CAPM and its Practical Applications - Essay Example

CAPM and its Practical Applications By Lecturer’s and Introduction John Lintner (1965) and William Sharpe (1964), about four decades ago, came up with the Capital Asset Pricing Model (CAPM), considered a first in asset pricing theory. This is a model that provides a formula used to calculate expected returns on securities based on their level of risk. The formula is given as: risk free rate added to beta multiplied by the difference of market return and risk free rate. Beta in this case represents a stock’s rate of rise and fall in comparison to the market in general. It is a measure of the sensitivity of an assets return towards market returns variation. The CAPM presents partial equilibrium model where agents consider the risk free returns and the probability distributions of the future returns on risky assets as being exogenous. In this paper, I seek to give an in-depth understanding of this model by delving into the logic behind it, exploring critiques levelled against it, and explaining why it is still the model of choice in financial analysis. Finally, I give practical examples of its practical application that show evidence of its usefulness and continued use to date. On What Logic is the CAPM based? The CAPM is built on the portfolio model that Harry Markowitz (1959) developed. In the model, a portfolio is selected by an investor at time t-1 which at t produces a stochastic return. Investors are assumed to be risk averse and, in their choosing among portfolios, care is only taken on the mean and the variance of their single-period investment return. This results in investors choosing “mean-variance-efficient” portfolios, the portfolios in this case 1) given variance, maximizes returns and 2) given expected returns, minimize portfolio return variance. For this, the approach is referred to as mean-variance model. An algebraic condition is provided by the model on asset weights in portfolios that are mean-variant-efficient. This algebraic statement is turned by the CAPM into a prediction that is testable about the connection between expected returns and risk through identification of an efficient portfolio if asset prices should clear all the assets off the market. To identify a mean-variant-efficient portfolio, Sharpe and Lintner added two crucial assumptions. The first one is complete agreement: taking asset prices to clear the market at t-1, it is agreed by investors that asset joint distribution returns from t-1 to t. This distribution is taken to be the true distribution, i.e. it provides the distribution giving returns that we employ in testing the model. Secondly, there is risk-free rate of lending and borrowing which applies to all investors and is independent of the borrowed or lent amount. With complete agreement over distributions’ returns, the same opportunity set is seen by all investors. They thus combine a portfolio T with similar risk tangency having risk-free borrowing or lending. This gives a straight forward punch line of the CAPM. With all investors holding the same risky assets portfolio T, it thus is the risky assets’ value-weighted market portfolio. Specifically, the weight of each risky asset within the tangency portfolio, which is taken as M, should be the market’s total value of every outstanding unit of the asset when divided by all of the market’s value of risky assets. The risk-free rate must, in addition, be set (together with risky assets’ prices) for the market’s clearance for risk free lending and borrowing. The CAPM’s assumptions, in short, suggest the market portfolio M, should be on the point of minimum variance for the asset market to clear. This implies the algebraic relation holding for whatever minimum variance portfolio should also hold for market portfolio. Toward the end in development of Sharpe-Lintner model, the risk-free lending and borrowing assumption is used to nail down zero-beta assets’ expected returns. Returns on risky assets and returns on the market are uncorrelated and must equal risk-free rate. The relation between beta and the expected return finally gives the Sharpe-Lintner CAPM equation. It provides that the return expected on any asset is given by the rate of risk-free interest, summed up with a risk premium which is the market beta for the asset, multiplied by the premium for every beta risk unit. The assumption of unrestricted risk-free lending and borrowing is considered unrealistic. A version by Fischer Black (1972) of the CAPM that is void of the risk-free lending and borrowing was developed. It points out the key result of the CAPM-the market portfolio being mean-variant-efficient-is obtainable instead by permitting risky assets’ short sales. Market clearing prices show that weighting the efficient portfolios of investors’ choice by their aggregate invested wealth shares results in the market portfolio. This is thus a portfolio of investors’ chosen efficient portfolios. When risky assets’ short selling is unrestricted, portfolios resulting from efficient portfolios themselves are efficient. As such, the market portfolio undoubtedly is efficient, meaning that the threshold condition of variance for M as provided above holds, and is the Black CAPM’s expected return-risk relation. The relation between market beta and the expected return of the Sharpe-Lintner and Black CAPM versions only differs on what each provides on the