Capital Asset Pricing Model - Essay Example

CAPITAL ASSET PRICING MODEL     By Location Capital asset pricing model Introduction Capital Asset Pricing Model (CAPM) is rooted in the selection theory by Markowitz and the Capital Asset Pricing Model by Sharpe; it greatly influenced the financial world on the basis of riskless assets and unlimited short sales. To date, CAPM is said to be the most utilized financial measure by academic researchers, firms and more so practitioners (Levy 2012, p. 5).It is however greatly criticized but all the same it is viewed as the backbone of theoretical discussions on asset pricing (Kurschner 2008, p 1); but all the same there is not a model that has come up that has proven to be entirely satisfactory. CAPM has the ability to elaborate the relationship between risk and return on an investment and in the long run assist in estimating a suitable price; It often depends on the level of risk- aversion that an investor is able to apply and is calculated by the difference between the return on the market and the risk free return (Kurschner 2008, p. 4).It advocates tha ownership of assests by various investors lowers their returns as while sky-rocketing their prices. Investors in accordance to CAPM should expect to receive rewards for every risk they take, then this rewards are then added to the risk-free rate of returns.This additional risk is hence called Beta which is often equated to the market risk.Therefore, it would be appropriate to say that Beta is somewhat a measurement for the risk of any stock (stock return variance to market return variance). It could be called a theory of equilibrium because investors often take means, variances and covariance’s into perspective; this is because the model often assumes that investors make decisions on the basis of the M-V rule. The paper aims at discussing the theory on the basis of: concepts and ideas that formulate it, its shortcomings, new developments that have come up in an attempt to resolve the mishaps of CAPM and a comprehensive conclusion on the presented work. Concepts The Capital Asset Pricing Model is founded on the Mean-Variance (M-V) rule (Levy 2012, p. 117).The M-V rule the most applied crietorion in finanace; it basically concentrates on two moments of the distribution outcome, mean nad variance.These outcomes are determined by the expected value, the mean, its risk and is in the long run measured by the value of outcomes. It is based on the fact that if the returns in one investment appear to have a higher variance or inconsistency while the returns to another appear to have a slightly lower variance or consistency then an investor will have no alternative other than going for the initial project. Ultimately, the alternative that is not subjugated by another alternative is called efficient and all the efficient alternative most times make up the efficient frontier. When applying the M-V rule it is often assumed that the expected value of the outcomes measures the prospect’s profitability while the variance (standard deviation) of the outcomes measures the risk involved. The M-V rule does influence does influence investment decision- making to various extents. It presents an opportunity for risk aversion; if an investor is a risk averter then there is a chance that this investor will decrease variance so as to also in turn increase utility -consumer satisfaction- (Levy 2012, p. 69).This is quite relevant in the business world mostly because all investors main goal is often to gain a market that is large enough to bring in returns. This is only attainable through quality production and fair price markets that keep consumers glued to the product thus, it is only logical for an investor to ensure that this is in place by avoiding inconsistency in production. All the same, it is also undisputed to say that not unless a potential investor is privy to the M-V rule then decision- making can be hazardous resulting in a decrease in the utility, in the end the smaller efficient set, the highly effective the M-V division is said to be established. Thus the M-V rule is highly applicable when risk aversion is brought into perspective, More to it, the quadratic utility function, an important facet in economics also stems from the M-V rule wherein the choices made by an investor do remain consistent with the expected utility in the long-run. When it comes to the quadratic preferences there is a possibility that the M-V rule may end up including prospects that not even one investor with a quadratic preference would choose. This translates into the inapplicability of the M-V rule in quadratic preferences because it does not bring into perspective made assumptions. Conclusively this is to say that when outcomes are larger than a certain outcome the quadratic utility function does decline making the M-V rule invalid in this case. Shortcomings of the Capital Asset Pricing Model CAPM often attempts to elaborate the risk-return relationship of assets; all the same it does have its limitations proven by empirical tests; this could be a possible explanation of the assumptions that CAPM makes. The assumptions tend to be ridiculously unrealistic and illogical, of discussion will be a few; they defy the reality as it is in the modern world. It is almost impossible to modify most of these assumptions (Pahl 2009, p. 19). One of assumption by CAPM is that the investor can participate in unlimited short sales; meaning that the investor can sell any of their given security and use the earnings generated to buy any other investment that they desire. This assumption was truly unnecessary because CAPM often advocates that investors access the market from an equilibrium perspective; in this case it is well known that short sales are never made in equilibrium. Therefore, putting a prohibition on short sales is irrelevant because irrespective of their case (permitted or not) equilibrium cannot be changed thus the CAPM relationship (returns and risk) could be still attained. Another concerns time, investors seem to only be concerned and interested in how much wealth their investment will earn them at the end of the period. In reality however, investors tend to invest over and over so as to secure their lifetime consumption level regardless of risk involved, thus it is out of order for CAPM to assume that investors will only make an investment upon knowing how much returns they are able to acquire at the end of the day. Another assumption is that the model seems to be interested in what is to happen in terms of expected returns and expected beta (Kurschner 2008, p.6).These two variables cannot be predicted without substantial supporting evidence, thus the mere precision that CAPM reflects is completely