, different journals. At first when CAMP was introduced, the investment community viewed it with suspicion because it seemed to insinuate that management of professionals’ investment was a waste of time. It took almost a decade for investment professionals to begin viewing CAMP as a vital tool that helped investors understand risk (Bangemann, 2007). The separation of the risk into two categories is the model’s key element. The first category or type is called unsystematic risk. The average long-term returns for this kind of risk are supposed to be zero. The second type of risk is the systematic risk that I die to general economic uncertainty. On average, CAMP states that return on assets should equal the yield on a free risk bond held over that time and a premium that is proportion to the amount of the systematic risk possessed by the stock. Measurement of a company’s cost of equity capital is one of the most important tasks of a financial manager. The challenging part of it all is estimating the cost of equity. Capital asset pricing model (CAMP) depicts priced securities by financial markets and thus determines the returns expected on capital investments. This model gives a methodology that quantifies and translates risk into estimates of returns expected on equity. The objective nature of the estimated cost of equity this model can yield is the advantage of CAMP. This model cannot be used alone for it simplifies the financial markets world. But financial managers can use it in attempts to come up with a useful and realistic cost of equity calculations by supplementing it to their own judgment and other techniques. The model can also be used to determine the necessary risk free rate to be used. Using CAMP, depending on the market where the asset is, risk free rate is used in computing financial asset’s rate of return (Weaver & Weston, 2001). It can be used to determine what index best represent ones market. The standard and poor’s 500 index could best represent the market. Or one could think the Russell 3000 is best for market representation, then use it. The use of Capital Asset Pricing Model (CAMP), helps isolating a target sector that depicts potential opportunities. For instance, companies with low capitalization most of the time have increased price fluctuation, while having the highest expectation in both return and risk. Corporate bonds and stocks lie in between these two extremes. An attempt is made to employ a method that will determine when individual stocks deviate from this essential relationship. Stocks are deemed as undervalued or discounted when they show potential return that is high but lower risk than expected. This philosophy is normally based on value investing that aims to find companies, which are good and are run by management of high quality with low market prices, relative to current values. Managers of investment select sound companies that are selling at a low Earnings Multiple with little or no debt. Camp rationale can be simplified as follows. Some sorts of risk, known as “residual risk” (alpha risks) can be eliminated by investors through holding a portfolio of assets that is diversified. To an individual asset these alpha risks are specific. Some risks cannot be eliminated by diversification such as that of global recession. All the shares in a basket will still be risky in a stock market. People investing in such a risky basket must be rewarded by getting returns that are above those they can get on safer assets, such as treasury bills. Assuming alpha risks are diversified away by investors, how an investor values a particular asset should crucially depend on how much the price of the asset is affected by the risk of the market. The risk contribution of the market is captured by a measure of relative volatility, BETA, which shows in overall market changes how an asset’s price is expected to change. Investments, which are safe, have a beta close to zero, these assets are called risk free by investors. Investments which are riskier such as a share, are supposed to earn a premium that is over the risk free rate. Due to opening of emerging markets in the recent years, there are more choices in investment. Many investors have been attracted in the international arena due to high investment return especially the emerging markets. This is because diversification is a strategy of established investment that can play a very important role in assisting to balance risk and potential of the long-term return. In addition, international investing offers performance to the maximum, and it brings opportunities in markets with greater growth potential. However, it is very important in most emerging markets like Asia, Africa, Europe and Latin America on how to select a profitable investment target. After the emerging markets are liberated, the capital flow becomes easier and the relative risk of increased investment (Neelan, 2006). The condition of markets integration and risk price before and after market liberalization are subjects of contemporary interest. In this study, the international CAMP model plus the exchange rate risk factor are used. Some of the core assumptions of the CAMP model are: Investors prefer more wealth to less and they are rational. Investors share expectations that are homogeneous on the distribution of security returns of the future. To maximize a linear of the variance and mean of security returns is what investors seek. No securities suffer from illiquidity and transactions and taxes costs are zero. The calculated expected return using CAMP is a very important tool in project appraisal.it is superior to Net present value (NPV) approach that uses for all projects only one discount rate regardless of their risk. The use of Camp has practical problems in investment appraisal as follow; 1. Estimating the risk free rate is difficult especially on projects under different economic environment. 2. CAMP cannot be used for projects that last for more than one year because it is a single period model 3. Estimating the risk free rate of return may be hard. 4. It is not easy to modeled complications in decision-making. CAMP was developed as a model for share valuation and investment appraisal. As seen in the above statements CAMP is not suitable for projects that take longer than one year due to it been a one-year model. A model known as arbitrage pricing model (APM) was developed from CAMP and which considers various numbers of independent factors that may the share price. CAMP considers risk in form of beta factor. Using APM the rate of return expected considers factors like unanticipated inflation, changes on bonds and in risk premium, changes in the level of industrial production as expected, and changes in term structure of interest rates that was unexpected. Vivian Fernandez and group formulated a time scale decomposition of international version of the CAMP. It accounts for both market and exchange rate risk (Sherman, 2011). In addition, they derived an analytical formula for time-scale value at risk of a portfolio. A methodology to stock indices for seven emergence economies belonging to Asia and Latin America was applied, for the period 1990-2004. The following are their main conclusions. First, the results of the estimation hinge upon the choice of the world market portfolio. The stock markets of the sampled countries in particular, appear to be integrated more with other emerging countries than with the ones developed (Ryan, 2004). Secondly, the value at risk depends on the time horizon of the investors. Potential losses are greater in the short run than in the end. Thirdly, the exposure added to some specific indices of the stock will increase value at risk to an extent that is greater, depending on the horizon of the investment. Their results go in line with research done recently in asset pricing that insists on the importance of heterogeneous investors. Examining the utility of the CAMP model is the main purpose of this article, which is one of the most important risk-return theories, to any emerging economy. This assumes greater importance since with the growth of India and China as twin engines of growth of the world economy; both Foreign Direct Investment (FDI) and portfolio investment have been greatly directed toward emerging economies. However, an environment of emerging economy such as India, there is existence of various limitations such as transaction costs, illiquidity, and taxes. which along with other factors such as non-availability of free and full information to the investing world in general, act to dilute the importance and free applicability of the CAMP model to conditions prevalent in emerging economies, thus necessitating making variations to the camp model. References Bangemann, T. O. (2007). Shared services in finance and accounting. Aldershot [u.a.: Gower. Weaver, S. C., & Weston, J. F. (2001). Finance and accounting for nonfinancial managers. New York: McGraw-Hill. Sherman, E. H., & American Management Association. (2011). Finance and accounting for nonfinancial managers. New York: American Management Association. Ryan, B. (2004). Finance and accounting for business. London: Thomson Learning. Rauf, S. B. (2011). Finance and accounting for energy engineers. Lilburn, GA: Fairmont Press. Neelan, M. H. (2006). Focus on finance and accounting research. Hauppauge, NY: Nova Science Publishers. Read More