Relative Merits of the Capital Asset Pricing Model - Case Study Example

Critically analyse the relative merits of the capital asset pricing model (CAPM) and empirical approaches to asset pricing. Table of Contents Table of Contents 2 Introduction 3 Capital Asset Pricing Model (CAPM) 3 Arbitrage Pricing Theory (APT) 5 Fama & French model 6 Conclusion 8 Introduction An efficient pricing mechanism is important for channelizing the savings of individuals into profitable avenues thus facilitating optimal asset allocation. It ensures that an investor is adequately rewarded. For this reason pricing function is considered to be important in stock market and is a subject matter of holistic research. Various asset pricing models like Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT), Fama and French model have been studied to study stock market behaviour. CAPM has for long been investigated empirically and theoretically. Capital Asset Pricing Model (CAPM) CAPM model is based on some simplified assumptions which examine the relationship that exists between return and risk of the security. This model assumes that all the investors are risk-averse who wish to maximise the returns on their investment. The investors have homogeneous expectations about the market. CAPM assumes that there is a risk-free rate of lending and borrowing and the investors can make unlimited amount of borrowing and lending at this rate. Markets are assumed to be frictionless and there exist no market imperfections i.e. there are no transaction costs or taxes (Javed, n.d.). Lintner’s (1965) and Sharpe’s (1964) capital asset pricing model is widely used in the pricing of assets. Although there have been various arguments regarding its validity in academic literature on asset pricing still CAPM assumes an important position (Michel, 2009, p.7). Advantages of CAPM- The CAPM model has various advantages that make it popular over the other pricing models. This model takes only systematic risk into account. It is based on the reality that the unsystematic risk of the portfolio can be easily eliminated by diversification of the portfolio. The cost of equity is a form of ‘opportunity cost’ and not ‘cash cost’ it must be estimated and not observed. American as well as European literature prefer CAPM in the estimation of cost of equity. But there are again others who advocate the use of alternative methods like estimating equity cost through APT. As the application of APT is time-consuming and complicated CAPM is given prominence over other models. Moreover the relative advantages of CAPM over APT are low. The CAPM formula expresses the linear relationship existing between the security’s required rate of return and systematic risk. This is stated as- E (Ri) = Rf + ((E (Rm) –Rf)βi E (Ri) is the required rate of return on Asset i. Rf is the risk-free rate of return. βi is the security’s beta. E(Rm) is the return on market. CAPM states that the “opportunity cost of equity” equals the risk-free rate of return, plus the systematic risk of the company multiplied by the stock’s excess return over the risk free rate of return (also referred to as market risk premium). The systematic risk of the security is also known as its beta. The merits of CAPM are mentioned below- CAPM is a simplified and useful method of evaluation of traditional investments. It is a standard method of pricing derivatives and options. Under the CAPM model an investor is rewarded for bearing the systematic risk of the security as this model assumes that the unsystematic risk can be diversified thus this model proves that there is no need for hunting for “Alpha opportunities”. As a model CAPM gives an insight into “portfolio analysis” that is helpful at the time of studying other complicated models (Hence & Rieger, 2010, p.138). Example- Suppose the risk-free rate of return in UK is 4.5%. Taking the beta of Tesco as 0.77 and assuming the return of FTSE 100 over the last one year as 8% The cost of equity as per CAPM model is calculated as- Return on Tesco = 4.5+ (8-4.5)*0.77 = 7.20%. Viability of CAPM- CAPM model assumes that the markets are perfect but in real world there exist taxes and other market imperfections. Also this model assumes that the investors hold diversified portfolios but in real world the investors can hold single stock. Under CAPM the market index is considered to be most diversified. But again there are other risky assets that are left out of the ambit of the market index. Again this model assumes that the lending and borrowing are done at the risk-free rate but in reality the borrowing rate is more than the lending rate. Moreover CAPM takes only one factor into consideration i.e. sensitivity to market but there are other macro economic factors which influence the return on a stock. Problems in application of CAPM There are various errors in the application of CAPM. Firstly the model may be inadequate in the description of financial market behaviour. Another shortcoming of this model is that the betas do not remain stable through time. This creates problems when the value of beta estimated using historical data is used for the calculation of cost of equity in discounting cash flows. With the change in capital structure and company fundamentals the beta of the company also changes. Other than this the beta estimated from historical data can get affected by “statistical estimation errors” (Mullins, 1982). Arbitrage Pricing Theory (APT) APT is considered to be an alternative to CAPM model. This model overcomes the “unrealistic assumptions” of CAPM. Tests on CAPM reveal overestimation of risk-free return, underestimation of market risk premium and poor explanation. This can have serious consequences in its practical use specifically with regard to the use of beta is the prediction of asset return. APT overcomes the inherent shortcomings of the CAPM. The explanatory power of APT is superior to CAPM as it is a multi-index model that permits the use of multiple factors. Despite of this APT cannot overshadow the CAPM model as evident by the popularity of CAPM in corporate finance. The reason for the failure of APT in replacing CAPM lies in the fact that APT model does not identify the relevant factors in asset pricing. This serves as strength as well as weakness. This proves to be strength in the sense that it allows the researcher in selecting the best factors with good explanatory power. On the other hand this becomes a weakness as contrary to CAPM this model cannot explain asset return variations when only few factors are taken into consideration. The multi-index model in APT is explained as under- Source: (Frohlich, 