wanting. Another assumption that is bewildering is the idea of risk-free assets which is uncontainable. It is true to say that risk-free assets do not in any way exist in the economic financial world as with every investment comes a risk. Even government- investments that often practically apply CAPM bear risks with them; thus there is no way that investors could operate in the economic field, lending and borrowing and at the end of the day bear no risk at all. This assumption is one of the most controversial in CAPM as it beats all logic. Risk, investments and business cannot be separated; business firms take risks in nearly everything they do. More to it the Capital Asset Pricing Model assumes totally ignores the existence of taxes when dealing with equilibrium. It is pertinent to be attentive to takes if anything in real sense capital gains are often taxed, this continues to bring out the unrealistic fundamentals that the model is founded. New Developments It is said that if alternative and realistic assumptions are incorporated into the model chances are that some benefits can be achieved. The CAPM does not often concentrate on individual behavior in terms of description yet on the ground many if not most of the institutions in place bare with them portfolios of risky assets that do not reflect or match up with the market in perspective. Therefore, if the assumptions were to be looked into and realistically amended then model would not only be applicable theoretically but also practically without having to face problems. Risk must therefore be assessed in Capital Asset Pricing Model so as to make the model more practical given the fact that risk-aversion is one of its key fundamentals. The only time that investors will opt for a risky option is when and only there will be some sort of compensation in this case a higher expected rate of return. Therefore, re-evaluating the models ideology on risk can assist in identifying the risks that investors face every other day. This can be achieved using the zero-beta CAPM which is an equilibrium theory that explains how investors maximize utility only by holding efficient portfolios (Danthine & Donaldson 2014, p. 228). Zero-beta CAPM helps in the modification of CAPM by ignoring or putting some restrictions e.g. different rates of borrowing and lending and others, on the assumed existence of a risk-free asset while maintaining all the other assumptions of CAPM in place. This restrictions in turn lead to the conclusion that the market portfolio would no longer be appropriate for all investors thus in turn pushing investors to a point where they now have to invest in any market they find suitable consequently bearing the risk they prefer (Sharifzadeh 2006, p.56).In the long run, if the suggested return- beta relationship of CAPM will not reflect capital market equilibrium. The Arbitrage Pricing Theory (APT) is another modification of CAPM; it however, differs from CAPM on the basis of assumptions.While CAPM focuses of acquiring equilibrium in markets with the optimal portfolio APT attains equilibrium through the cancelling out of arbitrage possibilities.It increases other sources of risk other than just the market as in CAPM.This allows for more prospects to be included such as the country and industrial influences. Conclusion The paper has illustrated to the extent to which the Capital Asset Pricing Model is founded on mere assumptions that have proven to be extremely restrictive and is challenged by various anomalies that seem to take the form of factors that ignore excess market returns factor while advocating for the pattern of excess security returns (equilibrium).For this reason, empirical tests done on the model have been challenging and as result regarded somewhat inconclusive; the earlier tests seemed to be in line with CAPM but recent ones have concluded that CAPM falls short of giving an expalanation on the returns. It is has therefore been a challenge to apply and explain the extent to which the capital asset pricing model can be put into perspective considering how fake it seems to appear. The mean-variance cretorion an important concept in CAPM advocates for risk as a single risk factor, the market.This is an explanation that well suits properly structured portfolios but it becomes wanting when it has to explain returns on an individual level.This means that the assets are not only normally influenced by the market but by other factors as well as illustrated by the Arbitrgae pricing theory.Through the model and its inconsistent empirical performance it is clear to see the mishaps in place.Consequently individuals now think differently concerning how risks and returns relate one to another and also how different investors ought to invest their portfolios not just on the basis of the mean-variance criterion of risk-aversion. All the same it is clear to see that modifications on CAPM are possible through the recent model developments.The main attempt of the new developments is to find oout how to determine the expected and appropriate return so as to make true the assumption of CAPM.Therefore, further amends through academic research can be put in place through the revisiting of the assumptions as illustrated in the paper. This will in turn result in the efficiency of the model and more practicability. All the same so far, there is no accepted or superior model of asset pricing in the financial world thus more effort in improving CAPM is required. Bibliography Ang, A 2014 Asset management, Oxford University Press, New York Danthine, J & Donaldson, J 2014 Intermediate Financial Theory, 3rd edn, Academic Press, UK Easley, D & O’hara, M 2004, ‘information and the cost capital’, journal of finance, vol. 59, no. 4, pp. 1553- 1583 Fama, E & French, K 2004, ‘the capital Asset Pricing Model: Theory and Evidence’, Journal of Economic Perspectives, vol. 18, no. 3, pp. 25-46. Hill, R 2010 The capital Asset Pricing Model, Robert Allan Hill& ventures publishing, London Kurschner, M 2008, ‘Limitations of the Capital Asset Pricing: Criticisms and new Developments’, Scholarly paper, pp. 8-20. Levy, H 2012 the Capital Asset Pricing model in the 21st Century, Cambridge University Press, United States of America. Neave, E 2009 Modern Financial Systems: theory and applications, John Wiley & sons, New Jersey. Pahl, N 2007, ‘principles of the capital asset pricing: model and importance in firm valuation’, Scholarly paper, pp. 18-23. Sharifzadeh, M 2006 an Empirical and Theoretical Analysis of Capital Asset Pricing Model, Universal Publishers, Florida Singleton, K 2006 Empirical Dynamic Asset Pricing, Princeton University Press, New Jersey Wu, D 2011 Quantitative Financial Management, Springer,Heidelberg Read More