The Most Popular and Important Model in Times of Pricing Assets - Essay Example

University: Student: Id: Course: Date: Introduction Capital asset pricing model has been used in the estimation of costs associated with capital and in performance evaluation. CAPM helps in measuring the risks that are likely to be faced in the process of making investments through establishing the relationship existing between risks and the returns expected. The risks that are related to the stock are then measured based on the comprehensive market portfolio that includes financial assets, human capital and consumer durables (Ahmed, 2012). The pricing model assumes that the investors are risks sensitive and they are looking for ventures that can generate high returns while taking calculated risks. There are some instances when the lending and borrowing is done at the risk-free rate. The pricing of assets is critical to investors as it helps in determining capital and making investment decisions. The model has then been considered useful in the process of calculating the expected returns expected. The risks involved in making investments are recognized by CAPM where they are considered in the pricing process. The pricing model considers the financial market conditions in the course of determining the prices of the assets. The stock market has also been relying on the use of CAPM in pricing the assets. In the essay, the empirical tests of CAPM are analyzed and the way the investors rely on the model explored. Capital asset pricing model Most of the finance analysts and corporate accountants are making use of CAPM in the process of estimating the costs associated with shareholders equity. The formula of CAPM that is in calculating the costs use the beta value of stock, return rate and rate that is risk-free. The return rate is taken to refer to the generated returns in the market stock of the company is traded. The rate is used in calculating the equity financing of the company while the beta stock is taken to refer to the level of risk that is relative to a wider market (Fama and French, 2004). The moment the beta is high is an indication that the stock is more volatile while the lower beta is used as a reflection of greater stability. Risk-free rate defines the return rate especially on short term treasury bills as the value of the security is stable. Cost of equity= (rate of return in the market-the risk-free rate)*beta plus risk-free rate Investors can easily eliminate the company risks by diversifying the portfolios where they cannot be compensated for bearing risks that are unsystematic. Investors who are well diversified are likely to be exposed to systematic risk in the financial market. Therefore, the investors can be rewarded returns that are high because of bearing market-related risks (Liu, 2006). The risks might seem to be inconsistent with the empirical evidence where most investors might fail to hold enough diversified portfolios despite the presence of low diversification vehicles that can include mutual funds. However, the investors that are significant and consistent with CAPM the institutions dominating the stock exchange are likely to hold portfolios that constitute many securities. The investors who are actively trading are likely to determine the prices of securities and the returns expected. The moment the portfolios of the investors are diversified their pricing strategies are likely to be consistent with the predictions of CAPM where what matters the most is systematic risks. Beta is being used as the standard measure when using CAPM in systematic risk. It is said to assess the tendency of security to move in a direction that is parallel with the stock returns in the market. Besides, beta can be taken to be the gauge of the volatility of security that is relative to the market volatility. For instance, the market stock that has a beta of 1 as the average of systematic risk is likely to fall and rise at a similar percentage with the index at broad market (Perold, 2004). The moment the beta of the stock is a bit higher than 1 tends to fall and rise by a percentage that is greater in the market. Therefore, such stock tends to have a systematic risk level that is high and very sensitive to the changes in the financial market. The stock that has less than one as the beta is likely to have a low systematic risk level and market swings that are less sensitive. The expected return relationship is usually referred to as security market line. The returns that are expected on securities are said to be equal to the risk premium plus the risk-free rate. The risk premium can be measured as the beta multiplied by the returns expected in the market less the rate of the free risk. The risk premium that is associated with the securities is a function that is related to the market risk premium (Liu, 2006). No measure concerning the unsystematic risk can appear because the diversification of CAPM eliminates the risks. However, the model for pricing started becoming less popular during the twentieth century, since a large number of models which were used for pricing assets started to emerge. Moreover, the argument concerning the utilization of the CAPM stated that by using a single factor; beta was not enough to provide returns that are related to the assets (Gatfaoui, 2010). Therefore, a comparison was conducted between the CAPM and other models which include ICAPM AND also the CCAMP, whereby these models depend on various factors thus making them reliable. Besides, there are still other factors which some models rely on them during the process of pricing assets, and those factors have impacts on the relationships of the risk-return. For instance, many of the companies such as reebok, Coca-Cola, Sony and Samsung have been utilizing the CAPM in its process of evaluating the prices for the assets. The aspect of motivation in studying a large number of models can be used in pricing assets and also can be associated with the failure of the CAPM to rely on distinct factors. However, the utilization of the CAPM is quite important in the recent world, whereby it has proved itself to be more reliable in the process of determining the prices for the assets. Significantly, the model of the capital asset pricing makes the foundation for the various theories of the asset pricing. Furthermore, the risk assets always have returns which are known to utilize the beta factor in a linear function. Besides, the debt-equity ratio is always