The-Strategy of the Capital Asset Pricing Model - Coursework Example

LIMITATIONS OF THE CAPITA ASSET PRICING MODEL Introduction This article, upon briefly introducing the capital asset pricing model will mostly focus on the limitations of the model and show the extent that multi-factors approach overcomes the limitations. The capital asset pricing model (CAPM) is simply a showpiece of financial economics in the modern world. The model provides an accurate prediction of the connection observed between the level of risk of any particular asset and the amount of return expected from the asset (Naylor & Tapon 1982). This relationship serves a very significant role during investment. Firstly, the model gives a point of reference rate of the return for the evaluation of the potential investments. Secondly, it assists the investor in coming up with a wise guess concerning the returns expected on the various assets that for the first time are finding their way into the market. The overall view about CAPM is that the investor needs to get compensation in two different ways; in terms of the time value of the money invested and the risk involved (Naylor & Tapon 1982). The time value of the amount of money invested is the risk free rate denoted by Rf and this provides compensation to the investor for investing his money for a specific period of time. The other part of the equation gives a representation of the risk involved and provides compensation to the investor for carrying more risks. The risk measure, which is beta (Bj) provides a comparison concerning the returns on the assets over a specific period of time in the market and also related to the market premium represented by the term (Rm-Rf). RJ = Rf + (BJ) (RM - Rf) Limitations of the CAPM Despite the popularity of the model in modern world of economics,o there are a number of limitations and criticism concerning the applicability of the model in some situations and the accuracy of the model in determining returns on capital invested. Among the major criticism of the model lies in its assumptions that shaped the conclusion arrived. Some of the assumptions are not realistic and possess rigorousness. A good example is the single time period horizon that means that the investor is only concerned with the earning and his portfolio comes at the end point of the present period (Banz 1981). However, in the real world, the investor also aims at securing his level of consumption in his lifetime through the act of investment. This view of making ultimate decisions of investment by only, looking at the returns in the coming period in the name of single period model, in only relevant by the incorporation of additional assumptions. Additionally, the model base only on future looking information such as the rate of return expected in the future and the value of Beta expected in the future. It is very clear that it is difficult to estimate all this precisely and hence their estimation only rely on history. There is also the absence of free and instant information available in the name of information market efficiency (Adler & Solnik 1974). There is also the absence of inclusion of transaction costs and taxes. In the real world, an asset that is free from risk is not there in that even the bonds issued by the government also have some risks. The assumption that all investors have expectations that are homogeneous and that they also behave rationally on basis of the returns they expect and the standard deviation is also very unrealistic. In the real world, it is impossible for all the investors to behave rationally and have uniform expectations and this makes the model irrelevant. The most important elements of the equation of the model as well as the relative volatility of the particular investment depend on the ability of measuring the entire volatility of the market. This requires an accurate assessment of the volatility of each individual potential investment in the entire market that is a condition not possible to meet (Banz 1981). The individuals who prefer the model utilize a proxy like S&P 500 that gives a representation of the market general volatility. Nevertheless, this is not the real measurement that the model requires for it to provide the most reliable answer. In other words, the model is only capable of giving estimated values necessitating the need for calling other methods to uplift its relevance (Adler & Solnik 1974). There is a lot of emphasis that the beta used in the equation of the model does not include new data (Adler & Solnik 1974). Considering an example of a utility company where the company receives the consideration of having a defensive stock with a low value of beta. When the company enters the business of merchant energy and makes an assumption of high levels of debts, the historic beta of the company does not incorporate the substantial perils that the company will carry on. Parallel to this, most technology based stocks are comparatively new in the market and thus they have inadequate history of price to be capable of establishing an accurate value of beta. This makes the model irrelevant to such companies trading in the market. Another terrible factor is that past movements of price are sometimes very poor price predictors for the coming days. These betas are simple rear view reflections, considering a very small portion of what will happen in the future. Additionally, the value of beta on one stock has the tendency of flipping around as time goes that makes it very unreliable measure (Naylor & Tapon 1982). This means that for the investors with the intention of buying and selling assets within a short duration, beta can be a useful measure of the risk involved. However, with long term deals then beta becomes a very misleading factor in determining the exact measure of the risks involved. The model is therefore very unrealistic in determining the outcome for investments established on long term basis and hence an alternative model must come to play. A value