1991). Where f refers to various factors, b is the sensitivity to various factors and e is taken as random variable (Groenewold & Fraser, 1997). The APT model has its own set of weaknesses. Its major criticism revolves around “factor analysis procedure”. Although some of these factors have been addressed by Dybvig & Ross (1985) and Roll & Ross (1980) yet there persist some problems (Frohlich, 1991). Fama & French model The estimation of cost of equity or expected return for stock is crucial for making financial decisions like the decisions relating to portfolio management, performance evaluation and capital budgeting. The “three factor model” or Fama & French model is an alternative to CAPM. Although academic literature provides evidence of support of this model in the estimation of expected returns the practitioners support CAPM in the estimation of the cost of equity. When the estimation is done using CAPM then the market beta is calculated with “simple OLS regression”. However if the Fama & French model is used then the beta relating to each factor is calculated which are then multiplied with respective risk premium of the factor to calculate the cost of equity. Fama and French model take “size and book to market factors” apart from the market index. But this model is not very popular. A comparison based on monthly data of 5 years shows that the Fama & French model at best explain five percent of the differences in stock returns. This limited gain fails to justify the additional effort involved taking two extra factors (Bartholdy & Peare, 2004). FFM is one of the most commonly used multi-factor models. The factors include- Like CAPM it takes into consideration market risk premium i.e. the return offered by the market in excess of the risk-free return. For the risk-free rate generally the Treasury Bill rate for one month is used. This model also take into account the ‘size’ factor or market capitalization or SMB factor. SMB basically refers to the “average return on three small-cap portfolios” minus the “average return on three large-cap portfolios”. This essentially represents the return premium on small cap. Another factor that is included by Fama & French is HML or “average return on two high book-to-market portfolios minus the average return on two low book-to-market portfolios”. This model is stated as under- E (R) = Rf+ Beta Market* RMRF+ Beta size*SMB+ Beta value*HML This model uses the historical approach in the estimation of the risk premia. RMRF is the premium in excess of the rate on “short-term government bonds”. Taking the example of equity market in US this rate is taken as 4.1%. RMRF is assumed to be 5.5%. Based on the historical data of 1926 the size premium is taken as 2.7% and the value premium is taken as 4.3%. Therefore the expected return is estimated as- E (R) = 4.1%+ Beta Size*5.55%+Beta Size*2%+ Beta Value*4.3% FFM considers the value factors and size factors as proxying a specific set of risk factors. For instance small market-capitalization companies are vulnerable to risks like limited access to public and private credit markets and also have certain competitive disadvantages. Again the shares with high book-to-market ratios may have depressed prices if they are exposed to conditions of financial distress. FFM considers return premiums on value and small size as compensations for tolerating systematic risk. But some of the practitioners are of the view that these premiums arise on account of market inefficiencies and are not compensation for bearing the risk. The main purpose of including extra factors in FFM i.e. the extension of CAPM is to give explanations in the equity returns that are not explained by the CAPM beta. Another reason for this extension is that the investors demand a higher premium for the stocks that are illiquid i.e. the stocks that cannot be easily liquidated and involve high transaction costs. FFM model has been further extended by Pastor and Stambaugh (2003) to incorporate compensation for the liquidity strength of an instrument. This has been used in valuing both the public and private security instruments. This model adds another factor to the Fama and French model called LIQ which represents the excess return on a portfolio investing in “high liquidity stocks” over “low liquidity stocks” (Pinto et al., 2010, p.69). Conclusion Research conducted has shown that the CAPM model can stand up on the criticism levelled on it by the advocates of other models. As already discussed the other extended models that include factors other than market index can explain only for very minimal variations in the expected return. CAPM model considers the market index as one of the factors in the estimation of cost of equity. Here the benchmark index that comprises of all the risky assets in the economy is taken into account. This kind of factor is capable of offering reasonable explanations to changes in the macro-economic conditions. The market index comprises of stocks of the various sectors and hence reflects the market conditions. Any kind of change in the market condition also impacts this index. Thus the risk premium of the stock i.e. the beta of the stock multiplied by the market risk premium offers suitable explanations to the changes in the return on the security. Reference Bartholdy, J. Peare, P. 2004. Estimation of expected return: CAPM vs. Fama and French. International Review of Financial Analysis. Elsevier. Frohlich, J.C. 1991. A Performance Measure for Mutual Funds Using the Connor-Korajczyk Methodology: An Empirical Study. Kluwer Academic Publishers, Boston. Groenewold, N. Fraser, P. 1997. Share Prices and macro economic factors. Journal of Business Finance & Accounting. Hence, T. Rieger, O.M. 2010. Financial Economics. Springer. Javed, Y.A. No date. 1. REVIEW OF THEORETICAL LITERATURE. Alternative Capital Asset Pricing Models: A Review of Theory and Evidence. Available at: http://www.eldis.org/fulltext/PIDE-alternative.pdf [Accessed on November 10, 2010]. Michel, G. 2009. Real Estate Risk in Equity Returns: Empirical Evidence from U.S. Stock Markets. Gabler Verlag. Mullins, W.D.1982. Does the capital asset pricing model work?. Harvard Business Review. Pinto, E.J. Henry, E. Robinson, R.T. Stowe, D.J. 2010. Equity Asset Valuation. John Wiley and Sons. Bibliography Baker, K.H. Powell, E.G. 2005. Understanding financial management: a practical guide. Wiley-Blackwell. Cochrane, H.J. 2001. Asset Pricing. Available at: http://faculty.chicagobooth.edu/john.cochrane/research/papers/samplechapters.pdf Ross, A.S. Westerfield, R. Jaffe, J. 2004. Corporate Finance. 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