Capital Asset Pricing Model - Literature review Example

CAPITAL ASSET PRICING MODEL Name: Course: Professor Name: Institution: City: Date: Introduction In the Financing, Business and Administration investment courses, for a long time, the CAPM has been the only pricing model that has been taught. The model draws itself from the times of William Sharpe (1964) and John Lintner (1965). It was these two people who started the asset pricing theory following a capital model (Fama and French, 2004). The widespread use of capital asset pricing model today follows the intensive search of the theory decades after its successful establishment. It later went to win the Nobel Prize for Sharpe in 1990. Over fifty years, considerable number of models had been developed from primary CAPM model that also called Sharpe-Lintner CAPM, including Zero-beta CAPM (Black, 1972), The Fame-French Three-Factor Model (Fama and French, 1993), The Intertemporal CAPM (Merton, 1973), Conditional CAPM (Jagannathan and Wang 1996) and Liquidity Based CAPM (Acharya and Pedersen, 2005). According to Celik (2012) points out all of these models are developed from Sharpe-Lintner CAPM that can be distinctively divided into two different kinds of parts; one which may be static or dynamic based on the framework. During the development of theoretical models, the empirical analysis of capital asset pricing model had also kept publishing for demonstrating these theoretical models. On the other hand, there is a considerable amount of empirical analysis research reject the validity of theories from some preconditions. This article will review literature about different vision of capital asset pricing models and corresponding empirical analysis research Literature Review In the world of financial economics, one of the most significant contributions is the invention of . Capital Asset Pricing Model. CAPM was conceived in the 1960s by some researchers including William Sharpe. The researchers built their theory from the Markowitz’s portfolio theory. It is the Markowitz’s portfolio theory that they developed a theory that would form the price for financial assets in what is presently called the capital asset pricing model. Markowitz's portfolio theory is usually meant to analyze how optimally wealth can be invested in assets and reduce the risk. Capital asset pricing model relies on foundation that an investor can be exposed to a considerable amount of risk. This can be through what he chooses to combine on the borrowing-lending ratio as well as what he chooses to combine as securities in his or her portfolio. Through evaluation by the investor, as explained by CAPM, an optimal portfolio depends on the prospects of the securities and not on the attitude of the investor towards risk. The investor's attitude towards risk is usually reflected on what the investor chooses to combine as risky portfolio and borrowing or investment which is risk-free. In the For an investor who has perfect information, there is usually no reason to hold the portfolio of shares that are different from the other investors- this is called the market portfolio of shares. CAPM consists of a factor known as the beta value. The beta value states the marginal risk contribution of a particular security to the whole portfolio that consists of risky securities. Beta is usually considered a high coefficient when its value is more than 1. This makes it have an above average effect to the whole portfolio. And when it is less than 1, it is considered as low and therefore has a less than average effect to the whole portfolio. According to capital pricing model in efficient markets, the expected return and the risk premium and the expected return will vary proportionately to the value of the beta. Ultimately, the formation of equilibrium price in markets which are efficient generates such relations. The publication of Portfolio Selection Book by Markowitzs (1959) was later followed by Treynor (1961) that developed the theory behind asset pricing. Treynor’s paper laid the groundwork for a theory of value of the market that consists of risk. Work done by shape later followed him. According to Sharpe (1964), through diversification, the risk inherent to a security can be mitigated so that the risk does not become a factor that can influence the asset’s price. Articles that were subsequently published such as Sharpe (1964), Litner(1965) and Mossin(1966) had countering opinions which tried to relax the assumptions that laid ground on the Theory of Capital Asset Pricing Model, latest one being that one of Black(1972). According to him, he tried to put up a model that showed the difference when riskless borrowing is not available. It eventually came to be referred to as the zero-beta CAPM. Another theory that came up is that of Brennan (1970). He proved that when factors such as taxes are introduced, the structure of the original capital asset pricing model remains constant.. Mayers (1972) also included non-traded assets into the portfolio that