Relevance of Portfolio Theory and Capital Asset Pricing Model - Essay Example

Relevance of Portfolio Theory and Capital Asset Pricing Model (CAPM) Contents Introduction Background Definition Thesis ment 2.Main Body 3. Conclusion 4. Limitations 5. Recommendations 6. References Introduction Background The amount of risk on investments depends on the type of investments. The safest investments that can be made are the Treasury bills. The cost of long term government bonds change with the interest rates. Investment performance concurs with the instinctive risk status. Treasury bills have the least mean return value when they are compared with other types of investments in the shares and stocks of large companies. Since investors are indisposed towards risk they like to play safe by paying more for safety and earning less. In fact risk taking is directly linked to larger amount of earnings. In order to lure investors, risky investments must offer greater returns. Actually risk and returns go hand in hand. Based on historical operations the following information is drawn: a) Treasury bills, even though has the least annual mean rate of return are less risky. b) The highest risk bearing investments are the common Stocks, hence provide higher mean yearly rate of return. c) Bonds, form the middle part in risk taking hence provides middle level of mean rate of return per annum. It is the belief of investors to distribute their risks and so they diversify their investments as well. They always like to make their investments in a portfolio of assets as they never like to stack all their eggs in one basket. Hence what really matters is not the risk and returns alone, but the risk and return on a portfolio of assets on the whole. Definitions The fundamental definitions of the portfolio theory and the CAPM have to be understood so that the theories can be well appreciated. Portfolio theory According to James Bradfield (2007, p167) an assortment of securities is known as a portfolio. Portfolio theory is a conventional scrutiny of the relationship between risk and return on the risky securities. The rate of returns is particularly measured through alpha, beta, and R-squared. A random variant denotes the rate of return from a portfolio. The computation of the probability distribution generating the returns rate of the security contained in the portfolio depends on the probability distribution creating the value for the portfolio. The hypothesis is helpful for a patron. It helps them to decide and allocate their funds in risky securities thus creating a portfolio. This investment indicates the preferences with regard to the combination of risk and anticipated returns of the investors. Capital Asset Pricing Model (CAPM) The CAPM is a link between the risks and returns on the investments. After (Sharpe, William F.1964, pp. 425-442) developed the CAPM theory several other researchers have developed the theory with giving importance to the diversifiable and non-diversifiable risks of different investments. Previously the CAPM had only a single risk factor which was the risk of the entire movement of the market. This risk is denoted as "market risk" and the formula for CAPM is as follows: E (Ri) = Rf +i [E (RM) - Rf] Where E (RM) = expected return on a "market portfolio" i = measure of methodical risk of asset i comparative to "market portfolio". "The expected return for an asset i according to CAPM is equal risk free rate plus a risk premium" (Frank J. Fabozzi and Harry Markowitz, 2002, p.67). Later on research was conducted and the creators of CAPM theory related diversifiable which are unsystematic risks and non-diversifiable which are systematic risks for all the securities in the portfolio. Some management individuals conceived that CAPM is not genuine as it dominates participating management and investment study. Frank J. Fabozzi and Harry Markowitz states "even though the idea is not true it does not mean that the constructs introduced by the theory are not important. Constructs introduced in the development of theory include the notion of a market portfolio, systematic risk, diversifiable risks and beta." Thesis Statement The key logic behind is that the investors estimate the overall risk of the investments in the marketplace. Their preference is towards portfolio of investments rather than single investments. The fundamental theory linking risk and returns is the Capital Asset Pricing Model (CAPM). The CAPM helps to comprehend the fundamental risk-return trade-offs implied in all cases of financial determinations (Lawrence J Gitman, page 246). Portfolio theory Portfolio theory conceives that variegation decrease unpredictability. Just a small degree of diversification is capable of providing an extensive amount of reduction in variance. Since the prices of different assets do not change at the same time the factor of diversification has its impact on the portfolio. More often than not the increase in price of a single asset in the portfolio is offset with the decreased in the price of other assets. The risk thus set off is the potential risk. But some risks cannot be easily eliminated. If the relevance of CAPM and the relationship between risk and return has to be appreciated then the portfolio theory has to be understood in a true manner. They are: i. Sureties are unsafe since their returns are inconsistent. ii. Standard deviation is the generally used measurement of risk or variability in finance. The reason for this according to Lawrence J Gitman (2006, p.238) is because "the return on a portfolio is a weighted average of the returns of individual assets." For example if 47% of a portfolio of assets is invested in 'A' anticipating a 17% rate of return and the balance is invested in 'B' predictable to render 14% on investment then the predictable return on the portfolio is only a weighted mean of the anticipated return on the individual assets which is computed as under: Anticipated returns on the portfolio = (0.47 * 17) + (0.53 * 14) = 15.41% It is crucial to know that the number of variances and covariance depend on the number of assets in the portfolio when the standard deviation is calculated. When there are several assets in the portfolio, the number of covariance is bigger than the quantity of variances. Thus the unevenness of a clear portfolio contemplates chiefly the covariance. Wise investors never try to put all their eggs into a single basket: they try to reduce their risk by variegation. They are concerned with the effect that each asset has on the risk of their