Capital Asset Pricing Model - Coursework Example

Running head: COMPANY ANALYSIS WORK: COMPANY ANALYSIS By s This coursework tests the CAPM of 20 companies from different sectors using weekly data while using one market index (FTSE) for two sample periods from January2008 to December2010 and from January 2011 to December 2013. For one to test precisely for the CAPM, there must be a profound understanding of how the formula is applied in the calculation of the various securities. The capital asset pricing model is for calculating the expected return of stocks depending on its level of risk in the sector or industry where it operates or carry its business (Fama, 2006). This formula is based on the risk free rate of the security, the beta factor of that security and the difference between the risk free rates of that stock. Understanding the testing of the CAPM, requires a good knowledge of these components of the CAPM. Investing in various securities in the securities market has various risks that the investors must consider when putting their funds in such securities (Sharpe, 2010). These risks are represented in the CAPM formula are the unsystematic risk in the market. The risk in each company’s stock is accounted for in the capital asset pricing model formula with the beta factor as the unsystematic risk factor. In this work of capital asset pricing model testing, beta factor in the formula is used to measure the level of risk when an investor decides to invest in any of the 20 companies discussed relative to the market risk (Mullins, 2012). For this coursework, the beta of the market would be 1 of the FTSE market index of the 20 companies. In measurement of the CAPM, an individual security, which will have a beta of 1.5 will be riskier than the market and less risky than the market if the stock has a beta of 0.5. The formula of the Capital Asset Pricing Model is given as Expected return= Risk free rate + Beta (Market rate-Risk free rate) The risk free rate in the Capital Asset Pricing Model (CAPM) formula is the rate which is expected by the investors to be free from any risk when they invest in any of the companies’ stocks. These are like the Treasury bill rate for governments and are generally used as it is short term. Besides, the risk premium is also a component of the CAPM. The capital asset pricing model is made up of two components. If this market risk is multiplied by the beta factor of the market and added to the risk free rate, then, the expected return of the stock can be determined and tested in this case (Lakonishok and Allan, 2013, pp.16). Risk is the same with the volatility. For example, if the market risk is 1 and in the test a better of 2 was found then, the stock is twice as risky as the market and stock with a beta less than 1 will have limited risk compared to the market risk. In this coursework, we are going to use the Lintner CAPM Test Methodology. This methodology illustrates a test of the CAPM, which is based on a simplified scaled-down version of the Lintner (2012) test. In this work, the first-pass time series regressions have already been run to obtain security betas for use in the second pass test as illustrated in the diagram below. Thus, we already have stock beta for the test of the 20 companies stock together with the calculated unsystematic variance of the entire sample securities. The next step is to run a single cross-sectional regression of the data of the 20 companies from the two subsequent periods of 2008 to 2010 and the 2011 to 2013 periods to get coefficients for the stocks (Bodie, Kane and Marcus, 2008). For these periods, the riskless rate of return and the market return for each company are already given in the data provided. Therefore, we will seek to test whether our regression coefficients E (Ri) = Y +λβi for all i= 20. The table provides data for 20 companies stocks from the two periods for the second-pass cross sectional regression. The dependent variable is the stock return Xi and the independent variable is the market return Yi. We will use the stock beta and the historical unsystematic return variance calculated to carry out a regression analysis. The various results of the companies’ regression are as shown in the table below. We can show from the table that the regression coefficients do not vary significantly from their predicted values. Therefore, CAPM holds and should not be rejected. The simple regression calculations are as represented below: Market returns Stock Unsystematic Companies Return (Yi) Beta Variance (Xi) 1 2.28254E-05 -0.007623111 0.341891632 0.144226520 3 0.054026653 -0.006219053 1.884677942 0.08421105034 4 0.140257354 0.030813515 0.617414746 0.08833643076 5 0.002251463 0.012633906 0.642175439 0.09667734481 6 0.030278276 0.056307403 1.0020504648 0.1613544638 7 0.03492238 0.089882039 1.204041226 0.2466059813 8 0.060406195 