showed the structure of original capital asset pricing model remained unchanged. The model was later incorporated with international investing as witnessed from theories of Solnik (1974) and Black (1974). Another model that tries to expand into the CAPM is the Fama and French three-factor model. This model tries to add the factor of size and value to the market risk factor of CAPM. The consideration put by the model is that small-cap and value stocks usually outperform the market on a regular basis. The inclusion of these two factors makes the model have a dynamic approach whereby outperformance of the stock is added to the risk. At times CAPM does not capture the movements that occur in an asset behavior, especially during turbulent economic conditions. Hence, this behavior usually invalidates the theory of capital asset pricing model. For instance, in the instance of value stocks and growth stocks, return for value stocks is usually higher than that of growth stocks. This, therefore, brings about the model of conditional capital asset pricing model. Assumptions of the capital asset pricing model CAPM tries to simplify itself through key assumptions. Despite the complexities involved in the stock market, CAPM tries to validate a theory depending on the empirical accuracy of its predictions and not realism of assumptions. The major assumptions are: • The main aim of all investors is to maximize utility they are to enjoy in the future from the holding of wealth • All investors usually operate on a common single period horizon • All investors have some securities to choose from based on risk and return in case they need alternative investments • All investors are risk averse • Capital gains and taxes are taxed at same rate • All securities are easily and highly divisible • There are no transaction costs CAPM of the Chinese market Literature that exists about the Chinese markets is before the year 1999. It is, however, unfortunate since the capital asset pricing model of that period is invalid. The reason is that A) The tests that were done previously had a negative risk-free rate (Yang & Xing, 1998, Chen & Qu, 2000). This is because it is totally against the assumption of capital asset pricing model. Li, Lee and Wu (2004) perceive the negative interest rate as a result of attributes of Chinese investors having a large appetite for returns which are high and also since the stock market was new, they were not trained on investment decisions. Therefore, the issue of irrationality was brought up. According to Drew, Naughton, Veeraraghavan (2003), investors in China heavily relied on rumors for information. Therefore, it violates the CAPM assumptions. B) Before the year 1999, the size of the market was too small. This provided limited opportunities for investment to investors. Considering that the total risk of a portfolio consists of systematic and unsystematic risk, CAPM assumes that risk which is unsystematic should be diversified (Mirza & Shabbir 2005). Before 1999 there were less than 900 listed companies and all of them were the key Chinese industries which large and middle-sized companies. Size and profitability were the requirements to be listed on the stock exchange. According to Drew, Naughton & Veeraraghavan (2003), the government had held off about one-fifth of the market capitalization. These properties were not to be traded hence retail investors had a barrier to trading which is against the assumption of CAPM. C) The control system and regulation were not perfect leading to asymmetry of information in the market during that period. The issuance of stock was done by enterprises, considering there was no regulatory body. Some investors had an upper edge since they got internal information. Considering that capital asset pricing model assumes that all investors are exposed to perfect/ symmetrical information, this was not the case then. Fama-French model literature review Proposals of a three factor model are encouraged by Fama French when the china stock market is to be tested. This is because the three dimensional is paramount especially in the time series framework. On the time series framework, the three-dimensional is paramount. Since CAPM fails to state correctly, the asset prices pre 1999, the Fama and French model comes in handy. This can be attested in the United States post 1963 where the average returns of the assets are better than that of the CAPM if the factors are put into consideration. Literature Review With the use of data from ten countries, HML and SMB are doing well regarding forecasting the economic growth of the future (Liew and Vassalou 2000). They found a relationship between macroeconomic risk with HML and SMB. Brennan and wang (2004) later test the ability of their pricing model and have a positive result that explains size effects and book to market. The applicability of three factor model of Fama and French was put into focus by Chui and We and the conclusion was that there is little effect that beta has on