Capital Asset Pricing Model and Theories Explaining Its Effectiveness - Example

The aim of this paper is to analyze the main ideas behind this notion of Capital Asset Pricing Model, and the various theories that explain its effectiveness. Further, this paper analyzes how CAPM is applicable in the modern economy. Capital Asset Pricing refers to the relationship that exists between risks, and the expected returns of an investment (Kodukula & Papudesu, 2006). It is therefore used to calculate the prices of high risk securities, and the expected profits that an investor would acquire from them (Kodukula & Papudesu, 2006). Capital Asset Pricing is therefore an important tool that investors rely on, when they want to invest in high risk stock securities. One major assumption of Capital Asset Pricing is that, the price of a particular security is not under the influence of all the risks that it faces. This is because it is possible to diversify an investment, hence spreading of the risks that an investor may acquire (Fama and Macbeth, 1973). Therefore, this model asserts that one of the major ways of determining the prices of a particular security is by carefully examining the size of the company that offers the security under consideration. Elton (2010) therefore explains that one of the major benefits of CAPM is its ability to predict the price of a given stock. Elton (2010) further asserts that in as much as it is possible for this model to project the price of a given equity, the CAPM cannot be used alone. This is because it requires that experts using these tools, need to use financial reports that are easy to understand, and interpret (Pratt & Grabowski, 2010). Pratt & Grabowski (2010) therefore explains that, the use of personal judgment, by a financial manager, would also influence the tools that the manager would use to calculate the future, and real prices of the security. Marciniak, Mykowiecka & Bolc (2009) argues against relying on personal judgment in choosing a tool of determining the prices of an asset. This is because personal biases can play a role in influencing a financial manager, when they are in the process of making a decision on how to calculate the prices of a given security, and the expected return that an investor would get (Banz, 1981). The modern theoretical framework that surrounds the use of the CAPM is developed, based on two major assumptions. The first assumption is that the security market is highly competitive. Therefore, any information regarding the performance of a company that owns the security is quickly absorbed, and distributed all over the world (Pratt & Grabowski, 2010). The second assumption is that to achieve success in the securities market, a financial manager has to be sensitive to the risks that he or she faces, and initiated a balanced and diversified investments. Under the first assumption, it is possible to assert that investors would only make decisions based on the knowledge they have concerning the security. The second assumption concerns itself with wealth creation (Pratt & Grabowski, 2010). The fundamental nature of the CAPM is the predicted return and organized risks correlation and the evaluation of the following security (Ross, 1976). This means that security will be required to give a return adequate to its organized risk, the risk that cannot be removed by the diversification (Elton, 2010). Elton (2010) explains that these securities are highly risky, but they have the largest expected returns. This is in case an investor manages to make profits. Elton (2010) explains that the following equation portrays the methods of calculating the CAPM, E (Ri) = Rf + βi × [E (Rm) -Rf]. Under this formula, E (Ri) is the projected return rate on the asset, and Rf is the return free from risk (Elton, 2010). Furthermore, βi represents the assets beta. E (Rm) stands for the projected return on the market portfolio (Elton, 2010). Marciniak, Mykowiecka & Bolc (2009) explains that one of the major weaknesses of the CAPM is its inability to recognize various anamolies. Examples of these anomalies includes, dividend yields, earning price ratios, precedent returns, etc. (Marciniak, Mykowiecka & Bolc, 2009). In a research conducted by Fama and French (1993), they were able to explain that anomalies are always depicted in ratios involving book to market, and the size of the transactions. The conservative measure of CAPM risk, beta, provides minimal use in cross-section dispersion explanation in projected return while giving the thought to the size factor effects (Merton & William, 1973). Under the three-factor model, most of the anomalies disputed on the projected return on a selection in more of rates free of risks (Fama and French, 2004). These are clarified by the compassion of its return on various factors. These factors are, a return on a wide market range, a return on small stock and large stock portfolio differences (Fama and French, 2004). They further gave the following equation on the projected extra return on selection (Fama and French, 2002). E(Ri) - Rf = bi ´[ E(Rm) - Rf ] + si ´E(SMB) + hi ´E(HML) Roll (1977), in his analysis of the CAPM, denotes that it is difficult to test the validity of its results. This is because of the difficulty in examining the exact market portfolio, of a particular security (Sharpe, 1961). Rolls work stands to reject the CAPM as not testable mathematically; however, some economists view other risks variables that cause CAPM model misspecification. Banz (1981) in his research, he manages to give the relationship that exists between market value and returns, of a common stock. He manages to explains that small organizations normally experience a predictable return on their investments, in comparison to big organizations (Banz, 1981). Berks article followed this in 1995, and he insisted that riskier organizations will have minimum market values and more projected returns. He therefore came up with a conclusion that, the size of an organization, does