Asset Pricing and Default Risk - Essay Example

Groppelli and Nikbakht de that the task of project appraisal, and investment capital budgeting is a challenging and complex managerial issue. On this basis, a variety of methods have been developed for purposes of aiding investment analysts and managers to find a proper mix of assets in any given project or portfolio, in which the company under consideration has an intention of making investment returns on the excess cash flow of the company. It is important to understand that the notion of the time value for money is a crucial aspect in developing these appraisal techniques and models. Campbell (2012) denote that there are various theoretical frameworks developed from these ideas, and these models include, accounting rate of return, discounted cash flow techniques, real options, internal rate of return, and profitability index. This paper analyzes the concept of Capital Asset Pricing Model abbreviated as CAPM, and its practical implications in the modern and current business world. This concept of CAPM was developed by William Sharpe in 1970, and it is based on the idea that an investment normally has two types of risks, namely, systematic and unsystematic risks. Systematic risks involve the market risks that are impossible to diversify (Wang and Xia, 2002). Examples of systematic risks include wars, recessions, and interest rates. Unsystematic risk on the other hand involves market risks that can be diversified by investors (Pesaran and Yamagata, 2012). These types of risks are also called specific risks, and this is because they are always specific to an individual stock. Groppelli and Nikbakht (2012) therefore denote that unsystematic risk is a representation of a component of the stocks return which does not have any correlation with the general market movement. Wang and Xia (2002) denote that it is possible to remove unsystematic risks through diversification. Scholars define portfolio diversification as a concept whereby an investor invests in a number of assets, in a particular ratio, as opposed to investing in one asset by using the same amount of capital (Wang and Xia, 2002). On the other, scholars denote that diversification does not solve the problems brought about by systematic risks. On this background, scholars denote that when calculating a return on an investment, investors normally suffer most from systematic risks. On this basis, CAPM came into existence for purposes of measuring systematic risks that investors will face. Wang and Xia (2002) further denote that it is always impossible for investors to avoid risks. This is no matter how good they are at diversifying their investments. However, Groppelli and Nikbakht (2012) are quick to point that all investors normally deserve a rate of return for their investments. This is because a rate of return for their investments is a compensation for the various risks that these investors took. On this basis, the CAPM helps investors to make a calculation on the expected rate of return, and the investment risk that they would face. It is important to understand that the main element of the decision making strategy of CAPM is the mean variance portfolio theory that was developed by Harry Markowitz in 1952 (Campbell, 2012). This theory denotes that in any given market, there is an optimal market line which enables an investor to rationally select his assets or investments (Pesaran and Yamagata, 2012). This optimal market line is responsible for minimizing the standard deviation for a given expected return, of an investment in a particular asset. Pesaran and Yamagata (2012) denote that the standard deviation under these circumstances normally represent the asset risk of an individual. Pesaran and Yamagata (2012) further denote that this market line is always called the efficient frontier, and it is a representation of economic points, in relation to the worth of a capital investment. These are investments that investors are always willing to trade, because they have a minimal risk. Groppelli and Nikbakht (2012) agree on the fact that, in a market situation that has a combination of options of a risk free investment such as treasury bonds and loans, and high risk assets such as stocks, then the standard deviation will depict a tangent line which passes through a risk free return rate. This return rate is found on the y-axis that touches on an efficient frontier that has minimum risk. The following is a following for calculating CAPM (Pesaran and Yamagata, 2012), ra = rf + β a ( rm – rf ) From this this formula, the following are the meanings of the symbols denoted, ( rm – rf ) symbolizes the equity market premium. rm symbolizes the expected market return. β a symbolizes beta of the security. rf is a symbol depicting risk free rate. Based on this formula, it is important to understand that the starting point for calculating CAPM is the risk free rate. On most occasions, the