The Capital Asset Pricing Model as a Very Useful Model - Essay Example

The Capital asset pricing model (CAPM) Contents Contents 2 Introduction 3 Discussion 3 Conclusion 7 References 7 Introduction Any investment in the share market comes with associated risk. It is a common knowledge that riskier a particular investment is; more will be the return generated by it. As a matter of fact investors try to take on more risk because they like to earn high return. The CAPM model predicts this relationship between the risk and return. It aims to predict the return of a stock best on the riskiness of the stock. The CAPM model comprises of two parts. The first part explains the risk free rate of return which the investor would earn by investing in a riskless government portfolio. The second part of the CAPM model calculates risk and represents the extra return that the investor should earn in order to compensate for the extra risk he is taking. The model is very simple and is widely used by investors to access whether they should or should not invest in a stock. Discussion Any investment except government bonds and stock is associated with risk. No matter how much diversified a portfolio is risk will always be associated with it. The investors like to take on excess risk or they invest in risky stocks because they expect extra return. In his famous book Nobel laureate Economist William Sharpe stated that there are generally two types of risk associated with an investment (Sharpe, 1964). One risk is systematic risk and the other unsystematic risk. Systematic risk: These risks are inherent in the system and cannot be nullified. Examples of these types of risks are recession, natural disasters, etc. Unsystematic risk: This is the risk that is specific to a stock. The risk can be diversified by selecting a portfolio of stocks. The unsystematic risk actually specifies how the return of a particular stock varies with respect to market. The CAPM as a model is based on modern portfolio theory which states that the specific risk that is associated with a stock can be nullified using diversification. The problem however lies with the systematic risk (Berk, & DeMarzo, 2007). The diversification of portfolio does not solve the problem of systematic risk. Therefore while predicting the return of a stock the risk that causes most of the trouble is this systematic risk. The CAPM model actually measures and takes into consideration this systematic risk (Pahl, 2009). The model takes into consideration the fact that the return of a particular stock or a portfolio should be equal to the cost of capital. The association of risk with return is given by the CAPM model. The formula for the CAPM model is Ra= Rf + β (Rm- Rf) Ra= Return of a particular stock or portfolio. Rf= Risk free rate of return Rm= Expected return of market β= measure of the riskiness of a stock. CAPM model by Sharpe is basically an extension of the efficient market hypothesis propounded by Markowitz (Markowitz, 2008). The basic assumptions of the CAPM theory are Investors in general like to avoid risk. The amount of funds that can be borrowed at risk free rate is unlimited. Taxes, Transactional costs or Inflation is not considered. All investors receive the same amount of information at the same time. The no. of sizes the investment can be divided into is unlimited. The main cornerstone of this model is β. Beta is a measure of the risk associated with a particular stock or portfolio. Beta measures the price volatility of a stock compared to the market. The market is assumed to have a β of 1. If the particular stock’s β is more than 1 then it is more volatile than the market and if it’s β is less than 1 then it is less volatile than market. β value of a particular stock gives the amount of extra return or the risk premium that is demanded by an investor to take on more risk. β is the key component in the CAPM model which roughly gives us the cost of equity capital (Pratt & Grabowski, 2010). The cost of capital is used to discount predicated future value of a stock while calculating its present value. The higher the value of β, higher will be the cost of capital. Higher cost of capital will imply a more risky stock and lesser will be the present value of the company’s future cash flow earnings. Thus β plays an important role in company valuation. CAPM model is widely used by investors while taking decision on whether or not to invest in a stock. The model tells that if the required return that the individual expects from his or her investment in a stock does not meet the calculated expected return then the individual should not invest in the particular stock. However the model has been criticized on several issues over the years. Banz in 1981 showed in his research that stock of small company (based on market capitalization) performed better than that was predicted by the CAPM model (Banz, 1981). This claim of Banz was however countered by berk in his 1995 paper where he showed that size related issues that were being observed by different researchers should not be considered as anomalies. They went to the extent of saying that true anomaly would have been the case if an inverse relation between the size and return of a particular would not have been observed (Berk, 1995). The CAPM model