The Capital Asset Pricing Model - Essay Example

The Capital Asset Pricing Model Is Superior to other Valuation Models Because it Considers both Risk and Future Earnings Atta ur Rehman Academia Research 06 May 2008 Introduction In a rational equilibrium market, a mathematical model called capital asset pricing model (CAPM) is used to clarify the association of risk and return (Haugen, R. 1993). CAPM has been used in number of applications ranging from public utility rates to corporate capital budgeting. It also endows with the validation for the tendency of passive investing in huge index mutual funds. No doubt, its impossible to get rid of all the risk irrespective of our diversification in investments. Naturally each investor deserves a velocity of return to assist him for taking on risk. The beauty of capital asset pricing model (CAPM) is that it not only helps the investors to calculate investment risk but also gives them a fair expected idea about the return on their investment (Fabozzi Frank, 1998). In the following paragraphs we will discuss the CAPM, its general theory, limitations and the reason of its adoption in the market Evolution of CAPM The CAPM was initially presented and developed by John Lintner, William Sharpe and Jan Mossin autonomously (Bernstein, 1992). During the period of 1964-66, the idea of CAPM was presented by them in three different and exceedingly valued journals. CAPM was considered as a misleading model at its early stage because the business community thought that professional investment management was mainly a misuse of time. This misconception about CAPM remained dynamic for next ten years. After a decade, investment experts came to know the CAPM and recognized it as a significant mean to assess the expected risk in the investment. Key Features The CAPM has two key elements: 1. Systematic Risk or Market Risk 2. Un-systematic Risk Capital asset pricing model (CAPM) is actually financial and economic related model which determines the rate of return of an asset in a well-diversified portfolio and thus subsequently determines its value. Capital asset pricing model (CAPM), determines the price of an asset in association with reward-to-risk ratio. Here 1. Reward is the expected rate of return in the market, and 2. Risk is the assets non-diversifiable risk (β), also referred to as systematic risk, or market risk. The β (beta) here is the measure of the risks involved in a particular stock or portfolio in relation to the overall market risk. The β (beta) of the stock or portfolio in question therefore equals to: Reward-to-risk ratio of the stock/portfolio / Reward-to-risk ratio of the market Derived from this formula, the capital asset pricing model (CAPM) is expressed as: E(Ri) = Rf + βim (E(Rm) - Rf); Where: E(Ri) is the expected rate of return, Rf is the risk-free rate of interest, βim is the beta coefficient, E(Rm) is the expected return in the market The long-term average returns for this kind of risk should be zero. The second risk is un-systematic risk which is caused by the general economic improbability. A share’s beta factor is the measures of measure of its volatility in terms of market risk. The beta factor of the market as a whole is 1.0. Market risk makes market returns volatile and the beta factor is simply a yardstick against which the risk of other investments can be measured. Risk or uncertainty describes a situation where there is not first one possible outcome but array of potential returns. Risk is measured as the beta factor or β. a) The market as a whole has β = 1 b) Risk free security has a β = 0 c) A security with a β < 1 is lesser risky than average market d) A security with a β > 1 has risk above market (Banz, R.W,1981). Examples (i). Find the expected return on a stock given that the risk-free rate is 12%, the expected return on the market portfolio is 24%, and the beta of the stock is 4. (ii). Find the beta on a stock given that its expected return is 8%, the risk-free rate is 2%, and the expected return on the market portfolio is 6%. (iii). Company X and Y both pay annual dividend of 40 tambala to their shareholders and this is expected to continue in perpetuity. The risk-free rate of return is 6% and the current average market rate of return is 10%. Company X’s ß is 1.1 and for Y is 0.8. What is the expected rate of return for each company and what would the share price of each company be? Solutions (i). E(Ri) = 12% + (24% - 12%)4 = 60% (ii). 8% = 2% + (6% - 2%)βi βi = (8% - 2%) / (6% - 2%) = 6% / 4% = 1.5 (iii). The expected return for X is 6% + (10%- 6%) x 1.1 = 10.4% The expected return for Y is 6% + (10% - 6%) x 0.8 = 9.2% The dividend valuation model can now be used to derive the expected share prices. The predicted share value of X is 40t/0.104= 385 tambala. The predicted share value of Y is 40t/0.092 = 435 tambala. Assumptions of CAPM The main assumptions of CAPM are given below. 1. Whenever buying or selling, the CAPM model always assumes that there is no involvement of taxes and transactions charges. 2. In CAPM, since there are no arbitrage prospects for investors, therefore it assumes that the capital markets are in stable form and that all investments are properly cost with respect to their risk intensity (Schwert, 1983). 3. The foremost assumption of the model is that it considers all the investors with homogenous expectations of returns. This assumption is based on all available information at the time and can be defined as the most excellent predictions of future returns in a particular time. 4. Lastly, the model assumes and depends upon absolutely well-organized markets (Sharpe, W.F.,1964). How CAPM is Superior? CAPM is a model which is preferably used as it assesses the risk level and can also remove it through diversification. However, one problem rests and that is the diversification still doesnt solve the problem of systematic risk. Moreover a portfolio having all the risky shares in the market is not able to resolve this risk. In such situation, this is the CAPM that evolves a way to evaluate this systematic risk. According to CAPM, beta is the only related measure of a stocks risk. It measures a stocks relative volatility i.e. it demonstrates how much the