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Corporate Finance - Essay Example

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Corporate Finance

Where represents the return on security I, is the return on a risk-free investment such as the Treasury bill or government bond is the sensitivity of the return on security I, to movements in the market portfolio, and is the expected return on the market portfolio. (Bodie et al., 2005).
The CAPM predicts that the expected excess return from holding an asset is proportional to the covariance of its return with the market portfolio (i.e., its beta) as shown in equation (1) above. (Merton, 1973). This implication of the CAPM has been contested by a number of researchers. For example, Black et al. (1972) provide evidence contrary to the above. They find that low beta stocks earn a higher return on average and high beta stocks earn a lower return on average than those predicted by the CAPM. This indicates that, there should be other variables that account for the return on an asset. Despite this criticism, Merton (1972) suggest that the CAPM is still useful because it is an equilibrium model which provide a strong specification of the relationship among asset yields that is easily interpreted although it fails to explain a significant fraction of the variation in asset returns. Based on the criticisms of the CAPM a number of other models have been developed to account for the variability of asset returns. These include models such as the Arbitrage Pricing Theory (APT) and the Fama and French three factor model. The APT was formulated by Ross (1976) and it offers and it offers a testable alternative to the CAPM (Roll and Ross, 1980). The APT is an asset pricing model that explains the cross-sectional variation in asset returns. (Chen, 1987).
The APT assumes that markets are perfectly competitive and frictionless and that individuals believe that returns are generated by a number of factors. For k-number of factors, the return on an asset i, can be written as follows (Chen, 1987):
(2)
Where is the expected return; , j = 1, ..., k, are the mean zero factors common to all assets; is the sensitivity of the sensitivity of the return on asset i to he flucatuations in factors j; and is the "firm specific risk" or "non-systematic" risk component idiosyncratic to asset i, which has a zero expected valued, that is, E{ / } = 0 for all j. In a well diversified economy with no arbitrage opportunity, the equilibrium expected return on asset i is given by (Chen, 1987):
(3)
If there exists a riskless (or "zero-beta") asset, its return will be . The other parameters, , ..., , can be interpreted as risk premiums corresponding to risk factors to . In other words, is the expected return per unit of long investment of a portfolio with zero net investment and and (Chen, 1987).
The APT is particularly appropriate because it agrees perfectly with what appears to be the intuition behind the CAPM. (Roll and Ross, 1980). Unlike the CAPM, the APT is not restricted to a single period; it holds in both single and multi-periods and the market portfolio need not be mean-variant efficient. (Roll and Ross, 1980).
In a study of the joint roles of the market, size earnings-to-price ratio, leverage and book-to-market equity in he cross-section of average stock returns, Fama and French (1992a) find that used alone or in ...Show more

Summary

The CAPM refers to a set of predictions concerning equilibrium expected returns on risky assets. The CAPM was developed twelve years following the foundations of modern portfolio theory laid down by Harry Markowitz. (Bodie et al., 2005). The CAPM was developed by William Sharpe, John Lintner and Jan Mossin…
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Corporate Finance Essay essay example
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