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

CAPITAL ASSET PRICING MODEL (CAPM) Introduction The Capital Asset Pricing Model commonly known as CAPM defines the relationshipbetween risk and the return on individual securities. CAPM was first published by William Sharpe in 1964 who wanted to extend “Harry Markowitz’s portfolio theory” to include the notions of particular and systematic risk. CAPM is a very useful tool that has enabled financial analysts or the independent investors to evaluate the risk of a particular investment while at the same time setting a specific rate of return with respect to the amount of the risk of a portfolio or an individual investment. The CAPM method takes into consideration the factor of time and does not get wrapped up over by the systematic risk factors, which are rarely controlled. In this research paper, I will look at the implications of CAPM in the light of the recent development. I will start by explaining and discussing the various assumptions, and theories upon which CAPM is based by critiquing the assumptions of the model. When Sharpe (1964) and Lintner (1965) proposed CAPM, it was majorly seen as the leading tool for measuring and determining whether an investment yielded negative or positive returns. The model attempts to expound the relationship between expected reward/return and the investment risk of very risky assets by helping determine the required rate of return for any of the risky asset (Reilly and Brown, 2011). The CAPM states that, “the expected return on a security or a portfolio equals the rate on a risk-free security plus a risk premium” (Heshmat, 2012, p. 504). It further states that the expected return of an asset has a positive linear correlation with a security of a non-diversifiable risk i.e. beta (Heshmat, 2012). Further, Ushad (2011) argue that CAPM is majorly based on the assumption that higher returns are linked to the higher beta values. Therefore, years after the publication of the Capital Asset Pricing Model, and after comparison of the actual and the expected returns was done many economic experts have come forward challenging and critiquing model because of its simplicity and the assumptions upon which it is based, which many of them feel are unrealistic and hence inapplicable to many of the world market economies (Banz, 1981). However, despite all this criticism many firms and financial analysts use the model in determining the cost of capital for a firm even though it lacks theoretical and empirical evidence supporting its applicability and relevance in determining the cost of capital since it is unrealistic to assume that the capital markets are perfect regardless of the high efficiency they might exhibit. It’s calculated as: E (Ri) = Rf + (E(Rm) - Rf) βi Where, E (Ri) is the required return on the financial asset, i Rf is the risk-free rate of return Βi is the sensitivity of the asset’s return to the market E (Rm) is the average return on the capital market. Sharpe (1964); Lintner (1965); Watson & Head (2007); Reilly & Brown (2011), have all articulated some of the assumptions upon which the model is founded. Some of these assumptions include: Investors can borrow or lend at the risk-free rate All the unsystematic i.e. non-market risks are eliminated Equal access to the securities in the market by all of the investors The transaction costs and the taxes are excluded A standardized holding period is assumed by the in order to make comparable returns on the different securities. Thus the single-period transaction horizon. CAPM has varied financial applications such as the valuation of the common stock of firms, capital budgeting, calculation of the mergers & acquisitions, the valuation of the convertible stocks & warrants (Thomas and Francis, 1982). The model assumes that investors in the market carry or face similar risks but at different intensities. Therefore, in order for the investors to consider putting their funds they will need to be motivated to invest, they require a rate of return or reward in order to compensate for the undiversifiable risk since the diversifiable risk will have overcome through portfolio market diversification. Though CAPM’s assumptions clearly brings out the relationship between the systematic risk and the return, it fails to reflect on what is happening on the reality whereby the investment decisions are usually made by the companies and the individuals. However, the extent at which these assumptions do not meet the real world reality unanimously affects the validity of the model hence rendering them as a major part of the classical economic doctrine, which can only hold in theorized perfect markets thus, rendering these assumptions unrealistic and inapplicable since there is no world economy or market which operates in isolation without e.g. the imposition of taxes or operates without any transaction costs; characteristics of a perfect market (Sharpe, 1964). The model’s assumption that investment only takes place over a single period has attracted a lot of criticism because experience