of beta that is less than one that will show an inverse relationship to the market is very possible but also very unlikely. The belief held by some investors that some assets such as gold should have beta values less than zero because they have a tendency of performing better when the market stock has reduced has not proved real over the long term period. This is because; the value of beta for cash is always zero regardless on the direction or manner that the market moves. Fugure1 below shows the zero beta security market line adopted from Sharpe. The companies with lower volatilities than that of the market have beta values of less than one but higher than zero that is the range of most of the utilities. A beta value of one gives a representation of the volatility of a particular index that in turn represents the entire market where the other assets and their beta values acquire their measurement (Banz 1981). A good example of such an index is the S&P 500. If a particular asset has a beta value of one then it implies that it will move in the same manner like the index. Hence, a fund index that reflects the S&P 500 is going to have a beta value very close to one. When the beta value greater than one, it means that the volatility of that particular asset is greater than the standard index value. However, just as mentioned before, most technology companies have a beta value that is greater than one. The return on the short term debt of the government that is the substitute for the return of the risk free rate is not constant but varies daily depending on the economic conditions. As a means of removing this volatility, it is important to make use of the short term average value. The process of determining the value for the equity risk premium is very difficult (Merton 1987). The return on any particular asset is the sum of the dividend yield and the average gain on capital. During the short term, an asset can give a value less than zero rather than a positive return in condition where the share prices are declining or lower than the yield on dividend. As a result, it is very normal to use a long term value when determining the equity risk premium. This can come from research but in most cases it is never stable since it keeps on changing from time to time. In the United Kingdom, an equity risk premium value is usually between two percent and five percent that is very reasonable for many investors. Nevertheless, any uncertainty concerning the exact value of equity risk premium induces uncertainty on the determined value of the return required (Merton 1987). Nowadays, there is regular calculation and publication of the values of beta for all the companies listed in the stock exchange market. However, the common fact is that the constant changes in the value of beta create uncertainty in the determination of the actual return. In the use of the model in the investment appraisal, problems can come during the calculation of the rate of discount. For example, the most common problem comes when finding the most appropriate proxy betas since the proxy organizations can undertake one business activity very rarely. It is necessary to disentangle the proxy beta for any proposed investment from the equity beta of the company. One method of doing this is by treating the equity beta as an average value of all the various betas of the proxy company. Their weight bases on the relative share of belonging to the market value of the proxy company from every activity. Nevertheless, the data concerning the relative shares of the market value of proxy companies is sometimes very difficult to acquire (Foster 1978). Another similar problem is that the acquisition of a proxy company beta makes use of the information on capital structure that may be very difficult to obtain. Some other companies have very complicated capital structures that have various sources of income. Some companies may use complicated sources of finance like convertible bonds while others have untraded debts. This idea of holding a simple assumption that the beta value of debt is zero will cause inaccuracy in the calculation of the discount rate of the project. All these factors limit the applicability of the CAPM model in the world of economics. The alternative asset pricing model The alternative asset pricing model together with the capital asset pricing model are two very important theories regarding the pricing of asset. The alternative pricing model (APT) differs from the CAPM in that its assumptions are not as strict as those of CAPM. APT allows for an explanation of the model of returns on assets as opposed to statistical (Ostermark 1989). APT assumes that each individual investor will have a specific portfolio with specific range of beta values as opposed to the identical portfolio of the market proposed by CAPM. It therefore means that the APT model has a great potential of overcoming the weaknesses of the CAPM. It needs less as well as more assumptions that are realistic to come from a simplified arbitrate argument. Its power of explanation is generally better because it is simply a model of multifactor. Nevertheless, both the power and its generality constitute the major strengths as well as the weaknesses. The APT model allows an individual to select the factors that will give the best explanation for the information. It however, cannot provide an explanation for the variation in return on asset in terms of the limited number of the factors easily identified. In other words, CAPM is easier to apply and it is also intuitive. The inter-temporal capital asset pricing model (ICAPM) The shortcomings of the CAPM led to the development of the ICAPM. In the ICAPM, the holding periods can change from time to time. It assumes that investors have the aim of maximizing their consumption utility expected during the whole period of their life Roll, R., & (Roll & Ross 1980). It also holds that the investors are capable of trading continuously over their lifetime. According to the model