The Capital Asset Pricing Model - Coursework Example

Recent Developments in CAPM Lecturer: Recent Developments in CAPM Introduction Due to the increasing popularity with the use of the capital asset pricing model (CAPM), it continues to receive attention in the world of finance and economics with the aim of testing the workability and justification for the use of the model. This is because until now, the CAPM is one of the widely used models in the industries for the determination of required rate of return of an asset when that asset’s non-diversifiable risk is known (Markowitz, 2009). By implication, the CAPM model helps those in the financial industry to determine the rate of return of assets by focusing on risk and expected return in a theoretically appropriate manner. When it comes to the risk however, the emphasis is on the asset’s sensitivity to non-diversifiable risk (Berk, 1995). Lintner (1965) indicated that studies continue to pop up from the use of the CAPM given its emphasis on theoretical assumptions. This is because as it is, there are schools of thought that argue that the assumptions are well explained with empirical tests and thus making them appropriate to use. There is however other schools of thought argue that the assumptions constitute empirical contradictions, making the model inappropriate for modern usage (Loughran and Ritter, 1995). This paper thus takes a look at recent developments with the use of CAPM more closely. This is done by first explaining how the major assumptions of CAPM affect its usage and then critique the assumptions from the perspectives of the two different schools of thoughts. A conclusion will thus be drawn based on the implications that the writer makes from the different arguments presented. Assumptions Underlying the CAPM and how they affect its usage There are nine major assumptions underlying the use of CAPM, which different theorists and economists believe affect its usage different. These assumptions are briefly outlined and discussed. In the first place, Treynor (1961) who introduced the model assumed that there are many investors all of who behave in a competitive way. Explaining how this assumption affects the practicality of the model, Banz (1981) noted that in a typical stock market, investors act as price takers who have no chance of influencing prices. By implication, unless the neutrality of investors is maintained, there cannot be a far stock market. The second assumption is that all investors look ahead over the same planning horizon. In actual industry setting, this assumption affects the usage of the CAPM from a perspective where investors are likened to have a homogenous expectation that is structured around a single period (Graham & Harvey, 2001). Once this holds, investors are said to have the same time opportunity to compete under the theory of market equilibrium. The third assumption states that all investors have equal access to all securities. This is another assumption that is directly related to the theory of market equilibrium, where all investors are said to enter into market competition with the all information needed to compete made available to them at the same time (Fama & French, 1992). There is also the assumption that there are no taxes accounting as part of transaction cost (Graham & Harvey, 2001). In the practical world, this assumption is expected to affect the usage of the model as investors are required to look at the rate of return of their assets without counting transaction and taxation costs. Similar to the assumption on taxation, it is also assumed that there are no commissions considered under transaction returns (Rubinstein, 2006). In today’s business usage, this assumption together with the one on taxation has been said to be in place as they seek to emphasize the rate of return on assets specifically on the actual value of the assets without considering any detractive inflows or outflows (Lintner, 1965). What is more, it is assumed under the CAPM that each investor cares only about expected return and given level of risk (Loughran and Ritter, 1995). In the real world, this assumption helps to define the precise expectations of invests as they engage in different forms of market investments. This means that having this assumption in place also defines what is measured in the long run after all investment durations have matured. Markowitz (2002) stressed that there is also the assumption that all investors have the same beliefs about the investment opportunities available to them. This is in place in a typical investment market so as to create a homogenous belief for the risk assets. The investment opportunities however focus on the expected returns, denoted as Er. There is also the assumption that all investors have the right to borrow and lend at the one risk free rate. The amounts to lend or borrow are considered as unlimited under the risk free rate of interest. The essence of this assumption can be seen to be a provision which seeks to make up for the non-entry nature of the taxes and commission (Markowitz, 2009). The final assumption based on which industries have used the CAPM is that investors can short any asset and also hold any fraction of an asset. Rubinstein (2006) argued that this provision can be seen to be workable as the securities traded in by the investors are generally considered as perfectly divisible and liquid. Major empirical test on the use of CAPM One of the most recent developments that influence the use of the CAPM is the series of empirical tests that are being performed as a way of justifying the assumptions elaborated above and also finding the best fitting scenarios in real world cases for the model. As most of the empirical tests are founded under known and existing theories, they are analysed and discussed under this section of the paper. As noted by Kothari et al. (1995) most forms of early empirical tests sought to establish the relationship between expected return and market beta. It would be noted that the CAPM is founded on the suggestion that an investor’s cost of equity capital is determined by beta (Treynor, 1962). This suggestion makes the beta a very important subject matter in the use of the model. One of such empirical tests for the relation between expected return and market beta was performed with the use of the Sharpe-Lintner model where a cross-section regression of average asset returns on the estimates of asset betas was performed (Lintner, 1965). In this test which focuses on risk premiums, it was predicted that just as the fundamentals of the CAPM holds, the coefficient on beta is the expected return on the market (Fama & French, 2002). This expected return was however justifiable only under the excess of the risk-free interest rate Rf. This means that the test on premiums brings out a new variable on the intercept in the regression, which is the risk-free interest rate, which is often denoted as Rf. This empirical test has however been criticised as not being conclusive as it fails to account for common sources of variations in determining average returns such as industry effects (Graham & Harvey, 2001). The concluding limitation found has been the centre of continued empirical test, where Friend and Blume performed tests on risk premiums by looking more into the use of portfolios instead of individual securities. This is because