the return of stocks. They found that average returns of portfolio are more affected by book to market ratio and size. Drew and Naughton on their test of the applicability of three-factor model to Shanghai A shares had converse and rather divergent opinion. They suggested that stock returns cannot be averagely explained by the market. He also found that size and market can produce excess returns but a book to market is not significant. When viewed from the angle of risk, it can be determined that low-BM is not a guarantee of earnings in excess but rather irrational behavior causes it. According to Van der Hart & Slagter (2003) value is more important than size considering that it generates more returns. Conditional Capital Asset Pricing Model This shows inconsistency since the betas of growth stocks is higher than that of value. The development of a conditional CAPM where such factors are included in the equilibrium is able to explain the differences of the static capital asset pricing model. Conditional CAPM is not without criticism, though. According to the Lewellen-Nagel critique, the returns that conditional CAPM brings are too small to make a difference. Conclusion The validity of capital asset price model is examined in this paper with the focus on the Chinese stocks at the Shanghai Stock Exchange. A-share stocks of the Shanghai Stock Exchange are studied from January 2005 till December 2009. The results of the tests, however, do not indicate that CAPM is valid on the Shanghai Stock Exchange. CAPM emphasizes that the only element that can emphasize the difference between variables is the beta. This paper, however, shows contradicted theory since the portfolio return, and the portfolio beta is flatter as compared to the CAPM’s prediction. There are instances where high beta does not necessarily relate to high yields. This finding seems to be unchanged earlier empirical test from Jian and Liu (2001) on the Shanghai Stock Exchange. Additionally, the linear relation between portfolio return and portfolio beta does not exist yet according to CAPM’s definition; there should be a relation that is linear. Shanghai securities exchange does is not compatible with size and book to market ratio therefore making the theory non existent. This is because book to market value is considered helpful only when it is used in explaining the stocks return. Considering that CAPM emphasizes that more risk can probably have more return, in conditional CAPM, the returns of stocks cannot be explained well by. List of references Acharya, V.V. and Pedersen, L.H., 2005. Asset pricing with liquidity risk. Journal of financial Economics, 77(2), pp.375-410. Brennan, M.J., 1970. Taxes, market valuation and corporate financial policy. National Tax Journal, 23(4), pp.417-427. Celik, S., 2012. Theoretical and empirical review of asset pricing models: A structural synthesis. International Journal of Economics and Financial Issues, 2(2), pp.141-178. Drew, M.E., Naughton, T. and Veeraraghavan, M., 2003. Firm size, book-to-market equity and security returns: Evidence from the Shanghai Stock Exchange. Australian Journal of Management, 28(2), pp.119-139. 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. Jagannathan, R. and Wang, Z., 1996. The conditional CAPM and the cross‐section of expected returns. The Journal of finance, 51(1), pp.3-53. Jensen, M.C., Black, F. and Scholes, M.S., 1972. The capital asset pricing model: Some empirical tests. Lettau, M. and Ludvigson, S., 2001. Resurrecting the (C) CAPM: A cross‐sectional test when risk premia are time‐varying. Journal of Political Economy, 109(6), pp.1238-1287. Li, J., Lee, C., & Wu, F. (2004, 03). A test of capm in shanghai stock market. J.North China Univ. of Tech , 16 (1), 78-82. Liew, J. and Vassalou, M., 2000. Can book-to-market, size and momentum be risk factors that predict economic growth?. Journal of Financial Economics, 57(2), pp.221-245. Lintner, J., 1965. The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. The review of economics and statistics, pp.13-37. Markowitz, H., 1959. Portfolio Selection, Efficent Diversification of Investments. J. Wiley. Mayers, D., 1972. Nonmarketable assets and capital market equilibrium under uncertainty. Studies in the theory of capital markets, 1, pp.223-48. Merton, R.C., 1973. Theory of rational option pricing. The Bell Journal of economics and management science, pp.141-183. Mirza, N., & Shabbir, G. (2005). The death of CAPM: a critical review. The Lahore Journal of Economics , 10(2) , 35-54. Mossin, J., 1966. Equilibrium in a capital asset market. Econometrica: Journal of the econometric society, pp.768-783. Sharpe, W.F., 1964. Capital asset prices: A theory of market equilibrium under conditions of risk. The journal of finance, 19(3), pp.425-442. Solnik, B.H., 1974. An equilibrium model of the international capital market. Journal of economic theory, 8(4), pp.500-524. Treynor, J.L., 1961. Toward a theory of market value of risky assets. Unpublished manuscript, 6. . Read More