Capital Asset Pricing Model - Essay Example

Essay, Finance and Accounting What is the CAPM and of what practical use is it? Capital Asset Pricing Model: CAPM is a financial model, stands for capital asset pricing model. CAPM was initially introduced in 1961 and 1962 by Jack Treynor later on updated version was presented by many other researchers individually however the Sharpe, Markowitz and Merton Miller nominated for the Nobel Memorial Prize in Economics (1990) mutually and get the award for their contribution in the field of financial economics collectively. CAPM is a model used by market to evaluate the cost of capital of a company on the basis of its required rate of return. This model presents the origin of asset pricing theory. Capital asset pricing model delivers a very simple and easy theory. It offers an utilizable measure to calculate risk that facilitate financier to find out that how much return they are going to get for putting their funds at risk. This model mainly targets the risk averse investors. Capital asset pricing model is the widely used and mainly preferable model for risk and return used in finance. CAPM specifies the association between the risk and expected return that an investor gets on asset. This model is basically used to determine the expected required rate of return on assets and to determine the price of risky securities in the portfolio. This is the model in which securities are priced in such a manner that investors get compensation for the risk involved in the security by offering them return. William Sharpe one of the financial economist and Nobel Prize holders stated in his book (Portfolio theory and Capital markets) that an individual investment is exposed to mainly two types of risk. Systematic risk Unsystematic risk Systematic risk is the market risk and the one that cannot be diversified easily or that can totally out of range to diversify away. It includes wars, an unpredictable variation in interest rates and many other macro economic factors. Unsystematic risk on the other hand involves those which can be sort out easily because this type of risk is related by means of the individual or stock an investor has in his portfolio. This is also identified as specific risk. This risk is not exposed to in general as a whole. An investor can diversify away unsystematic risk by raising the figure of stocks in his portfolio. So in technical words it can be stated that unsystematic risk does not move with the market as a whole. According to Modern Portfolio theory, it is concluded that unsystematic risk can be diversified but systematic risk still one of the troubles for the investors which cannot be ignored. So here the capital assets pricing model fully fitted and solve the problem because it is applicable for both type of risk either systematic or specific by diversifying it. CAPM itself exposed to some factors that are prevailing within capital market and that is why not successfully implementing in some countries. Factors include liquidation, insider trading and weak data base etc. CAPM is important for two main reasons: It facilitates investors to assess and determine portfolio risk and the required rate of return that is expected to get in return of bearing that risk. The formula of CAPM helps investors in deciding and finalizing investment strategies and projects. If the formula shows that investment is not generating enough return then the company should invest in other stocks or portfolios. Capital asset pricing model also described as theory of equilibrium. Formula of CAPM: The standard formula for capital assets pricing model is as follow: Expected rate of return = Rf + β (Rm - Rf) Where Rf = Risk-free rate (e.g. Government bond yield). β = Beta Rm = Market return In capital asset pricing model an investor is usually compensated in two ways Time value of money Risk The first part of the formula initiated with risk free rate (Rf) which actually is the time value of money. Time value of money basically compensates the investors for putting the money in any investment over a time period. The other half of the formula is associated with beta (β) that represents and measures risk. Beta is used to evaluate the return on equity and market premium (Rm) with the utmost factor time period. For computing risk of individual assets standard deviation has been used instead of beta. With respect to CAPM formula it is stated that return on individual asset or portfolio of stocks should be able to recover its cost of capital atleast. By using the Capital asset pricing model we can compute the expected return of a stock by following a supposition: For example: If the risk-free rate (rf) is 5%, the beta (β) of the stock is 3 and the expected market return (rm) over the period is 10%, then expected return of the stock will be 20% (5%+3(10%-5%)). The return on the asset is entirely depending upon the risk means beta, so beta is utmost important factor of capital asset pricing model. Beta is used to measure the relative tendency of volatility in stocks. Volatility in the prices of stocks that whether it will go up or down. According to research, it is stated that if the stock price is moving exactly with the market prices then the beta is suppose to 1. It is also analyzed that high beta stocks more than the market as compare to low beta stocks. Investors should go for high beta stock when the market is rising and go for low beta stocks when the market is falling. High n low beta stocks can be gauge by the standard 1, more than 1 identified as high beta stocks whereas less than 1 identified as low beta stocks. High beta shares performance get most horrible when the market turn down. When the beta is equal to 1, it indicates that stock prices will move with the market simultaneously. The beta of the shares represents risk. Risk may be occur due to many factors of the firm or industry e.g. operating leverage, business climate, financial statement of the business etc. now first of all there is utmost need to eliminate or reduce the effect of risk. There are certain factors that affect beta while calculating and that are historical data, subjectivity, skewed index, combination of volatility and correlation. Practical Implications: Researchers are from many decades establishing and trying new risk/ return approaches in order to maximize return and minimize risk. In this framework, different researchers offer different models and their implications. But the widely used Capital asset pricing model is more in practice. On the basis of theoretical background it is concluded that CAPM is easy and simple to apply. It supports modern portfolio theory. It is applicable for both systematic and unsystematic risks. It offers very easy pricing form. At times, when CAPM were getting greater appreciation, it was exposed to some critics as well. There are also some controversies while implementing its practical implication e.g. it is not easy to examine, complicated to estimate return on assets and expected risk. However some of the essential practical implications are under mentioned on the basis of research and analysis. Investors should opt Markowitz algorithm in order to establish the same set of effective and efficient portfolios by using capital asset pricing model. Risk averse investors are those who are not willing to take risk so this type of investors put most of their wealth in risk free assets like T bills and Government yield bond etc CAPM model states that investors require rate of return should at least cover the beta of that specific security. Capital asset pricing model is more concern about risk averse investors. Risk lovers or risk tolerant are those who can bear risk in order to get more and more return on assets so these investors should opt for risky assets. Corporate managers should be very careful while executing CAPM because it helps them to verify cost of equity for investment. Fund managers can use this model for estimating cost of assets and performance of portfolio. CAPM has investment implications as well. For investment implication, it is suggested that investor should pick the asset for his portfolio on the basis of its capital weight age. CAPM states that investor should pick risky asset with the risk free asset in his portfolio. This investment strategy is more effective while adopting CAPM. Experts and analyst suggested that capital asset pricing model is more beneficial for long term investors so that’ why long term investors ought to rely upon CAPM formula. With respect to investment it is concluded that if the expected rate is not battered the theoretical required rate of return then the investment should not be take on. Reference Coffie, W., & Chukwulobelu, O. (2012). The Application of Capital Asset Pricing Model (CAPM) to Individual Securities on Ghana Stock Exchange. Research in Accounting in Emerging Economies, 12, 121-147. Read More