when individual securities are used, most of the assumptions that act as the basis for the model become challenged with changing industry effects, making the individual assets imprecise. Today, a significant development in industries has to do the reliance on the use of portfolios. This is because by so doing, investors are given the opportunity or mandate to combine expected returns and market betas in the same way (Banz, 1981). Major justification have been given with this new trend of development, given the fact that it gives the opportunity that CAPM will be used to explain security returns and portfolio returns at the same time (Fama & Macbeth, 1973). It is therefore very common to find industry players use portfolios in cross-section regressions where the average returns on betas are predominate in reducing the critical errors in variables problems (Fama & French, 1992). Based on the empirical test that justified the use of portfolios over individual assets, it is also common to find that there is now a modern development where the emphasis that used to be placed on the beta has been reduced drastically. This is because according to Sharpe (1964), today, grouping made with portfolios ensures that there is a shrinking on the range of betas and thus a reduction in statistical power. Application problems against empirical contradictions of the CAPM Regardless of the empirical tests and their outcomes, there are researchers who continue to highlight on the application problems associated with what they refer to as the empirical contradictions of the CAPM. According to such researchers, there is an empirical contradiction because most of the assumptions as outlined earlier are unrealistic. For example there are recent developments where investors focus on more than one-portfolio return for their investments. Meanwhile there are assumptions under the model which suggest that investors are only concerned about the mean and variance of one-period portfolio returns (Fama & French, 2002). Kothari et al. (1995) stressed that without refuting this assumption, there is the creation of an application problem that limits the extent of investment engagement for investors with only those involved in one-portfolio investments. Roll (1977) also explained the possibility instead of investors to be mindful of the mean and variance of one-portfolio returns only, they would also focus on how their portfolio return co-varies with other industry conditions such as labour income and future investment opportunities. In effect, the CAPM carries an application problem whereby return variances of portfolios are made to miss important dimensions of risk when the assumption in question is made to stand (Markowitz, 2002). Again, as the emphasis on betas becomes very central in the endorsement for CAPM, there is a recent development with investment trends where it has been realised that the betas have been unstable with time (Fama & Macbeth, 1973). What is more serious is the fact that the conditions that cause the betas to be unstable with time have been noted to be industry wide factors that can hardly be controlled by the investor in anyway. Examples of such factors are global economic recession and changes in buyer behaviour. As a result of this, there is always a challenge when betas that have been estimated from historical data are used in the calculation of cost of equity when evaluating future cash flows (Roll, 1977). With this said, an application problem is created due to the empirical contradictions created with the over reliance on historical data in the determination of betas. But without condemning the overall applicability of the model in line with changing betas through time, Berk (1995) indicated that corporate finance executives and investors who make use of the model can emphasise on the need to change the beta with changing company fundamentals and changing capital structure of their firms. Conclusion This study was undertaken with the aim of understanding the recent developments in the area of CAPM. It was noted from the onset that the CAPM is a model that is heavily based on theoretical assumptions to identifying the appropriate required rate of return on an asset. Since the CAMP was proposed in 1961 by Treynor however, there have been several studies that have arisen to scrutinise the effectiveness of the model, given the fact that the model is heavily centred on assumptions. Because of this, several empirical tests have been performed to find the most precise and workable scenarios in the real world where the CAMP can be applied. One such empirical test that has been reviewed in the paper is the tests on risk premium, where it has been noted that outcomes with the test has showed that there are several limitations when individual assets are used with the CAPM as against the use of portfolios. Because of this, there has been a new development where most investors use groupings instead of individual assets in determining expected returns. This outcome notwithstanding, there are those who continue to highlight on the empirical contradictions of the CAPM and thus downplay the place of the model in modern financial industry. Most of these opposing arguments are based on the fact that the model’s assumptions are unrealistic. Using examples from the real world however, it can be concluded that even though there may be short comings with the model’s assumptions, the real emphasis should be on how well it works, of which there is sufficient evidence to suggest workability. References Banz, R (1981). “The Relation between Return and Market Values of Common Stock”, Journal of Financial Economics, 9, pp. 3-18 Berk, J.B (1995). “A Critique of Size Related Anomalies”, Review of Financial Studies, 8, pp. 275-286 Fama, E & French, K (1992). “The Cross Section of Expected Stock Returns”, Journal of Finance, 47, pp. 427-465 Fama, E & French, K (2002). “The Equity Premium”, Journal of Finance, 57, pp. 637-659 Fama, E & Macbeth, J (1973) Risk Return and Equilibrium: Some Empirical Tests, Journal of Political Economy, 8, pp. 607-636 Graham, J & Harvey, C (2001). “The Theory And Practice Of Corporate Finance: Evidence From The Field”, Journal Of Financial Economics 60, pp. 187-243 Kothari et al. (1995). Another Look at the Cross Section Of Expected Stock Returns, Journal of Finance, 50, pp. 185-224 Lintner, J. (1965). “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics. 47:1, pp. 13–37. Loughran, T. and Ritter J. R. (1995). “The New Issues Puzzle.” Journal of Finance. 50:1, pp. 23–51. Markowitz, H. (2002). “Portfolio Selection.” Journal of Finance. 47, pp. 77–99. Markowitz, H. (2009). Portfolio Selection: Efficient Diversification of Investments. Cowles Foundation Monograph No. 216. New York: John Wiley & Sons, Inc. Roll, R (1977). “A Critique of the Asset Pricing Theory Test”, Journal of Financial Economics, 4, pp. 129-176 Rubinstein, M. (2006). A History of the Theory of Investments. Hoboken: John Wiley & Sons, Inc. Sharpe, W.F (1964). “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk”, Journal of Finance 19, pp. 425-442 Treynor, J. L. (1962). Toward a Theory of Market Value of Risky Assets. Unpublished manuscript. A final version was published in 1999, in Asset Pricing and Portfolio Performance: Models, Strategy and Performance Metrics. Robert A. Korajczyk (editor) London: Risk Books. Read More