Assumptions of Capital Asset Pricing Model - Essay Example

CAPITAL ASSET PRICING MODEL (CAPM) By Location Capital asset pricing model (CAPM) Introduction Capital asset pricing is a model used when calculating rate of return in case of risky assets. The needed rate of return refers represents the increased value that one should expect, depending on the characteristic of the level of an asset’s risk. The theories of asset pricing try to give explanations giving the reason some assets have higher returns than others. Consequently, themainobjective of using the capital asset pricing model is to understand the values or prices of all claims to undefined payments. The main feature is the risk-return tradeoffs. In most cases, investors demand extra returns for assets, thus increasing the risk. Such a relationship can be empirically inspected when assessing development of return of varying assets. For instance, between the years 1926 and 1999, the United States’ small stocks had an average returns of approximately 19%, while the large stocks had approximately 13% and the Treasury-Bills had about 4%.Evaluating the assets’ risk, which is measured using returns’ standard deviation, the relationship is obvious: the standard deviation of small stocks is almost 40% that of large stocks is 20%, while that of Treasury-Bills is 30%. However, challenges of using Capital asset pricing model arise when an individual is trying to determine the pertinent factors of risk with their approximated compensation. Today, Capital Asset Pricing Model is widely used in many business organizations, but still with some challenges, which are negatively affecting the users. These challenges have resulted in a number of adaptations as well as additional developments of the Capital Asset Pricing Model. However, till up to date, there is no model that have been able to persuade practitioners and financial scientists adequately. The aim of this paper is to give a discussion on why Capital Asset Pricing Model is widely used despite its strong assumptions. The paper will also highlight the recent developments in this area. Assumptions of Capital Asset Pricing Model There are many critics who often criticize the use of CAPM arguing that the model is unrealistic because it is based on strong assumptions. Therefore, is important for all users to have a full understanding of these assumptions as well as there as on the assumption are being criticized. Discussed below are the assumptions of Capital Asset Pricing Model. Investors have diversified portfolios- this assumption implies that investors only require a systematic risk return for their portfolios. This is because the unsystematic risk is removed, and one can ignore it. Single-period transaction horizon-the CAPM assumes a standardized holding period for it to be able to make equivalent the returns on varying securities. For example, a return of more than six months cannot be comparable to an over twelve-month return. Therefore, the holding period that is one year is normally used. Investors can lend and at the same time borrow during a risk-free ROR (Rate of Return)-this assumption is made from the theory of portfolio, from which the model was developed. The assumption gives the lowest return level that is required by investors. The rate of return that is risk-free corresponds to SML (Security Market Line) intersection at the y-axis. The Security Market Line is a graphical illustration of the formula of CAPM (Fama& French 1993, p. 15). Perfect capital market­- this assumption entails that every security is correctly valued and, therefore, all their returns will plot to the Security Market Line. Perfect capital market needs the following four aspects. (1) There are transaction or tax costs, (2) Perfect information is readily available to investors who have similar expectations. (3) Every investor is rational, risk-averse, and wishes to maximize his her utility. (4) Lastly, there is a large population of both sellers and buyers in the market (Roll 1977, p. 131). While all these assumptions of CAPM allow the model to focus on systematic risk and return relationship, the idealized world that these assumptions create is not similar to the real world where decisions about investments are carried out by individuals and companies. For instance, the capital markets of the real world are clearly non-perfect (Fama&MacBeth 1973, p. 609). Even if many people argue that good-established stock market in practice exhibits a higher degree of competence, there are still market securities that are incorrectly priced, that result in their returns not plotted on the Security Market Line. The single-period transaction assumption appears reasonable from the perspective of the real world. This is because even if a large number of investors who hold market securities for more than one year, the quotation of returns on securities is usually on a yearly basis. Secondly, the assumption that stakeholders have varied portfolios entails that all investors hold a portfolio that can mirror the entire stock market as one entity. Although owning the portfolio of the market is not possible, it is rather cheap and easy for investors to differ away unsystematic and specific risk and come up with market portfolios that can “track” the whole stock market (Fama& French 1992, p. 67). Assuming that all investors are only worried about how to receive financial reimbursements for systematic risk looks more reasonable. One of the serious problems with Capital Asset Pricing Model is that, it is impossible for stakeholders to borrow in situations of a risk-free rate. The main reason behind this notion is that the risks for a single investor is much more than that of the government. The inability to borrow entails that the SML slope is less applicable in a practical world than in theory. In general, it is logical to conclude that although the assumptions of Capital Asset Pricing Model have an idealized view than real-world outlook, in reality, there is a possibility of a continuous relationship that exist between systematic risk and required return (Banz 1981, p. 5). However, these strong assumptions have led to recent developments of the Capital Asset Pricing Model that are discussed below. CAPM recent developments In the year 1963, the journal article on finance “Capital Asset Pricing” gave an introduction to the CAPM foundation. The CAPM has highly provided a compelling and simple theory of asset pricing through portfolio investment association to one risk factor, known as the “beta factor”. This theory is based on the prediction that the expected return of an asset, which is higher than the risk-free level is relative to the non-diversifiable risk (Graham & Harvey 2001, p. 189). This entails that, the more security beta quantity, the more the asset’s expected return. Several years after the