therefore, the investors will consider both their wealth as well as the uncertainty prevailing in the economy in the coming days in their present decisions on investment. The investors will hedge against the economic shocks expected that are probably going to reduce the consumption utility they expect. The most important implication of this model according to Roll & Ross (1980) is the range of betas needed to provide the explanation on the return as well as the number of beta values that will be equal to one in the name of broad market factor. It also incorporates in the list the further state variables that affect the investment potentials and the preferences of consumption and therefore the utility expected over the period. APT and CAPM ATP takes considers more than one factor during the determination of the return on the investment of the asset. This discredits CAPM as a method of evaluating return on capital since it shows the possibility of coming up with an answer that is more accurate and realistic. In explaining that the risk premium on the particular asset involved relies only on the loadings of its systematic factor, it means that the ATP model is capable of providing investors with an answer that is more practical than that of CAPM. In other words, the APT model provides a very superior alternative CAPM despite that it is the one mostly used by the investors. CAPM provides very poor explanation and overestimation of the rate of risk free and underestimation of the premium risk of the market. The major shortcoming is specifically the use of beta values to assess the return of an asset. The return on higher beta assets tends to gain overestimation while the assets with lower beta value tend to gain underestimation. The ATP does not place assumptions concerning the real distribution of the returns on asset (Ross 1976). The powerful assumption hold by CAPM concerning the theory of utility is not necessary and therefore disregarded by the ATP model. The ATP model also accepts sources of risks and hence can gain greater operational and has greater capability of forecasting than the CAPM. ATP according to Solnik (1974) does not assign a specific role for the portfolio of the market making it simple to apply in the prevailing condition as opposed to CAPM that needs an efficient market portfolio. The ATP model also extends to a multi period construction. There are various tough assumptions that need to play during the process of derivation of the CAPM like the absence of friction in the market. For example, the restriction of short selling, the investors can borrow and lend money at a rate that is free from risk as well as the absence of taxes. It holds that there are many securities allowing the diversification of the idiosyncratic risk and the investors aim at maximizing wealth. In addition, APT model provides the best warning of the risk on assets as well as the estimates of the return rate required in comparison with CAPM that relies on beta as the only risk factor in the market. ATP is thus the most new and the major promising relative return explanation (Liu 2006). The ATP model promises to give a description that is more complete about the returns on assets than CAPM. However, one major similarity between the two models is that both assert that each particular asset must receive compensation only based on the systematic peril it has. The only variation is in the determination of the systematic peril where in the APT the systematic peril is the co variation with a set of factors while in the CAPM, the systematic peril is the co variation of the particular asset with the portfolio of the market. Conclusion The CAPM as a model for determining the return on asset is very popular and most preferred by the majority of investors in the world. However, the model possesses some various limitations that under some conditions produce results that lack accuracy and reliability. Most of the limitations emanate from the assumptions that the model rely in the determination of the outcome. The calculation of the value of beta for a particular asset is that which poses a very great challenge and in some conditions makes the outcome difficult or impossible to obtain. An alternative model that helps to overcome the weaknesses of the CAPM model is the APT model that places less restrictions and assumptions in its calculation. It allows the investor to choose the combination of the various factors that will help provide a good explanation for the situation and hence improving the reliability of the answer provided. Bibliography Adler, M., & Solnik, B. H. 1974, ‘The international pricing of risk: an empirical investigation of the world capital market structure’, The Journal of Finance, Vol. 29, No. 2, pp. 365-378. Banz, R.W. 1981, ‘The relationship between return and market value of common stocks’, Journal of Financial Economics, Vol.9, No.1, pp. 3-18. Foster G. 1978, ‘Asset pricing models: further tests’, Journal of Finance Quantity Analysis, Vol.13, No.1, pp. 39-53. Liu, W. 2006, ‘A liquidity-augmented capital asset pricing model’, Journal of financial Economics, Vol. 82, No.3, pp. 631-671. Merton, R. C. 1987, ‘A simple model of capital market equilibrium with incomplete information’, The journal of finance, Vol. 42, No. 3, pp. 483-510. Naylor, T. H., & Tapon, F. 1982, ‘The capital asset pricing model: an evaluation of its potential as a strategic planning tool’, Management Science, Vol. 28, No.10, pp. 1166-1173. Ostermark R. 1989, ‘Arbitrage Pricing Models for Two Scandinavian Stock Exchanges’, Omega, Vol.17, No.5, pp. 437-447. Roll, R., & Ross, S. A. 1980, ‘An empirical investigation of the arbitrage pricing theory’, The Journal of Finance, Vol. 35, No. 5, pp. 1073-1103. Ross, S. A. 1976, ‘The arbitrage theory of capital asset pricing’, Journal of economic theory, Vol.13, No.3, pp. 341-360. Solnik, B. H. 1974, ‘An equilibrium model of the international capital market’, Journal of economic theory, Vol.8, No.4, pp. 500-524. Read More