Evolution of Asset Pricing Theories - Example

Introduction In the traditional, ideal markets, corporations were able to raise sufficient funds on the financial market. However, over time, the cash needs of modern corporations grew so vast that a cushioning mechanism was required to stand up against liquidity shocks. Financial institutions then began using, liquid assets as security for credit availability in the future. Price determination for these assets nevertheless, poses to be a problem, with investors themselves being doubtful of the accuracy of its various pricing theories. On the other hand, financial market signals are very crucial to understand as they decide, business movement, distribution of wealth and fiscal solidity. This paper uses secondary sources of data and explores the functioning of two famous asset pricing theories, namely Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT), in the context of the efficient market hypothesis. It attempts to give a theoretical understanding on the factors that affect expected returns from assets and find general explanations for the same. The paper also assesses the validity of the two asset pricing theories from an investor’s point of view. Evolution of Asset Pricing Theories In 1776, Adam Smith defined, natural price of commodities, to be such that it gives the owner a sufficient profit and market price of commodities, he deduced to be determined by the demand and supply of an asset (Smith, 1776). However, he believed that prices of assets would digress from their normal price to a market price only for a short period of time, for in the long run; the market price would become the normal price. This theory by Smith (1776) has been further strengthened by financial experts through empirical studies on asset pricing and by the surfacing of the efficient market hypothesis, a concept revived by Fama in his article, “Efficient Capital Markets: A Review of Theory and Empirical Work” (1970). Assuming that prices of assets fluctuated over a given period of time, it was imperative to understand, why people invest. Investment is not just a question of stocks and bonds but that of protection and opportunities with respect to a wide range of contingencies (Markowitz, 1952). It helps individuals and corporations to allocate financial resources to areas where future cash flows are assured. While deciding to invest, an investor essentially settles on an amount for investment, assets to invest in and the proportion in which the amount will be divided among the various assets. Here, the possibilities of jeopardy arise with investors facing the possibility of a risky portfolio. For investors’, time predilection and risk avoidance is key. This risk avoidance is possible only when investors have ready information at hand, which only asset pricing theories can provide them. Capital Asset Pricing Model This paper first examines the Capital Asset Pricing Model (CAPM) which was developed by both William Sharpe (1964) and John Lintner (1965), autonomously. The very foundation of CAPM is laid on the portfolio theory which states that the price of an asset are determined by forces outside of the market and are not influenced by any investor. This pricing theory believes that the return on an asset depends on whether the assets price follows the prices stated by the market as a whole. By giving a statistical expression to past risks, CAPM helps draw out the projected return from an asset by depending linearly on the measure of risk for an asset and the market portfolio. The assumptions held under CAPM as elucidated by Sharpe (1970) are: No transaction costs and taxes Assets are indefinitely dividable Each investor can invest into every asset without restrictions Investors maximize expected utility by using the mean-variance criterion Prices are given and cannot be influenced by the investors (competitive prices) The model is static, i.e. only a single time period is considered Unlimited short sales Homogeneity of beliefs All assets are marketable Arbitrage Pricing Theory Even though CAPM assumptions fit near perfectly for optimal or even well spread out portfolios, to explain returns on individual assets got a little more complicated. It is into this gap that the Arbitrage Pricing Theory (APT) was first established by Ross in 1976. The theory theorizes that the expected return on a financial asset is driven not just by market movement but also by influences from the industry or country, also referred to as, "beta". Beta in APT refers to the gauge of relationship between the company related influences and the overall market in which the asset competes. The assumptions under APT as described by Schneller (1990) and Ross (1976) are: The returns are assumed by investors to follow equation (7.1) Investors are risk averse with a finite Arrow-Pratt measure of risk aversion No transaction costs or taxes exist No restrictions on short sales for any asset In equilibrium no arbitrage possibilities exist For at least one asset the possible loss from holding the asset is limited to t < Every asset wants to be held