portfolio. iii. The jeopardy of a surety can be divided into unique risk and market risk. Unique risk is induced by elements specific to the asset that bring forth unpredictability, for instance, an alteration of management of a company. This kind of unpredictability is unique to the assets, or irregular. (Bruce J Feible, 2003, p.191) Unique risks shoots from firm explicit constituents like the creation of a new product, strike by laborers, or the outgrowth of a new challenger. Events of this type affect only the specific firm and it does not affect all firms in general. Therefore, unique risk is also denoted to as diversifiable risk or irregular risk. The market risk of a stock constitutes that part of its risk which can be credited to economy linked factors like the growth rate of GNP, government expenditure, money supply, the structure of the interest rate, and degree of inflation. In view of the fact that these elements impact all firms to a larger or slighter degree, investors are not able to evade the risk developing from them, nevertheless how much ever diversified their portfolio may be. Thus it is known as systematic risk or non-diversifiable risk. "Systematic risk factors are reflected in the market returns; therefore, we can isolate the influence of systematic factors on an individual asset by observing market returns." (Bruce J Feible, 2003, p.191) Thus the risk of a sound -diversified portfolio reckons on the market risk of the assets within that portfolio. iv. The role of a security to a completely diversified portfolio is evaluated by its beta. According to Lawrence J Gitman (2006, p.247) "The beta coefficient is a relative measure of non-diversifiable risk. It is an index to the degree of movement of an asset's return in response to a change in the market return. An asset's historical returns are used in finding the asset's beta coefficient. The market return is the return on the market portfolio of all traded securities." For computing the beta of a security, the following market model can be used: Rjt = j + j RMt + ej Where Rjt = return of security j in period t = intercept term alpha j = regression coefficient beta RMt = return on market portfolio in period t ej = random error term Stocks which have beta greater than 1.0 are inclined to intensify the entire movement of the market. Stocks which have beta between 0 and 1.0 are inclined to move in the same direction as the market moves. Thus a portfolio of all stocks contains an average stock of 1.0 beta. Bruce J Feible (2003, p.192) defines CAPM as "If an asset does have an element of market risk, CAPM states that it should earn a risk premium propitiated to the amount of market risk reflected in the asset. If the underlying market itself has a degree of return uncertainty, we assume that the market return will be higher than the risk free return. This is the excess market return. To derive the incremental excess return, we lever the excess market return up or down by the degree of market risk exposure inherent in the asset." Conclusion It is pragmatic that variegation decreases risks and as a result makes sense for investors. John Mauldin (2005, P.93) states that "If an investor is diversified in accord with the theory, then CAPM indicates that the percentage of returns that is due to the market should be 100 per cent. As a result, effective diversification under CAPM should provide investors with investment returns that are consistent with market returns." The variance of stocks constituting unparalleled risk can be eradicated by variegation, but diversification will not do away with market risk. Beta calculates the amount that investors anticipate the change in stock prices. A stock whose beta is greater than 1 is abnormally responsive to market actions, whereas a stock with a beta less than 1 is uncommonly insensitive to market actions. The standard deviation of a good branched out portfolio is relative to its beta. Limitations "CAPM is not testable. The market portfolio is theoretical and not really observable, so we cannot test the relation between expected return on an asset and the expected return of the market to see if relation specified in CAPM holds."(Frank J Fabozzi and Pamela P Peterson, page 299) Only unparalleled risks are considered by CAPM and market risks are not at all covered. Moreover John Ogilvie (2007, p.185) states that "CAPM assumes that risk can be encapsulated in a single figure (beta). Peter J Booth ( 1998, p.97) argues that "it is not necessarily reasonable to measure risk purely in terms of variance of portfolio returns." Actually CAPM is believed to be present in both its normal form and with allocation parameter extensions an uncompleted example of asset pricing Robert R Trippi and Jae K Lee, page 38) Recommendations Risk is best estimated in portfolio circumstance. Part of the doubt about a security's return is branched out when surety is grouped with others in a portfolio. Not to say that diversification is good for investors. This does not entail that firms should branch out. Corporate diversification is unnecessary if capitalists can branch out on their own account. According to Frank J Fabozzi and Pamela P Peterson (2003, p.299) "Though it lacks realism and is difficult to apply, the CAPM makes some sense regarding the role of diversification and the type of risks we need to consider in investment decisions." Word Count: 2111 References 1. Lawrence J Gitman, Principles of Managerial Finance, Pearson Education, 2006, page 246 2. Lawrence J Gitman, Principles of Managerial Finance, Pearson Education, 2006, page 238 3. Bruce J Feible, Investment Performance Measurement, John Wiley and Sons, 2003, page 191 4. Lawrence J Gitman, Principles of Managerial Finance, Pearson Education, 2006, page 247 5. Bruce J Feible, Investment Performance Measurement, John Wiley and Sons, 2003, page 192 6. John Mauldin, Just One Thing: Twelve of the world's best investors reveal with one strategy, John Wiley and Sons, 2005, Page 93 7. Frank J Fabozzi and Pamela P Peterson, Financial management and analysis, John Wiley and Sons Inc., 2003, page 299 8. John Ogilvie, CIMA Learning System 2007 Management Accounting Financial Strategy, Elsevier, 2007, page 185 9. Peter J Booth, Modern Actuarial Theory and practice, Part I, CRC, 1998, page 97 10. Robert R Trippi and Jae K Lee, Artificial Intelligence in finance & investing state of art, Irwin Professional Book Team, 1996, page 38 11. Frank J Fabozzi and Pamela P Peterson, Financial management and analysis, John Wiley and Sons Inc., 2003, page 299 Read More