The Capital Asset Pricing Model:Theory and Evidence - Essay Example

Essay, Finance and Accounting Contents Introduction 3 Discussion 3 CAPM Assumptions 3 CAPM Model 4 Practical Application of CAPM Model 6 Conclusion 8Reference 9 Introduction The pricing of assets like bonds and stocks which trade in the capital market is one of the most practical areas of investment and finance and it affects economic life of organisations and individuals. According to economic theory, value of any asset trading in the capital market depends in three components, timings of expected cash flow, future cash flows from the asset and required rate of return which will be used to discount expected future cash flows. With uncertainty of future expected cash flow the expectations of the investors will differ from asset to asset classes. These variations on required rate of return on different assets reflect different degrees of risks which investors must take before investing in different assets. Thus in case two assets which are similar on expected cash flow pattern will trade at different prices in stock market in case the investors assign varying degrees of risk to it. This dependence of risk included in the asset with expected rate of return makes the issue a fundamental one and is captured by Capital assert pricing model (CAPM). Discussion CAPM Assumptions It is a single period model, which indicates that all the investors make same decisions over the same time period. Thus the expected returns are calculated from the expectations which happen over the same period of time. All investors are rational and risk averse All investments are infinitely divisible. All investors are price takers and no firm, individual or financial institution is large enough to distort prevailing market values. Existence of perfect capital market and hence all information is costless and readily available. All investors can borrow and lend without any restrictions at risk free market rate of interest. Transaction costs are zero and the tax system is neutral CAPM Model The CAPM Model describes the relationship between expected return and risk and is used for pricing risky securities. = = Risk free rate = Beta of the security = Expected market return The general idea of CAPM model is for the investors to compensate them in two ways namely risk and time value of money. Risk free rate of return represents the time value of money which investors invest into securities over a period of time. The second half of the formula indicates risk which an investors takes and it also indicates the amount of compensation which an investors needs for taking on additional risk. The amount of risk is calculated by beta which indicates the returns of securities to the market over a period of time with respect to the market premium. The CAPM indicates that the expected rate of return of individual asset or a portfolio of asset equals the risk-free rate of return on a security plus security risk premium. In case the expected rate of return does not meet the required rate of return on security the investors won’t do the investment. The investors need to reduce the unsystematic risk component in order to minimise total risk to reduce that component to reduce it. Investors can reduce their risk by diversifying their portfolios. When stocks are fairly valued then investors will receive a return only on the portion of risk which they cannot eliminate. In case arbitrage opportunities exist in market, investors will not be amply remunerated for a risk which would be eliminated by them through diversification of their portfolios. According to portfolio theory, required rate of return of an investor is not linked to total risk but it is solely based on market risk. This indicates the required rate of ret urn is equal to risk free rate of return plus risk premium for market risk. The coefficient measures the non-diversifiable risk of an asset and it is not the total risk. Hence it is possible to have a stock which is highly risky but with a low if it is only loosely correlated with the market. The difference between the return expected on market as a whole and the risk-free rate is called the equity risk premium. An important property of CAPM is that measures of risk for individual assets are proportional to the weight of each security when the assets are combined into a portfolio. Thus, for example, when an investor buys of asset X which has a systematic risk of and places 1-X of the total wealth in asset Y which has a systematic risk of, then the beta of the portfolio would simply be the weighted average of the betas of single securities. This feature is extremely useful when an investor wants to compute the beta of a diversified company. But there are many limitations of CAPM theory. It is based on the assumption that diversification will reduce risk. According to a study by Campbell, diversification is a very complex process and it changes with time. For example in 1970s a portfolio of 20 stocks reduces the risk significantly but now it takes more than 50 stocks to achieve the same level of diversification. This happens mainly due to other things like high volatility of individual stocks in spite of the fact that market as a whole is not volatile. Other factors for such phenomenon are Internet, biotechnology, younger companies and dwindling prominence of conglomerates which resulted in some diversification. Meanwhile the correlation between individual stocks and market return is falling. This undermines the relevancy of the CAPM and thus beta is becoming less and less relevant. The term risk free means no risk of default and no coupon reinvestment risk. In this respect zero coupon government bonds come closest to meeting this definition. Practical Application of CAPM Model In real world, investors get higher return for higher risk and hence they are more concerned with business related risks than with market related risks. CAPM is used by firms in determining cost of equity for the firm and is used to estimate the required return for divisions and determines the hurdle rates for corporate investments and to evaluate the performance of investment Division in terms of returns and costs. In general the hurdle rates of return are required rates of return and the firm asses the past performance of the costs and related returns for each of the Division. The CAPM Model can be used to estimate the rates and costs of public utilities which are to be charged for covering the costs. From the point of view of cost CAPM is thus used for regulating the public utilities. Betas and historical return are used to select proper risk in investments in the portfolio. The model is used for selecting the securities, evaluating the performance of portfolio and constructing portfolio. Hence CAPM is an important tool for portfolio management and investment analysis. CAPM is a nice tool for appraisal of project as well as its valuation. It can be used for comparing investment projects of different types of risk. CAPM is considered to be superior to net present value because it uses a single discount rate for all the projects instead of leaving it up to the discretion of finance manager or project manager (Fama and French, 2004, pp. 25-29). The investors in the real world are more concerned about how to get high return in exchange for high risk and hence they are more interested in company risk rather than with market risk. CAPM is used by companies to calculate the cost of equity and also used to estimate the required return for different business and determines the hurdle rates of corporate investments. Companies use CAPM to calculate the performance of investment division in terms of costs and returns. Hurdle rates of return indicate the actual required rates of return and organisation uses CAPM to assess the costs for each of the divisions and past performance of the return. CAPM Model is used for estimation of costs and rates charged to cover the costs for public utilities. The application of CAPM and beta factors is done in stock markets. The CAPM model assumes that there are three options for investors for managing their portfolio. These are trading, holding and substituting. A trader can accomplish profitable trade by selling and overvalued securities or buying undervalued securities relative to an appropriate measure of systematic risk. In case the market is bullish and stock prices are expected to increase then it is worth buying the stocks which have high values since they such stocks or assets are expected to rise faster than the market. On the other hand in case the markets are bearish in nature and the stock price is expected to fall, then securities which have low values are considered to be far more attractive since they can be expected to fall less in comparison to overall prices. Conclusion CAPM model is a model used by corporate finance managers to determine the risk return trade off of a security and determine how the assets are priced in the market. CAPM model is based on a number of assumptions which does not hold true in practical real life. CAPM is used for finding out overvaluation or undervaluation of assets and hence indicates whether one should invest into the asset. In the CAPM model there is beta concept related to value of security which can be used for portfolio diversification. But there are many disadvantages to the model like many authors argue about whether the value of beta is valid or not. Thus CAPM model has both practical usability but has its limitations. Reference Fama, E.F. and French, K.R. 2004. “The Capital Asset Pricing Model:Theory and Evidence”, Journal of Economic Perspectives. Vol. 18(3), pp. 25-29 Read More