Empirical Tests of Capital Asset Pricing Model - Coursework Example

Empirical tests of CAPM University Student Id Course Date Introduction CAPM assists in the process of calculating the asset prices and the returns on investments that are expected. The pricing model recognizes the two risks that exist in any investment, which include systematic and unsystematic risks. Systematic risks that affect the capital asset pricing in the financial market where the risks cannot be diversified. The unsystematic risks that are also known as specific risks as they are unique to individuals. CAPM has been considered necessary in the process of measuring the systematic risks (Post, 2003). The validity of CAPM has been proved to make the pricing model commonly used by the investment community. Investors have been making use of CAPM in deducing the portfolio associated with the stocks and the direction that are likely to be taken by the stock prices in the market. The knowledge of CAPM is very important to the fund managers especially in managing cash where they might fail to hold cash at the moments when market seem to fall. The investors tailor their risk-return requirement according to their portfolio. The share market is largely based on CAPM where the pricing models have proved to be useful in the rising indexing. Investors are utilizing CAPM in the process of earning higher returns. The essay will be critically analyzing the CAPM empirical tests and the meaning of the tests to the investors. Empirical tests of CAPM Capital asset pricing model is the most popular and fundamental model in the process of pricing assets. It explores the relationship existing between risk components associated with any investment and return on assets. According to the model, only one component can explain the process of generating returns from the assets that can involve systematic risk and risks associated with the assets. The CAPM provides the equilibrium relationship especially between returns and risks associated with assets (Fama and French, 2004). It assists in identifying the overpriced and underpriced assets where the existing relationship between the beta of asset and return of asset can be explained. The pricing model started losing its popularity in the twentieth century because many models for pricing assets emerged. The argument against the use of CAPM was that using single factor; beta could not be enough for providing the returns associated with assets. The CAPM was compared with other models such as CCAPM and ICAPM that rely on various factors hence making the more reliable. There are other factors that the other models use in the process of pricing assets that affect the risk-return relationships (Lewellen and Nagel, 2006). Many companies such as Sony, Samsung, IBM, and burger king have been making use of CAPM in the process of determining the prices of the assets. The motivation to study more models that can be utilized in pricing assets can be associated with the failure of CAPM to use different factors. However, the applicability of the CAPM is significant in the current world where it has proved to be reliable in determining the asset prices. Capital asset pricing model forms the foundation of all the theories for pricing assets. The risky assets have returns that that are said to use the beta factor in a linear function (Post, 2003). Besides, the debt-equity ratio has been said to be critical in the process of providing explanations concerning return generation. Beta has been considered to be the factor affecting and explaining the process of generating returns, in particular by the risky assets. However, the size factor and the market ratio are among the factors that have been used in the process of explaining the relationship existing in risk returns. CAPM has been said to be applicable in stock markets of different nations where it is used in the pricing process of assets. Besides, the pricing model is useful in providing explanations of the risk-return relationships existing in the financial market (Da, Guo, and Jagannathan, 2012). CAPM has been helpful for many decades before and is considered crucial in the process of analyzing the risks associated with the invested funds. Taking high risk has been considered crucial in increasing the level of returns where the higher the risk, the higher the expected returns. However, the investors need to take calculated risks with the aim of avoiding losing their invested funds. The investors make use of the CAPM with the intention of making sure that they maximize the utility of their wealth. However, avoiding risks is among the major the primary objectives of the investors as they expect to maximize the security returns. There are some instances where the rate of return is risk-free where the investors are given the opportunities for borrowing and lending money without any risk (Lewellen and Nagel, 2006). The risks in some markets can be associated with obstacles and taxes that can result in the imperfection of the money market. Measuring the risks is crucial in establishing the average returns of the assets while considering the risks surrounding the invested funds. The CAPM mainly depends on two factors that can include portfolios entailing non-zero and zero beta. The zero beta is said to be mainly used as the model for specifying the equilibrium that shows the expected returns from the assets invested. The beta factor in the zero beta portfolio is usually uncorrelated with the market portfolio and the minimum variance. Usually, the zero beta portfolio is said to play the role that is equivalent to the risk of return that is risk-free. Comparing CAPM with other models CAPM has been said to fail in the process of explaining the average returns of the cross section that is attributed to a single period that is static. New models that are continuous have emerged that can be used as the alternative pricing models. For instance, ICAPM requires some additional factors to the market factor. The times of stochastic variations in the opportunities for making investments state variables can be relied on in the process of describing the investment opportunities (Lewellen and Nagel, 2006). In such situations, innovations are the significant risks facing the investment opportunities as technology keep changing. However, no theory can be used in the process of specifying the state variables hence ICAPM is the motivated model that has been suggested depending on the state variables chosen. The ICAPM model makes use of dividend yield, relative Treasury bill rate, real labor income growth rate and