not provide an adequate proof that a connection exists on the market value, and the projected returns of the organization (Berk, 1995). Acharya & Pedersen (2005) and Amihud & Mendelson (1989) had various discussions on the liquidity risks factor benefits on CAPM. They, therefore, accustomed the standard model of Sharpe (Sharpe & William, 1961) through consideration the liquidity risk impact on it and the foreseen the returns needed in this condition. They, therefore, came up with Adjusted-CAPM, which considered both the market and security liquidity risks (Mun, 2003). They, therefore, concluded that, in a condition where there is a decrease in the stock return, the investor should be expecting a decreased return (Bali & Engle, 2009). One of the difficulties of the application of the modified model is grounded on the liquidity in the determination of appropriate input data for the model (Ross, 1977). Calculations of the net return directly are also not possible. This is because of the dependency of the net return on the recent economic condition, and the investments held on the term basis (Evans & Bishop, 2001). Merton (1973) therefore came up with his own version of CAPM which comprised of wealth variables that predict changes in the expected returns of an investment, and the future income. This model is applied by the investors in the getting solutions for long-term choices at the times they are under ensure conditions (Kodukula & Papudesu, 2006). Investors were trying to evade the variables negative effects in bear and bull situations in the market (Merton & Robert, 1973). Merton (1973) stated that the investors responded based on the recent and upcoming market situations to face their risks. Hence, on decisions by the investors concerning their investments, they are supposed to consider variables like employment opportunities, inflation, and upcoming stock market returns. The ICAPM model, however, experiences various complications. (Chang, Hung and Lee, 2003) applied the model in the evaluation of the capability of selecting optimal portfolio and evaluation existing abilities in the timing capacity in the investment selection. The outcome of their research showed the right time to invest based on critical planning and timing (Amihud, 1989). A classification for the development of their investment asset distribution has an affirmative capacity on market timing. They can notice market opportunities at the correct time and by applying these opportunities make great profits for the stakeholders (Berk, 1995). This model is in a position to provide the estimation of unpredictable trends affecting the risk premium. Current studies have also shown better outcomes about the model. The force of changing in risk and return to the stock of exchange of New York was analyzed by this model (Bali and Engle, 2009). In conclusion, despite the clear void of the CAPM, it is still applied by many organizations in the calculations of capital cost. Graham and Harvey (2000) explain that the major intention and function of CAPM is to estimate the equity capital costs of an organization. The model has been also considered simple due to its ability in the measuring and comparison of two important variables about capital budgeting in its return and risks equation (Evans & Bishop, 2001). However, the model is grounded on strong assumptions about the actions of the investors; in spite assessing ideas in its in its perfect application. Different improvements in the model with different researchers have shown to be having drawbacks and benefits. The theory background and the development of arguments formed by various researchers have led to the improvements of the model hence wider application in the current financial world. Bibliography: Acharya,V.,Pedersen,L. (2005). Asset pricing with liquidity risk, Journal of Financial Economics,forthcoming.2(77):375–410. Amihud, Y,Mendelson, H.(1989). The Effects of Beta, Bid-Ask Spread, Residual Risk, and Size on Stock Returns,the Journal of Finance, 44(2):479-486. Bali, Turan, Engle,Robert F.(2009). Investigating ICAPM with Dynamic Conditional Correlations, New YorkUniversity Stern School of Business, 44 West Fourth Street, Suite 9-62, New York, NY 10012 Banz, R. F., 1981, “The Relation between Return and Market Value of Common Stocks,” Journal of Financial Economics, 9, 3-18. 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French, 1993, ‘Common risk factors in the returns of stocks and bonds’, Journal of Financial Economics, 33, 3-56 Fama, E & Macbeth, J (1973) ‘Risk Return and Equilibrium: Some Empirical Tests’, Journal of Political Economy, 8, 607-636 Top of Form Graham, John R., Harvey, Campbell R., 2000, “The Theory and Practice of Corporate Finance:Evidence from the Field”, Duke University. Top of Form Kodukula, P., & Papudesu, C. (2006). Project valuation using real options: a practitioners guide. Fort Lauderdale, Flor, J. Ross. Bottom of Form Top of Form Marciniak, M., Mykowiecka, A., & Bolc, L. (2009). Aspects of natural language processing: essays dedicated to Leonard Bolc on the occasion of his 75th Birthday. Berlin, Springer-Verlag. Bottom of Form Merton, Robert C. (1973). Theory of Rational Option Pricing. Bell Journal of Economics and Management Science(The RAND Corporation), 4(1):141–183. Top of Form Mun, J. (2002). Real options analysis: tools and techniques for valuing strategic investments and decisions. New Jersey, Wiley. Bottom of Form Top of Form Pratt, S. P., & Grabowski, R. J. (2010). Cost of capital applications and examples. Hoboken, N.J., John Wiley & Sons. Bottom of Form Roll, Richard. 1976. “A Critique of The Asset Pricing Theory’s Tests.”Journal of Financial Economics 4, 1977. Ross, Stephen A. (1977). The Capital Asset Pricing Model (CAPM), Short-sale Restrictions and Related Issues, Journal of Finance, 32 (177) Sharpe, William F., 1961, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.”The Journal of Financial Economics, Vol.19, No.3. (Sept. 1964) pp. 425-442. Read More