1.95461516 0.249818276 9 0.0079248 -0.014228283 0.558824804 0.1674667191 10 0.0244457 0.01138685639 0.724450633 0.09456674363 11 0.001291418 -0.02266329 1.111698914 0.1545159862 12 0.040442695 0.124784267 0.680578437 0.256194354 13 0.003779402402 -0.100539027 0.47182564 0.3284307781 14 2.22599E-05 -0.043735159 1.234921578 0.2658517632 15 0.006012132856 0.015395321 1.392638979 0.1411672488 16 0.002892397551 0.02417418 0.143556064 0.2004225262 17 0.027395546 0.035521007 1.244309862 0.1155813263 18 0.020058434 0.010508119 2.066409056 0.1433647272 19 -0.103596955 -0.016834408 0.275555203 0.1326654514 20 0.00989186874 0.027881483 0.406767372 0.226642346 SUMMARY OUTPUT Regression Statistics Multiple R 0.782924252 R Square(R^2) 0.612970385 Adjusted R Square(R^2) 0.592049865 Standard Error 0.030129587 Number of companies 20 SUMMARY TABLE df SS MS F Significance F Regression 1 0.05319654 0.02659827 29.29995971 2.3619478 Residual 19 0.033588305 0.000907792 Total 20 0.086784845 Coefficients Standard Error t Stat P-value Intercept 0.029839246 0.011433755 2.609750431 0.013001586 Xi Variable 1 0.073402158 0.009588721 7.6550521 3.869734309 The CAPM analysis has both advantages and disadvantages. The advantages of the analysis of CAPM are such as; first, it eliminates the unsystematic Risk and simple to use. The CAPM is easier to use compared to other methods used in testing the viability of investing in some stocks. It also eliminates risks that are to a given company or the industry where it operates. Therefore, when an investor wanted to invest in a given sector or firm or industry, he can use the CAPM to eliminate those risks, which are specific to that industry or company (Rubinstein, 2009). Therefore, it is a simple method of calculation and use. Second, it is testable. CAPM is used to test for the prices of the various stocks listed in the securities market whether they are worth investing or not. It can also be used to predict prices of these various stocks in the market so that one makes precise decision on which stock to invest in for a good return in the future. Since its development, CAPM has been tested by various researchers and analysts to find out whether it is significance in decision making in investing in various securities in the market (Douglas, 2008). Third, it is better than other methods. If it is compared with other methods CAPM may lead to better decision in investing in various stocks compared to the other methods, for example, the weighted average cost of capital. On the other hand, CAPM also has various disadvantages such as: First the use of the CAPM requires that a risk-free rate and the market return, or the risk premium and the beta of the stock have to be assigned values before they are used (Kothari, 2012). The return on government bonds or treasury bills which is used as a risk free rate changes continuously on a daily basis depending on the economic situation. Therefore, uncertainty arises in the security’s value of the return as the risk free rate changes with time. Second, the Capital Asset Pricing Model (CAPM) does not take care of the systematic risks in the portfolio investment. Third, the reward for risk assets is the beta factor, but in a well-functioning market, the ratios are the same for all the assets. In conclusion, the CAPM is one of the methods that are used by the investors to find which stocks to invest in. This Capital Asset Pricing Model can be tested as discussed above using various methods of tests. The model also has various advantages and disadvantages to the investors as discussed. Therefore, the test suggests that the CAPM cannot be rejected in investment scenarios as it has a high level of significance. References Bodie, Z; Kane, A; Marcus, A. J. 2008. Investments. 7th International ed, Boston, McGraw-Hill. Douglas, George W, 2008. ‘Risk in the Equity Markets: An Empirical Appraisal of Market Efficiency’ Yale Economic Essays, pp. 3-45. Fama, Eugene F, French & Kenneth R, 2006. ‘The Capital Asset Pricing Model: Theory and Evidence.’ Journal of Economic Perspectives 18 (3): 25–46. Kothari S, P, Jay Shanken and Richard Sloan 2012, ‘Another Look at the Cross-Section of Expected Stock Returns’, Journal of Finance, vol.50, No. 1, pp. 185-224. Lakonishok, J, Alan, S, 2013. ‘Systematic Risk, Total Risk and Size a Determinants of Stock Market Returns’, Journal of Banking and Finance. Lintner J, 2012. ‘The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets’, Review of Economics and Statistics. 47:1 Mullins, D.W, 2012. Does the capital asset pricing model work? Harvard Business Review,January–February 1982, 105–113 Sharpe, W.F, 2010. Capital asset prices: A theory of market equilibrium under conditions of risk, Journal of Finance, 19 (3), 425–442. Rubinstein, M, 2009. A History of the Theory of Investments, Hoboken, John Wiley & Sons, Inc. Read More