future growth of GDP in determining prices of assets. There are unconditional pricing models for assets that are used by investors that can include CCAPM and APT motivated models. CAPM is considered to be conditional as it entirely depends on the instrumental variables (Ang and Chen, 2007). Other asset pricing models make sure of more than one factor such as FF3 which has three factors into consideration in the pricing process and FF5 that has five factors consideration in the price determination models. Considering various factors in the pricing process of the assets can be crucial in making sure that the accurate and real prices are determined. The asset pricing models can be compared to performing numerous cross-sectional tests and time series tests that are based on the t-tests individually. The returns of the assets entirely depend on the market portfolio and the state variables innovations. The variables are mainly used in forecasting the future returns in the market and the labor income in the future. The changes that take place in the investment opportunities can be summarized using the changes in the future growth of GDP (Fama and French, 2004). Many investors have been making use of a two-factor model that has GDP factor and market factor. Considering the two factors in the process of pricing the assets helps in making sure that they take risks that are calculated hence helping in making investments. Considering the model comparison tests the basic CCAPM and CAPM specifications are the worst performers in pricing assets. There has been evidence that the pricing significance for ICAPM and consumption has reduced. The consumption-wealth ratio based on the conditional CCAPM has been shown to be a poor performer (Dongwei and Yuanxun, 2004). However, the model based on three factors is dominated; statistically, the other pricing models hence considered precise in determining asset prices. ICAPM exceeds the CAPM regarding accuracy in the process of determining the asset prices by around 65%, but this has not been considered to be statistically. However, comparing the models can be challenging at some point where due to the limitations of the comparing point estimates. The process of comparing the pricing models extends and reinforces simulation based conclusion that is focused on other factors but not the cross models differences. The relative performance of CCAPM deteriorates substantially the moment we constrain the rate of the zero beta to be equivalent to risk-free (Lewellen and Nagel, 2006). The CSR approach is modified with the motivation fueled by the observations that the zero beta rates are inconsistent with the plausible spreads existing between lending rates and the borrowing rates. Besides, the moment a model has been not specified the fit of the model usually varies from the test assets that are utilized. Empirically, the model that might be performing well in a set of test portfolio but fail to perform well in another asset of interest. The comparison is better performed using CAPM beta and the size of the stock for ranking. Considering the comparison, ICAPM and CCAPM are performing the best in the pricing of assets as compared with the other models as they dominate the three-factor model (Peiyuan and Donghui, 2002). The pricing models that are not three factor oriented are not statistically dominated. However, it has been considered crucial in determining whether multifactor models can be in a position to make any incremental contribution to the explanatory power of the model when other factors are present. Assumptions of the CAPM In the year 2002, Peiyuan and Donghui made an assumption that investors do not incur any transaction cost neither income taxes. Besides, they also made an assumption that assets are easily divisible and there are no various restrictions concerning short selling. Furthermore, investors are always permitted to lend and also borrow amounts which are not limited to an interest rate that is a free risk. Importantly, they made an assumption that investors usually possess effective portfolios that are of medium variance. Another assumption which is made about the CAPM is that almost every asset inclusive of the human capital are always marketable, even though CAPM is a period model that is single. However, there is clear evidence that, these assumptions do not have any truth related to the real world; hence the validity of this model has been suspected as an outset. Therefore, closer examinations concerning these assumptions made about the CAPM have shown that they are not stringent as it appeared in the first. Hence, the CAPM would still obtain similar results even if short sales were not allowed (Patton and Timmermann, 2010). Moreover, in a state of equilibrium there is usually no single investor who makes sales of any security short, thus prohibiting the short selling cannot in any way bring any change to the equilibrium. Besides, some conditions allow the multi-period problem to be reduced to a single period CAPM, whereby individuals maximize the utility function of a single period. Some of these conditions include; consumers should act in a manner which suggests that one-period returns are not a state dependent. Therefore, the distribution of the single period returns in all assets is usually referred to as the start of the period (Dongwei and Yuanxun, 2004). Another condition states that the consumption chances are not depended on the state, and also the tastes of consumers are always independent of the future events. The conditions have shown that the one-period utility is usually equal to the function of the multi-period utility provided that both non-satiation and risk aversion are present. However, the majority of the investors have made an argument that the above conditions are in most cases restrictive. Also, Fama and French, (2004) showed that it is necessary for the investors interests to be geared towards maximizing the returns with proper calculation of the risks involved. Moreover, in the case of the assumption of risk of either lending or even borrowing has been violated; still, a linear relationship between the returns of the assets and their risk can be obtained. However, this kind of model which is usually different from the standard CAPM is usually referred to as the zero-beta CAPM. Therefore, even though the assumptions which underlie the model of the capital asset pricing are demanding, they have established the base of criticism against the model. Besides, it is not all assumptions that are not flexible. Importantly, the final test for this model is not