risk free rate is a ten year bond yield of the government. Lee (2010) denotes that a premium is added whereby investors demand for compensation because of the extra risk that they are willing to engage in. This is referred to as the equity premium, and it consist of an overall expected return from the market, minus a return rate that has no risks. This equity market premium is always multiplied by the coefficient referred to as beta. According to the philosophies of CAPM, beta is the major measure of the risk of a stock (Lee, 2010). Scholars denote that beta is responsible for measuring the stock’s relative volatility, i.e. how much the price of a given stock moves up and down, in comparison to the overall up and down movement of the entire stock market. For instance, Campbell (2012) denotes that if the share price of a particular stock moves in line with the entire market, then the beta of this stock is 1. Campbell (2012) gives an example by denoting that a beta of a stock that is 1.5 will most definitely rise by 15%, if the movement of the entire market rose by 10%. The same beta of the given stock will fall by 15%, if the movement of the entire stock market fell by 10%. Breig (2011) observes that beta is found through a statistical analysis of the daily share price returns of a particular stock, when compared with the daily return of the market, over the same period in time. Breig (2011) denote that there is always a linear relationship that exists between the beta, and the financial returns of the given stock. Breig (2011) further goes on to denote that when there is a comparison between beta and the equity risk premium, then investors are able to know the compensation that they will get by taking additional risks. On this basis, Back (2010) denotes that having knowledge of the various parts of the CAPM is advantageous because it will help an investor to know on whether the price of his investment is consistent with the returns that he or she expects. It is therefore important to understand that extensive use of the principles of CAPM helps an investor to isolate a target market, where numerous opportunities exist. For instance, Back (2010) denotes that companies that have limited capitalization are characterised by increased price fluctuations. On this basis, their rates of return are high, as well as their risks. Back (2010) further goes on to denote that in between the higher rates of return, and high risks, lies the bonds and corporate stocks. On this basis, there is always an attempt in determining the level in which the stocks under consideration will deviate from their original prices. It is therefore important to denote that the values obtained through calculating the CAPM is useful for investors to know good companies, that are well managed, and the rates of return that an investor will get by investing in stocks of the particular company (Campbell, 2012). Take for example, an hypothetical company X, with the beta of 1.6, 7% free risk return, and a risk premium of 8%. Using the formula above, the expected rate of return will be, 7% + 1.6 (8%) = 19.8%. The rate of investment of the stocks of company X is 19.8%. In conclusion, the CAPM is a simple theoretical framework that gives out a simple solution, in the name of the return to investment of a particular stock. This model denotes that the only reason as to why an investor should get a higher rate of return by investing in one portfolio is because it is very risky to invest in one stock. The main element in this model is the beta, as it is the main factor that determines the rate of returns of a given stock. However, there are doubts on the validity and accuracy of the CAPM to depict the rate of returns of an investment. This is because there is a proof from research that the differences in betas of a stock cannot explain the performances of a variety of stocks. In as much as there are doubts’ concerning the validity of CAPM, this model is widely used by various investment groups. This is because investor can correctly deduce the fact that a portfolio that consists of high beta will most likely have a rapid movement on the prices of its stock, and vice versa. Bibliography: Back, K. (2010). Asset pricing and portfolio choice theory. Oxford: Oxford University Press. Breig, C. (2011). Asset pricing and default risk. Hamburg: Kovač. Campbell, J. Y. (2012). An intertemporal CAPM with stochastic volatility. Cambridge, Mass.: National Bureau of Economic Research. Groppelli, A. A., & Nikbakht, E. (2012). Finance (6th ed.). Hauppauge, N.Y.: Barrons ;. Lee, C. L. (2010). Lower partial moment-capital asset pricing model in listed property trusts. Saarbrucken, Germany: Lambert Academic Publishing. Pesaran, M. H., & Yamagata, T. (2012). Testing CAPM with a large number of assets. Cambridge: University of Cambridge, Faculty of Economics. Wang, S., & Xia, Y. (2002). Portfolio selection and asset pricing. Berlin: Springer. Read More