by investors, i.e. the total demand for every asset is positive Homogeneity of beliefs, i.e. all investors expect the same μi < ∞ and agree on βi CAPM or APT Both CAPM and APT are broad-spectrum theories and this remains for them their biggest drawback. However, alternative approaches that use different variables in asset pricing are not to be found. In regard to supremacy among the two asset pricing theories, many critics argue that APT is far more advanced than CAPM, which has serious empirical failings (Groenewold & Fraser, 1997). A study on the Indian Stock Market by Dhankar & Esq (2005) found that CAPM also has a tendency of downplaying risk sources and using betas to foretell the return to be got from an asset, which may not always be the right strategy. APT on the other hand, works cautiously, admitting several risk sources and ensuring a well equipped forecasting ability. While APT looks promising and competent in the market, it fails to stand on strong theoretical foundations. The economic variables which influence the price of assets remain undetermined and unidentified under this theory. So even though APT includes new factors to foresee prices in the market, CAPM includes more information in its ambit. Modern Financial Markets and Information Misuse Asset pricing information under the efficient market hypothesis should ideally cause no added value because it is already imitated in the prices. Hence, it can be deduced that asset pricing information within the efficient market hypothesis has no value. However, since the hypothesis has no practical applications, financial advisors with information play a key role in today’s financial markets. Where once financial information and decision making was done by experienced professionals, today fresh upstarts, who are least prepared to handle the market are heading it. The market insiders are now aware that if information is played well, there is the possibility of earning extra profits. Hence, by adopting a ruthless approach, risks are often ignored or downplayed and the failure possibilities of different strategies are never understood by new investors. Making a decision towards investing in an asset or assessing the investor’s saving, without even accepting or for that matter estimating tentative risks, seems to be the biggest factual error. The onset of technology also affects fiscal planning as there is no mechanism to control and govern what is put up on the Web. Such free-flowing and unverifiable new information are causing upheavals in the financial markets, as the market takes time to adjust to the new information. Instability has today become the key word in the market with investors pursuing new information and reacting to them in different ways. Trading of assets using insider information, which is forbidden by modern laws, is widely practiced under the watchful eyes of the law. Conclusion Asset pricing theories are tricky as they try to determine the potential of an asset to generate a return or a loss. While CAPM on one hand tries to uncover an equilibrium within the market by focusing on optimal portfolios, APT finds this equilibrium by ruling out risk possibilities. Nonetheless, factors like positioning of companies, growing market for a product, corporate culture of the company, market share, flow of funds and public’s reaction to the information provided can all influence the predictions made. Sometimes, prices deviate markedly from the predictions made based on latest trends, irrational behavior of investors and herding. However, such deviations are very short lived because in the long run, the bubble bursts. References Avramov, D. and Chordia, T., 2006. Asset Pricing Models and Financial Market Anomalies. The Review of Financial Studies, Vol. 19, pp. 1001-1040. Fama, E. F., 1970. Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of Finance, Vol. 25, pp. 383–423. Holmstrom, B. and Tirole, J., 1998. LAPM: A Liquidity-based Asset Pricing Model. NBER Working Paper Series, (e-journal) Working Paper 6673, Available through: National Bureau of Economic Research , (Accessed 2 January 2013). Lintner, J., 1965. Security Prices, Risk, and Maximal Gains from Diversification. Journal of Finance, Vol. 20, pp. 587–615. Markowitz, H. M., 1952. Portfolio Selection. Journal of Finance, Vol. 7(1), pp. 77-91. Pastor, L. and Stambaugh, R. F., 1999. Comparing Asset Pricing Models: An Investment Perspective. Available through: The Rodney L. White Center for Financial Research < http://finance.wharton.upenn.edu/~rlwctr> (Accessed 2 January 2013). Ross, S. A., 1976. The Arbitrage Theory of Capital Asset Pricing. Journal of Economic Theory, Vol. 13, pp. 341-360. Schneller, M. I., 1990. The Arbitrage Pricing Theories: A Synthesis and Critical Review. Research in Finance, Vol. 8. Sharpe, W. F., 1964. Capital Asset Prices: A Theory of Market equilibrium Under Conditions of Risk. Journal of Finance, Vol. 19, pp. 425–442. Sharpe, W. F., 1970. Portfolio Theory and Capital Markets. New York. Smith, A., 1776. An Inquiry into the Nature and Causes of the Wealth of Nations. London. Read More