writing of the above-mentioned article, there have been several critics who argue against the simplicity of the model and its application in the real world. Although this model has been a major in many academic papers, the model still has many critics, which have contributed to its recent developments. The financial uses of CAPM are many. The model is indeed used in the valuation of an organization’s common stock, capital budgeting, acquisition, and merger analysis (Kothari, Shanken& Sloan 1995, p. 78). The model is also used to evaluate convertible and warrants. For the model to be valid, the above-discussed assumptions should be incorporated for investors to create market equilibrium. The CAPM derives the price commanded by an asset to enable the investors hold the portfolio of the current market. Under CAPM, all investors bear a similar risk in varying amounts. They hold varied portfolios and requires a return of systematic risk for these portfolios because unsystematic risk is removed, and one can ignore it. Investors then can rank the portfolios in accordance with the utility function that depends on the expected return rate of the portfolios. Since all investors have a similar portfolio of the risky assets, ordinary, every investor will enjoy buying the market portfolio (Fama& French 2002, p. 645). Moreover, it is easy to increase the risk by purchasing numerous different assets. The risk of a stock is essentially not related to the difference of its returns. The difference represents the suitable measure if an individual investor puts all his or her money in only one asset. In real sense, it is possible for investors to expand a part of a risk by purchasing many varying assets. Diversification makes it possible to do away with the risk that is distinctive to individual stocks (Berk 1995, p. 278). The non-diversifiable risks arise from factors of microeconomics that cause influence to all assets all at once. For example, when most companies have “credit-crunch”, they tend to have decreased profits, as well as negative cashflows. However, despite the model being based on strong assumptions, it is widely used, and this broad use has resulted to its recent developments. Theoretically, similar investors can access and use similar information and have identical behaviour regarding risk of portfolios. Every investor has similar information, and, therefore, he or she will be able to buy more quality stocks than bad stocks. For instance, if investor X buys more of A than B, then every investor will put his or her focus on commodity A. CAPM assumes that all investors evaluate information in a similar way and thus, they come up with a similar conclusion. William Sharpe argued that, all investors have similar beliefs on expected returns and strategies of investment. However, in reality, investors may end up having different views, expectations, risk preferences, and investment horizons (Sharpe 1964, p. 427). According to the Quantum Group Manager, George Soros, the theory of classical economic assumes that the actions of participants of any market are based on perfect knowledge. This assumption is false. The actors cannot all have perfect knowledge about the market since their thoughts are always being affected by the market and their thoughts affecting the market. In general, many investors attribute greatly on numerical data while others use time-series analysis formulas. In such a case, investors end up having different strategies and expectations. CAPM is more advantageous than the other model sused to calculate the required return. This is the basic reason CAPM has been widely used over the last 40 years. During the years that followed the foundation of the model, a number of researchers developed their models with the aim of countering CAPM. The assumption on the standard deviation made McBeth and Fama to stress that the idea of “Beta” is meaningless and also the standard deviation is irrelevant when it comes to explaining excess returns (Fama&MacBeth 1973, P. 645). Furthermore, in the year 1977, Roll Richard, in a very significant analysis of CAPM pointed out that the model seems challenging to test because of factors like impossibility to test the exact market portfolio as well as benchmark error using incompetent market proxy. In addition, French and Fama’s multi-factor model considers the market index and the ratio of book-to-market. On top of the size effect, they argued that the variables “result in un-diversifiable risks that are not captured in the market return. In summary, these un-diversifiable risks have no link with factors of beta and; therefore, they do not appear in the CAPM model. These two analysts argue that their model is empirically correct and complete CAPM version. Additionally, using CAPM has challenges when quantifying investor behaviour. Conclusion Despite the criticism placed on CAPM, the model remains to be one of the widely used models in a firm for calculation of cost of capital. Additionally, the model is currently the most popular method used in the estimation of cost of capital in organizations. Approximately 73% of total firms in the world use CAPM. Further, many critics argue that the model is only based on a comparison of two variable, which makes it simpler, but mathematically, CAPM is a very sound model. Additionally, the results obtained using this model in most cases are similar to the expected results. It is logical to assert that CAPM is more advantageous than the other models used to calculate required return due to its broad use and recent developments. Bibliography Banz, RW 1981, The relationship between return and market value of common stocks, Journal of financial economics, 9(1), 3-18. Berk, JB 1995, A critique of size-related anomalies, Review of Financial Studies, 8(2), 275-286. Fama, EF, & French, KR 1992, The cross‐section of expected stock returns, the Journal of Finance, 47(2), 427-465. Fama, EF, & French, KR 1993, Common risk factors in the returns on stocks and bonds, Journal of financial economics, 33(1), 3-56. Fama, EF, & French, KR 2002, The equity premium, The Journal of Finance, 57(2), 637-659. Fama, EF, &MacBeth, JD 1973, Risk, return, and equilibrium: Empirical tests, The Journal of Political Economy, 607-636. Graham, JR, & Harvey, CR 2001, The theory and practice of corporate finance: evidence from the field, Journal of financial economics, 60(2), 187-243. Kothari, SP, Shanken, J, & Sloan, RG 1995, Another look at the cross‐section of expected stock returns, The Journal of Finance, 50(1), 185-224. Roll, R 1977, A critique of the asset pricing theorys tests Part I: On past and potential testability of the theory, Journal of financial economics, 4(2), 129-176. Sharpe, WF 1964, Capital asset prices: A theory of market equilibrium under conditions of risk, The journal of finance, 19(3), 425-442. Read More