price of a certain stock goes up and down when it is compared with the market’s total ups and downs. The stocks beta is1whenever the price of a share travels right in line with the market. A stock with a beta of 1.5 would fall by 15% if the market fell by 10% and similarly if the market rose by 10%, it rises by 15%. Here the importance of CAPM is illustrated through the classic 1972 study titled "The Capital Asset Pricing Model: Some Empirical Tests", financial economists (Fischer Black, Fama, E.F. & J.D. MacBeth, 1973).confirmed a linear relationship between the financial returns of stock portfolios and their betas. They studied the price movements of the stocks on the New York Stock Exchange between 1931 and 1965. Beta, compared with the equity risk premium, shows the amount of compensation equity investors need for taking on additional risk. If the stocks beta is 2.0, the risk-free rate is 3% and the market rate of return is 7%, the markets excess return is 4% (7% - 3%). Accordingly, the stocks excess return is 8% (2 X 4%, multiplying market return by the beta), and the stocks total required return is 11% (8% + 3%, the stocks excess return plus the risk-free rate). What this shows is that a riskier investment should earn a premium over the risk-free rate i.e. the amount over the risk-free rate is calculated by the equity market premium multiplied by its beta. In other words, its possible, by knowing the individual parts of the CAPM, to gauge whether or not the current price of a stock is consistent with its likely return - that is, whether or not the investment is a bargain or too expensive. This example is a clear evidence of the significance of CAPM to assess the risk factor. This model presents a very simple theory that delivers a simple result. The theory says that the only reason an investor should earn more, on average, by investing in one stock rather than another is that one stock is riskier (Lintner, 1965). Not surprisingly, the model has come to dominate modern financial theory. But does it really work? Its not entirely clear. The big sticking point is beta. When Professor Eugene Fama and Kenneth French looked at share returns on the New York Stock Exchange, the American Stock Exchange and Nasdaq between 1963 and 1990, they found that differences in betas over that lengthy period did not explain the performance of different stocks (Markowitz, 1952). The linear relationship between beta and individual stock returns also breaks down over shorter periods of time. While some studies raise doubts about CAPMs validity, the model is still widely used in the investment community. Although it is difficult to predict from beta how individual stocks might react to particular movements, investors can probably safely deduce that a portfolio of high-beta stocks will move more than the market in either direction, or a portfolio of low-beta stocks will move less than the market (Stulz, R.M. (1999). This is important for investors especially fund managers because they may be unwilling to or prevented from holding cash if they feel that the market is likely to fall. If so, they can hold low-beta stocks instead. Investors can tailor a portfolio to their specific risk-return requirements, aiming to hold securities with betas in excess of 1 while the market is rising, and securities with betas of less than 1 when the market is falling (Harvey, 1995 & Frank K. Reilly, Keith C. Brown, 2005). Not surprisingly, CAPM contributed to the rise in use of indexing i.e. assembling a portfolio of shares to mimic a particular market. This is largely due to CAPMs message that it is only possible to earn higher returns than those of the market as a whole by taking on higher risk (Gitman Lawrence,1992). Conclusion By no means, capital asset pricing model (CAPM) is a perfect theory as well as the strength and approach of CAPM is correct. It provides a practical measure of risk to the investors to determine an estimated return they ought to have against money putting at risk. The CAPM is a standard model in finance as it advises its users where and how to invest and what discount rate to use for project cash flows (Ross, Westerfield, & Jaffe and Van Home, 2002). Besides this, the simplicity of the model can be judged by the factor that the expected return depends only upon simple statistic ß. One of the reasons of its practicability is that the correlation between risk and return is linear and it provides trivial results of portfolio risk (Graham, J.R. & C.R. Harvey, 2001). The CAPM can be said revolutionary as it notifies that the variance of a particular stock is not a factor in determining the appropriate risk-adjusted discount rate. References Banz, R.W. (1981).The Relationship between Return and Market Value of Common Stocks. Journal of Financial Economics. No. 9. p. 3. Bernstein, P. (1992). Capital Ideas, the Improbable Origins of Modern Wall Street. New York: Free Press. Fabozzi, Frank J. (1998). Handbook of Portfolio Management. New York: McGraw-Hill. Fama, E.F. & J.D. MacBeth. (1973).Risk, Return and Equilibrium: Empirical Tests. Journal of Political Economy No. 81, p. 607. Frank K. Reilly & Keith C. Brown. (2005). Investment Analysis and Portfolio Management. 8th. Ed. Gitman, Lawrence. (1992). Basic Managerial Finance, 3rd Ed. New York: Harper Collins. Graham, J.R. & C.R. Harvey. (2001). The Theory and Practice of Corporate Finance: Evidence from the Field. Journal of Financial Economics. Haugen, R. (1993). Modern Investment Theory. 3rd Ed. Englewood Cliffs, NJ: Prentice Hall. 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. No. 47. p. 13. Markowitz, H. (1952). Portfolio Selection. Journal of Finance. No. 7. Ross, S.A., R.W. Westerfield, & J.F. Jaffe. (2002). Corporate Finance. 6th Ed., New York, NY, McGraw-Hill. Schwert, G. (1983). Size and Returns, and other Empirical Regularities. Journal of Financial Economics. No. 12. Sharpe, W.F. (1964).Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. Journal of Finance No.19. pp. 425. Stulz, R.M. (1999). Whats Wrong with Modem Capital Budgeting? Financial Practice and Education No. 9. p. 7. Van Home, J.C. (2002). Financial Management and Policy. 12th Ed. Upper Saddle River, NJ, Prentice-Hall. Read More