predicts the intercept to be risk free rate of return by expected return line predicted by the CAPM model and the factor to be multiplied by β is (Rm- Rf). In other words the coefficient of the regression line as predicted by the Sharpe model is (Rm- Rf). But empirical tests have shown that the actual intercept is greater that the risk free rate of return and the coefficient of β is less than the value of (Rm- Rf) as predicted by the Sharpe model (Fama & Macbeth, 1973). Fama and Kenneth in their research found that if only β is used to predict the return then the results are accurate in only 70% of the cases. The accuracy of the model however, increases to a great extent (about 95%) if other factors such as size and value are also considered (Fama, & French, 1992). Another paper by the same researchers in 1993 identifies 5 risk factors in case of stock and bond return. The factors related to stock market are overall market risk (β), firm size, and book to market equity. The factors with respect to bond market are maturity related and default risk related (Fama, & French, 1993). However another study by a different researcher showed in his research that the relation between book to market value and return is weak and far less regular and consistent than the values said by Fama and French (Kothari Et Al, 1995). They concluded that the data used by Fama and French for their research was not free from biases. The basic problem that researchers have found with the CAPM model is that although it is simple, intuitive and easy to use but its assumptions are too simplistic and do not take into consideration real life scenario. Fama and French go on to state that as the CAPM model as propounded by Sharpe fails in empirical tests it goes on to show that that application of the model is not valid in most of the cases (Fama, & French, 2002). However a major researcher in this field suggests that testing the CAPM model is very difficult and almost infeasible. Due to the fact that there exists equivalence in mathematical terms in between β, expected return and mean variance efficiency of market portfolio; any test in this regard should presume total knowledge about the composition of a true market portfolio (Roll, 1977). What this means is that every individual asset must be included in the portfolio. After a survey of 392 CFOs regarding, cost of capital, capital structure and capital budgeting Graham found in his research that where as large firms depend on present value techniques and Capital Asset Pricing Model, small firms are more likely to use pay back techniques when evaluating investments (Graham, & Harvey, 2001). Conclusion In the course of discussion on the subject matter in this paper it is found that no matter how diversified a portfolio is one cannot eliminate all the risk. The risk associated with a portfolio gives rise to higher return for that portfolio. To predict the risk return relationship of a portfolio a simple model in the form of CAPM is used. Although CAPM is very simple and intuitive to use in order to predict expected return of a stock and predict its value, it is not free from criticism. The model is often criticized on the ground that its assumptions are too simple. There have been various studies around this model and applying it to practice has found that the model lacks viability and accuracy in many cases. There have been attempts at making the model more viable and accurate by incorporating other factors but none of the efforts have been universally accredited by all researchers. The fact remains that despite all the drawbacks the CAPM model is still the most used one and most loved one. References Banz, R., (1981). The relation between return and market values of common stock, journal of financial economics, 9, 3-18. Berk, J. B. & DeMarzo, P. M., (2007). Corporate finance. London: Pearson Addison Wesley. Berk, J.B., (1995). A critique of size related anomalies, review of financial studies, 8, pp. 275-286. Fama, E. & French, K., (1992). The cross section of expected stock returns, journal of finance, 47, pp. 427-465. Fama, E. & French, K., (1993). Common risk factors in the returns on stocks and bonds, journal of financial economics, 33, pp. 3-56. Fama, E. & French, K., (2002) The equity premium, journal of finance, 57, pp. 637-659. Fama, E. & Macbeth, J., (1973) Risk return and equilibrium: some empirical tests, journal of political economy, 8, pp. 607-636. Graham, J. & Harvey, C., (2001). The theory and practice of corporate finance: evidence from the field, journal of financial economics 60, pp. 187-243. Kothari Et Al. (1995). Another look at the cross section of expected stock returns, journal of finance, 50, pp. 185-224. Markowitz, H.. (2008). Harry markowitz: selected works. Singapore: World Scientific. Roll, R., (1977). A critique of the asset pricing theory’s test, journal of financial economics, 4, pp. 129-176. Sharpe, W.F., (1964). Capital asset prices: a theory of market equilibrium under conditions of risk, Journal of Finance, 19, pp. 425-442. Pratt, S. P. & Grabowski, R. J. (2010) Cost of capital: applications and examples. NJ: John Wiley & Sons Pahl, N. (2009). Principles of the capital asset pricing model and the importance in firm valuation. Norderstedt: BoD – Books on Demand. Read More