market uncorrelated assets’ expected return. Black’s version says that the market uncorrelated return should be no greater than expected market return, thus the beta premium is positive. On the other hand, for Sharpe-Lintner’s version, the market uncorrelated return should be the rate of risk-free interest together with the premium for every beta risk unit. It can be said that assuming unrestricted short selling is similarly as unrealistic as unrestricted risk-free lending and borrowing is. Without risk-free assets and risky assets’ short sales allowed, mean-variance investors will still prefer efficient portfolios. However, without risky assets’ short selling and risk-free assets, the portfolio efficiency algebra provides that portfolios created out of efficient portfolios typically are not efficient. The relation by the CAPM between market beta and market return is thus lost. This however does not serve to rule out predictions pertaining betas and expected returns with respect to alternative portfolios-if efficient portfolios can be specified by theory. This has apparently not been possible. The CAPM is highly attractive to investment analysts. This is because it offers powerful predictions on risk measurement and the connection between risk and expected returns. Its empirical record, unfortunately, is a poor one. For instance, finance books recommend use of the Sharpe-Lintner CAPM relation on risk return in estimating equity capital cost. By prescription, a stock market’s beta is to be estimated and combined with risk-free rate of interest and the markets average premium risk to produce the estimated cost of equity. However, old and new empirical work show the relation between average return and beta as being flatter than the Sharpe-Lintner version predicts. This result in the estimates by CAPM, of the equity cost for stocks with high beta, being too high (compared with historical average returns). Low beta stocks’ estimates also get to be too low. Similarly, if the implication of a stock’s high average return on value is a high expected return, then for such stocks, the equity cost estimates by CAPM are too low. The CAPM provides a way of reasoning through the risk-return trade-off within an efficiently diversified investments portfolio context. The empirical evidence against the CAPM, as argued by Dempsy (2013), is massively compelling and should thus be abandoned. Two flaws, however, are evident in his argument. To start with, it presumes valid evidence. The CAPM’s valid tests should have efficient benchmarks, which have up to now remained elusive. Secondly, the idea that there is no expectation of compensation by investors for unavoidable risk does not conform to the beliefs of practitioners and theorists. The two believe that the risks matter so much to investors that, ex ante, a risk premium has to be existent. Declaration of beta as dead has not been once, despite it being central to the CAPM. Practitioners and researchers have, however, continued to use the CAPM. This is believed to be due to the strength of its intuitiveness in prediction. Practical Applications of the CAPM The CAPM, an ex-ante concept fundamentally, is widely applied by corporations during decision making in capital structures and forward-looking capital budgeting. It is also used in academics during consideration for adjustments on risk differences. Below I give an account of some of the applications. Use in capital budgeting: A survey by Harvey and Graham (2001) involving chief financial officers of 392 firms in the U.S revealed heavy reliance by large firms on the CAPM and present value techniques in capital budgeting. In the study, almost 73.5% of all correspondents agreed to having used CAPM in their capital cost estimation. This shows it is a valued tool in budgeting. Use in price setting by regulatory agencies: The CAPM is actually an ‘industry standard’ on regulatory decisions pertaining cost of capital and determination of utilities’ prices (Romano, 2005). Gray and Hall (2008) point out more than ten Australian bodies regulating infrastructure assets amounting to over $ 100 billion of total worth. The CAPM was used to evaluate the assets before their acquisition-estimate of derived capital cost. Teaching and in academics: The CAPM is used in teaching courses in corporate finance by many academicians’. A report of a survey by Fernandez et al (2011) shows results for practitioners’ and academicians’ market’s estimates on risk premium. Provided estimates are for fifty six countries, with most respondents coming from the U.S (1,503 respondents) and Spain (930 respondents). The market’s premium risk ex ante mean for the U.S came to 5.5%, having a 1.7% standard deviation. Spain’s mean estimate was 5.9% with a standard deviation of 1.9% Similar other academic surveys have been done and most have made use of the CAPM in estimating capital cost. References Reinganum, Marc R (1981). A New Empirical Perspective on the CAPM. Journal of Financial and Quantitative Analysis. 16:4, pp. 439–62. Black, Fischer, Michael C. Jensen and Myron Scholes (1972). The Capital Asset Pricing Model: Some Empirical Tests, in Studies in the Theory of Capital Markets. Michael C. Jensen, Ed. New York: Praeger, pp. 79–121. Graham J. R., and C. R. Harvey. The Theory and Practice of Corporate Finance: Evidence from the Field’, Journal of Financial Economics, Vol. 60, Nos 2–3, 2001. . Read More