referred to as critical in the aspect of giving explanations about the return generation. Beta has been viewed as the factor which affects and also that explain how returns can be generated specifically by the risky assets. However, both the market ratio and the size factor are some of the factors that have been employed in the process of giving an explanation about the existing relationship in the risk-returns. Moreover, the CAPM has also been applicable in the various stock markets of distinct nations, whereby it is utilized in the process of pricing assets. Importantly, the pricing model is always necessary for the provision of an explanation concerning the existing relationships of the risk-return in the financial market. Also, the CAPM has also been useful for several years hence it has been considered as critical in the process of evaluating the risks that are related to the invested funds. However, taking high risks has also been considered to be significant in the process of increasing the return level, whereby when the risks are high; consequently, the expected returns are also high. The investors are usually required to make use of the calculated risks to avoid losing the funds which they have invested. Therefore, investors utilize the CAPM intending to ensure that they maximize on their wealth utility. However, the avoidance of risks is always one of the major basic objectives which are set by the investors in their process of maximizing the security returns. In some situations, the rate of return is mostly risk-free, whereby the investors are provided with the chances of either borrowing or even lending money. Some of the risks which investors face in the various markets are related to the obstacles and also to the taxes which can lead into the imperfection in the money market. Measuring the level of risks is quite necessary for the establishment of average returns of assets. Also, by measuring the level of risks investors can understand the risks revolve around the invested funds. There are usually two factors which the CAPM is always dependent upon, and these factors are the portfolios which are related to the non-zero and also to the zero-beta. The zero-beta is mostly used as the model for identifying the equilibrium which shows the expected returns related to the invested assets. However, the beta factor which is found in the portfolio for the zero-beta is always not correlated with the portfolio for the market and also with the minimum variance. In most cases, the zero-beta portfolio is usually known to play a role which is equivalent to the return risk. Comparing CAPM with other models There has been a failure of the CAPM in its process of giving an explanation to the average returns of the cross section which are related to a single period. Moreover, new continuous models have now emerged, and they usually provide alternatives to the pricing models. For example, the ICAPM requires some other factors apart from the market factor. However, in the case of stochastic variations in the chances of making various investments, the state variables can be dependent upon in the process of evaluating the investment opportunities. Besides, no single theory can be utilized in the course of identifying the state variables, and therefore the ICAPM is the motivated model which has now been suggested. Moreover, the ICAPM model usually employs various factors such as the growth rate, real labor income and also the Treasury bill rate in its process of determining the asset prices. There are also pricing models that are not conditional for the assets utilized by the investors such as the motivated models of the APT and the CCAPM. However, the CAPM is always viewed as conditional since it mostly relies on the instrumental variables. Some of the models for the asset pricing such as the FF3 makes use of more than a single factor for considering in the pricing process. For instance, the FF3 always consider three factors in its pricing process whereas the FF5 has five factors which it has to consider in its process of determining the price models. Furthermore, through consideration of the various factors related to the process of pricing assets can be of great importance in ensuring that there is an accurate determination of the real prices. However, the models of the asset pricing can be compared to a large number of cross-sectional tests as well as to the time series tests which are always dependent on the t-tests personally, whereas the asset returns are usually based on the market portfolio as well as the innovations of the state variables. Besides, these variables are mostly used in the process of forecasting about the market future returns and also about the future labor income (Perold, 2004). Therefore, various changes which occur in the investment changes can be noted in a summary of the future GDP growth. The majority of the investors in most cases utilize a model that has two factors which are; the market factor and the GDP factor. Importantly, the consideration of these two factors in the pricing process of the assets assists in ensuring that investors take risks which are calculated. Besides, by considering the comparison between the various model tests, both the primary CCAPM and the CAPM have been proved to be the worst performers regarding pricing assets. Also, there clear evidence on the pricing importance for the ICAPM and also a reduction in the level of consumption (Falahati, 2008). Besides, the ratio of the consumption-wealth which is based on the conditional CCAPM, have also been proved to be a poor performer. However, the pricing model which depends on three factors is always dominated and therefore it is considered as the appropriate determiner of the asset prices. Furthermore, the CAPM is exceeded by the ICAPM regarding accuracy through determination of the asset prices even though that has not been statistically considered. However, the aspect of comparing the pricing models can be quite challenging in some various points as a result of the limitations of carrying out a comparison between the point estimates. Moreover, the comparison process of the pricing models emphasizes on the stimulation depending on a conclusion which is focussed on other various factors rather than the differences in the cross models (Liu, 2006). Also, the performance of the CCAPM goes on decreasing drastically during the time when the zero-beta is equivalent to the risk-free. Barberis, et al. (2015), assumed