actually how reasonable the assumptions seem to be, but rather it is all about the conformity of this model to the reality (Post, 2003). However, the majority of the proponents for the CAPM have made an argument that, as a result of technological advances, the capital markets, therefore, operates in a manner which shows that assumptions are always satisfied. Meaning of empirical tests to investors The model of the Capital Asset Pricing which came into existence in the year 1960, in most cases, considers various assumptions which are related to the markets and also about the investor behavior, in a situation when they are setting equilibrium conditions. Moreover, these equilibrium conditions which are determined by the model usually create room for predicting about the asset returns in the level of non-diversifiable risk (Lewellen and Nagel, 2006). Furthermore, the CAPM utilizes the measure of non-diversified risk which can be compared to the other available assets in the market. Besides, by making use of this measure of risk theoretically creates room for the investors to improve on their portfolios and also for the managers to look for the rate of return that is required. However, the empirical test in this paper has been conducted by making use of the data from the S$P 500 in the process of determining the validity of the CAPM (Patton and Timmermann, 2010). The major significant implication about the CAPM is that all the investors intend to hold the risky assets portfolio in proportionately to the duplicate representation of the available assets in the portfolio of the market. In general, all the risky assets are usually referred to as the stocks. However, it is not only that the portfolio of the market is viewed as an efficient frontier, but also it is usually seen as the tangency portfolio to the allocation line of the optimal capital, which is derived by every investor. Moreover, the risk premium related to the market portfolio is always proportional to the standard deviation and also to the extent of the risk aversion of the investors. The portfolio selection has introduced the idea of the diversification of the stock portfolio to yield up maximum returns basing on the amount of risk a given investor is ready to take on. After twelve years later on after the establishment of the above idea, the CAPM was then developed into a series of articles. Moreover, after the development of the CAPM, the majority of the empirical tests of the model were conducted by making use of the proxies which are of distinct variables. In nowadays, the CAPM have been broadly taught as a result of its sufficiency for the large number of important applications (Dongwei and Yuanxun, 2004). In order to reach the CAPM equilibrium, various assumptions are required to be defined. The assumptions include maximization of the utility wealth by the investors and the utilization of a similar input list by all investors. Different empirical tests and interpretations The empirical tests of CAPM are usually based on two major predictions that include the efficiency of the market portfolio. The return-beta relationship that is expected can accurately describe the involved risk return trade off the moment the values of alpha are zero. However, there has been a challenge in the process of testing the portfolio of the hypothesized market as it is unobservable (Patton and Timmermann, 2010). The market portfolio is said to include the riskiest assets that the investors can have in the asset market. The hypothesized market can sometimes be more extensive when compared with the equity index. The market portfolio, in this case, can include real estates, bonds, human capital and privately held businesses. However, these assets especially the human capital are usually traded thinly, and sometimes no trade takes place. It can be challenging to test the efficiency of the observable portfolio and even the unobservable portfolio (Fama and French, 2004). Slight departures from the efficiency in the portfolio of the financial market might result in major departures from the return-beta relationship that is expected and which is useful in negating the practicality of the model. Conclusion The empirical testing of CAPM shows that it is fairly successful in the process of making predictions concerning the prices of the individual assets. Despite the fact that CAPM might not be considered perfectly accurate, it ensures legitimate explanations concerning the prices of assets. The expected returns are said to be proportional to the involved systematic risks and the excess returns that are expected in the market. The inaccuracies associated with the empirical tests can better be improved using better proxies, better econometric techniques, and rates that are risk-free. The CAPM is not a perfect theory, but the spirit of the pricing model is correct as it provides a usable risk measure that can help investors in determining the returns. The investors are said to differ concerning their willingness of accepting the risks associated with high returns. However, the moment the investors have the will to make investments in the stock market then they can be willing to assume some significant risks. The CAPM is said to provide consistent means necessary for pricing the risk premiums. Some of the investors have been willing to accept high risks with the aim of getting high returns. References Ang, A. and Chen, J., 2007. CAPM over the long run: 1926–2001. Journal of Empirical Finance, 14(1), pp.1-40. Da, Z., Guo, R.J. and Jagannathan, R., 2012. CAPM for estimating the cost of equity capital: Interpreting the empirical evidence. Journal of Financial Economics, 103(1), pp.204-220. Dongwei, S. and Yuanxun, M., 2004. Liquidity and Asset Pricing: An Empirical Exploration of Turnover and Expected Returns on Chinese Stock Markets [J]. Economic Research Journal, 2, pp.95-105. 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. Lewellen, J. and Nagel, S., 2006. The conditional CAPM does not explain asset-pricing anomalies. Journal of financial economics, 82(2), pp.289-314. Patton, A.J. and Timmermann, A., 2010. Monotonicity in asset returns: New tests with applications to the term structure, the CAPM, and portfolio sorts. Journal of Financial Economics, 98(3), pp.605-625. Peiyuan, S. and Donghui, S., 2002. CAPM Based Study of Herd Behavior: Evidence from Chinese Stock Market and Discussion with Song Jun and Wu Chongfent [J]. Economic Research Journal, 2, pp.64-71. Post, T., 2003. Empirical tests for stochastic dominance efficiency. The Journal of Finance, 58(5), pp.1905-1932. Read More