indicates that, in reality this it’s not true. When Greene (1990) analysed the UK private sector data, it became apparent that CAPM was not applicable in the UK. Though the model suggests that there is a positive linear relationship with the systematic risks and the rates of return, evidence indicates that additional risk variables need to be brought into the limelight (Reilly & Brown, 2011). For instance, the Arbitrage Pricing Theory (APT) reflects on the linear multi-factor relationship to the systematic risk and the other macroeconomic factors as unlike CAPM and, therefore, necessitating the need for such factors to be brought into consideration. CAPM’s assumptions that there is no transaction costs, suggests that trading is costless, and that the investments pricing is done in such a way that the prices of the securities fall on the line of the capital market. However, in reality since there are no perfect capital markets, which are perfect and given that many of the world economies are open economies as opposed to closed economies, then it is unrealistic to say there is no transaction costs or taxes imposed by the governments for any economic activity. Therefore, it is theoretical and unrealistic to assume that the return are unaffected by transaction costs and government taxes. For instance, governments impose taxes on taxes on capital gains and dividends due to investors in such a way that the taxes are levied differently depending on their status i.e. to say the investors individuals or institutions. Contrastingly, most investments in the real world involve some transaction costs. Additionally, under this model, the investment trading is a tax-free, and the returns are not affected by the taxes. However, most of the returns such as the capital gains and the dividends are taxed in varied ways and, therefore, forcing the investors to consider taxes. Moreover, many investment transactions have the capital gains taxes. In reality, different investors are taxed differently depending on their status; individuals vs. pension plans. Therefore, it is evident that many investors consider the impact of taxes & transaction costs on their returns because these factors play a major role in determining the final return figure attributable to each investors; thus raising the question, are the assumptions of the model realistic? What is the validity of the model? The model’s assumption that the investors are able to borrow the money at the risk-free rate is not a reality. The risk-free rate is the interest that an investor would get from an absolutely risk-free investment over a certain period. A risk-free asset, on the other hand, is the type of the asset with certain future return (s), such as the treasury bills. This is done purposely increasing the number of the risk assets in the portfolio. However, in reality it’s hard for the investors to borrow at risk-free rates simply because the risk that is associated with the individual investors is relatively higher that those associated with the government (Fama & French, 2002). Conversely, the model assumes that investors hold a diversified portfolio of assets implying that all the investors in the market hold a portfolio that depicts the whole stock market; an assertion, which is impossible in reality because of other forces inherent in the market that cause distortions to the information received by investors (Berk, 1995). CAPM assumes that investors in the market are homogeneous and that they have equal access to similar information (information asymmetry). Since the investors have the same information, any rational investor will buy less bad stocks and more good stocks. For instance, if investor M buys more of A than B, then everyone in the market will do the same and focus on A (the decision by one investor can have an influence to the other investors). The model (CAPM) assumes that the investors are evaluating the information in the market in the same manner and that they will all arrive at the same decision, which is not the case because all the investors have homogeneous expectations about their returns, risk of the available investments and investment strategies as long as they remain risk-averters (Sharpe, 1964). However, in reality the notion of homogeneous expectations by investors can only hold in an inefficient market that is characterised with the periodic and predictable crashes and brooms, which is not tenable in efficient capital markets where investors are presumed to have similar information about the capital market (Kothari et al., 1995). In an effort to counter the model, many researchers came up with many models to try and counter it. For instance, CAPM assumes that the risk is measured by the ‘standard deviation of assets’ undiversifiable risk in relation to the whole market standard deviation, which is used to determine the volatility of the investment. However, McBeth and Fama stressed that the “Beta” doesnt matter & that the standard deviation on return of any asset is irrelevant in explaining its excess return because it does not measure