that do not bear up any expenses of either transaction cost or even income tax. Apart from this, they also assumed that the assets could be divided easily and also there are no barriers which are related to the short selling. Moreover, the investors are always granted permission of both lending and borrowing amounts that are not restricted to the interest rate. Significantly, they also made an assumption which stated that investors possessed portfolios which were effective and also of medium variance. They also made an assumption concerning the CAPM that, in around each asset including the human capital are usually marketable. Empirical tests impacts on investors Investors are said to rely heavily on CAPM in the process of coming up with the necessary prices of capital assets. As a result, the investors are in a better position to make investment decisions that are wise and able to guarantee an increase in the returns. The conditions in the financial market are crucial in determining the equilibrium while taking advantage of the pricing model. The equilibrium arrived at in the process of pricing capital assets assists in the course of making the predictions concerning returns of the asset (Falahati, 2008). The CAPM sometimes utilizes non-diversifiable risks in comparing the capital assets found in the financial market. The investors can make use of the pricing model in developing a room for improving their portfolios in the financial market. The primary implication concerning CAPM is that investors have the intention of holding the assets that are risky where the risky assets are market stocks. The allocation of capital in an optimal way can be possible through viewing tangency portfolio as the frontier that is efficient (Khan, 2008). The risk premium that is associated with the market portfolio is normally proportional to the deviation standard and the risk aversion ability among the investors involved. The diversification idea in the portfolio selection can yield the maximum returns depending on the level of risk. The empirical tests of the pricing models made use of different variables in the process of developing capital asset pricing model. Currently, CAPM applications in pricing have increased leading to an increase in its popularity in the financial market. However, the use of capital asset pricing model relies on some assumptions that the financial analysts need to know before applying the model (Holton, 2013). The assumptions that the analysts must be aware of in the process of making of CAPM can include the intention to maximize wealth and the need for investors to use of inputs that are similar. The market portfolio efficiency is among the predictions that are made in empirical tests of capital asset pricing model. The beta relationship concerning the asset returns can be best achieved the moment the values associated with alpha is zero (Perold, 2004). The major challenge that has been facing the hypothesized market is that is unobservable in the process of testing the market portfolio. The market portfolio includes the most risk assets in the market that the investors look to use in the investment process. The market portfolio includes bonds, real estate, businesses that are held privately and human capital. The hypothesized market is usually extensive more than the equity index in the financial market. Some of the capital assets like the human capital are traded thinly where in some instances no trade can take place. There are slight departures from the portfolio efficiency of financial markets that can result in big return beta relationships departures (Frencha, 2003). The risk averse notion that has been common implies that the investors might demand some compensations for taking risks. The financial markets that risk-averse investors dominate the securities with high risks are likely to yield high returns. Conclusion The CAPM can be considered to be the most popular as well as an important model in times of pricing assets. The model explores the relationship which exists between the components of risk that are related to any form of investment and also associated with the return on assets. However, in agreement with the model, it is only a single component which can give an explanation concerning how returns are generated from the assets through the involvement of systematic risks and also risks that are related to the assets. Moreover, the CAPM usually provides an equilibrium relationship in mostly between the returns and the risks that are related to the assets. Importantly, the equilibrium relationship facilitates the identification of the assets that are overpriced, and also those underpriced, whereby an explanation concerning the existing relationship between the return of asset and the beta of the asset can be given. The empirical tests have been shown to be successful in the process of predicting the prices for assets in the stock market. CAPM provides the explanations concerning asset pricing that is useful for the investors in the financial market. The pricing spirit when making use of CAPM is crucial in making sure that the necessary determination of returns is done in the stock market. Therefore, empirical tests are necessary for the investors to make investment decisions that are wise as the various factor affecting the prices of capital assets can be learned. References Ahmed, T., 2012. Capital asset pricing model. Docs. school Publications. Barberis, N., Greenwood, R., Jin, L. and Shleifer, A., 2015. X-CAPM: An extrapolative capital asset pricing model. Journal of Financial Economics, 115(1), pp.1-24. Falahati, K., 2008. Capital Asset Pricing Model. Available at SSRN 499441. Fama, E.F. and French, K.R., 2004. The capital asset pricing model: Theory and evidence. The Journal of Economic Perspectives, 18(3), pp.25-46. Frencha, C.W., 2003. The Treynor capital asset pricing model. Journal of Investment Management, 1(2), pp.60-72. Gatfaoui, H., 2010. Capital Asset Pricing Model. Encyclopedia of Quantitative Finance. Holton, G., 2013. Capital Asset Pricing Model. Retrieved August, 7. Khan, M., 2008. Are accruals mispriced? Evidence from tests of an intertemporal capital asset pricing model. Journal of Accounting and Economics, 45(1), pp.55-77. Liu, W., 2006. A liquidity-augmented capital asset pricing model. Journal of financial Economics, 82(3), pp.631-671. Perold, A.F., 2004. The capital asset pricing model. The Journal of Economic Perspectives, 18(3), pp.3-24. Read More