risk when the returns are not evenly distributed around the mean (Fama & Mcbeth, 1973). Moreover, in his analysis Richard Roll argued that CAPM isn’t testable due to factors such as the inability of testing the true market portfolios in addition to the benchmark error of putting into practice the inefficient market proxy (Roll, 1976). In his analysis, he noted that using the market proxy in determing the market portfolio is subjective and difficult. Additionally, Fama and French believe that that their “Three Factor Model” is empirically correct and a complete version of the CAPM (Fama & French, 1992: 1993: 2002). Despite its weakness, the model is still popular among many firms in the calculation of the cost of capital. Most researchers believe that 73.5% of the firms use CAPM in the calculation of the cost of the equity (Harvey and Graham, 2000). Additionally, a comparison by CAPM of two essential variables in connection with the capital budget in its equation such as return and risk; makes it relatively simpler, but a mathematically sound model. Moreover, the expected returns concur with the actual returns in a way that the higher the returns, the riskier the project. This in itself is something that happens in reality. Some of the merits of the model include; the model considers the systematic risk thereby reflecting on the reality whereby most investors have diversified risk that has essentially eliminated unsystematic risk, CAPM generates theoretically-derived type of the relationship between the systematic risk and the return, it’s the most relevant method for the calculation of the cost of equity because it considers the company’s level of the systematic risk in comparison to the whole stock market and finally, the method is superior as compared to WACC especially in providing the discount rates for the calculation of the investment appraisal. Some of the shortcomings of the model include; it cant be use in the calculation of the project-specific discounts rates, its assumption of the single-period time horizon makes it inefficient in using it for the multi-period investment appraisal, and among others. Conclusion Therefore, it is evident although the model is mostly used to solve business problems, it cannot be fully relied upon because of the nature of the assumptions upon which it’s founded. The model, however, assesses some of the ideas such as the investor’s diversification in ensuring that risks are kept at bay. However, despite the weaknesses and criticism of the model as highlighted above, the model can be relied upon in calculating a firm’s cost of capital by modelling its return and risk. Bibliography BANZ, R., 1981. The Relation between Return and Market Values of Common Stock, Journal of Financial Economics, 9, 3-18 BERK, J.B., 1995. A Critique of Size Related Anomalies, Review of Financial Studies, 8, 275-286 FAMA, E., & FRENCH, K., 1992. The Cross Section of Expected Stock Returns, Journal of Finance, 47, 427-465 FAMA, E., & FRENCH, K., 1993. Common Risk Factors in the Returns on Stocks and Bonds, Journal of Financial Economics, 33, 3-56 FAMA, E., & FRENCH, K., 2002. The Equity Premium, Journal of Finance, 57, 637-659 FAMA, E., & MACBETH, J., 1973. Risk Return and Equilibrium: Some Empirical Tests, Journal of Political Economy, 8, 607-636 GRAHAM, J., & HARVEY, C., 2001. The Theory and Practice of Corporate Finance: Evidence From The Field, Journal Of Financial Economics 60, 187-243 GRAHAM, JOHN R., & HARVEY, CAMPBELL R., 2000. “The Theory and Practice of Corporate Finance: Evidence from the Field”, Duke University. HESHMAT, N. A., 2012. Analysis of the Capital Asset Pricing Model in the Saudi Stock Market. International Journal of Management, 29. 2, 504-514. Available at www.sagepub.com [Assessed 23 Nov. 2014]. KOTHARI ET AL., 1995. Another Look at the Cross Section Of Expected Stock Returns, Journal of Finance, 50, 185-224 LINTNER, J., 1965. The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. Review of Economics and Statistics, 47. 1, 13-37. Available at www.proquest.umi.com [Assessed 23 Nov. 2014]. REILLY, F., & BROWN, K., 2011. Investment Analysis and Portfolio Management (10th ed.). Mason, OH: South-Western College Publications. ROLL, RICHARD, 1977. “A Critique of The Asset Pricing Theory’s Tests.” Journal of Financial Economics 4, 1977. SHARPE, W. F., 1964. Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. Journal of Finance, 19. 3, 425-442. Available at www.proquest.umi.com [Assessed 23 Nov. 2014]. THOMAS H. NAYLOR, & FRANCIS TAPON, 1982. "The Capital Asset Pricing Model: An Evaluation of Its Potential As a Strategic Planning Tool."The Capital Asset Pricing Model: An Evaluation of Its Potential As a Strategic Planning Tool Vol.28.No.10 1166-173. USHAD, S. A., 2011. Capital Asset Pricing Model: Evidence from the Stock Exchange of Mauritius. The IUP Journal of Financial Economics, 9. 1, 24-40. Available at www.proquest.umi.com [Assessed 23 Nov. 2014]. WATSON, D., & HEAD, A., 2007. Corporate Finance: Principles and Practice (4th Ed.). London: FT: Prentice Hall. Read More