Of What Practical Use Is CAMP - Essay Example

What is the CAPM and of what practical use is it? Contents Introduction 3 Discussion 3 Conclusion 7 References 8 Introduction The Capital Asset Pricing Model (CAPM) is considered to describe the relationship among risk and return of risk associated securities. The model helps the investors to evaluate their compensation on investment in two ways such as risk and time value of money that they are considered to bear. Risk free return is considered to be the representation of time value of money in the formula for the Capital Asset Pricing Model. It is considered to deal with compensating investors for making an investment and holding it for a period of time. The model is also considered to represent risk and is considered to calculate the amount of compensation in accordance with the risk bearing capability of an individual. According to CAPM, the expected return of a portfolio or a security is considered to be equal to the rate of a risk free security plus a premium for the risk factor. Discussion The risk factor is mainly calculated by taking a measure of risk called as beta in the model of CAPM. Beta is considered to compare the returns on a particular security to the market return. The formula for the CAPM is as follows: Rj = Rf + βj * (Rm – Rf) Where Rf is considered as risk free rate of return, Bj is considered to be the beta of the security j, and Rm is considered as the market return. The development of the CAPM was mostly to explain the pricing of risky securities in the market. It is considered as a more practical approach to stock valuation as compared to the Markowitz theory which is considered to be more theoretical (Armitage, 2005, p. 51). The assumptions of the Capital Asset Pricing Model are as follows: I) It is considered that investors in general tend to maximize the utility of their wealth. The preferences of investors are taken into consideration through the concept of utility in the CAPM. Investors considered to be more willing to take risks are considered to have increasing marginal utility with regard to wealth while investors who are considered to be risk averse tend to have less preference for incremental wealth when it is considered to be associated with higher risk. II) It is considered that investors in general show similar expectations with regard to return and risk. It is considered in this regard that if investors do not have similar expectations, there will be no homogeneity in the conceptions of investors and as such no single efficient frontier line will apply to all investors. III) It is held that investors tend to make investment decisions on a rational basis depending on their preference for return and risk. Risk is considered to be mainly measured by two factors such as variance and mean. CAPM is considered to assume that rational investors tend to diversify away unsystematic risk and only systematic risk is considered to remain with securities which tend to vary in accordance with the beta of securities. IV) It is considered that investors have free access to all available information. If information is not considered as the same for all, the existence of a common efficient frontier with regard to all investors is not possible. V) It is also held that investors have the ability to lend and borrow any amount at same prices. VI) Investors are considered to have identical time horizons which to a certain extent can be termed as unrealistic. Investors are regarded to have different time horizons and as such estimation of the value of stocks by them may differ in a significant manner even as estimated earnings are considered as same per year. VII) CAPM assumes the existence of a risk free asset which is considered to provide risk free returns to investors. VIII) CAPM is also considered to assume that there is no existence of commissions and taxes. It is considered as very difficult to determine the intrinsic value of securities. The main salient use of the Capital Asset Pricing Model is considered to be pricing of assets. Investors and analysts are considered to use it to compare the market value as well as book value of a stock or security. CAPM is considered to be a measure of the intrinsic value (Fabozzi, 2009, pp. 55-59). It can be said in this regard that assets which are considered to trade lower than its intrinsic value can be said to be good deal. It is also considered to be an important tool with regard to valuation needs and appraisal of projects. It is considered to have wide uses with respect to comparison of investment projects with different types of risk. It is also considered as much superior as compared to Net Present Value (NPV) in comparing investment projects of different risks. NPV is considered to use one discount rate for all investment projects having different risks. In the CAPM, the risk return trade off for individual securities are considered to be explicit. The model is considered to specify expected returns which can be used in regulation, valuation, and capital budgeting. The risk premium of an individual security is considered as a function of systematic risk which is considered to be measured by the covariance with the market. Risk is considered to have two components such as systematic risk and unsystematic risk. Investors are considered to make proper diversification of their portfolios to reduce the unsystematic risk (Kürschner, 2008, pp. 43-46). Investors, with respect to systematic risk, are considered to use beta of relevant securities to adjust to their preferences or requirements. Capital Market Line (CML) is considered to be used in the CAPM to illustrate the returns on efficient portfolios depending on the level of risk and the risk free rate for a particular portfolio. Capital Market Line is considered as much superior as compared to efficient frontier because it takes into consideration the inclusion of risk free assets in the portfolio. CAPM seeks to consider that market portfolio is essentially considered as the efficient frontier. It can be said in this regard that an investor can use the risk free rate to easily alter his/her risk profile. Market portfolio is considered to consist of all combinations of various risky assets and also the risk free asset such that determination of weights can be done using market value of assets. The CML is considered to solve for expected returns at various levels of risk. It should be mentioned in this regard that while building a sound portfolio, the main aim should be to achieve a higher rate of return possible through taking the least amount of risk (Levy, 2006, p. 67). It is not a guarantee that with higher levels of risks, there will be a significant increase in returns. Rewards can be achieved through increased risks but the potential of losses should also be kept in mind in this regard. It is considered to be stated by the CAPM that in equilibrium conditions, investors need to be compensated only for systematic risks and not for the total risks. Investors need not be compensated for unsystematic risks or unique risks. CAPM is considered to use the Security Market Line (SML) to show the systematic or market risks of a security against its expected returns at a certain point in time. It is considered to also show all risk associated marketable investment instruments. The SML can be considered as an important tool which plays a significant role in determining whether an asset is offering reasonable rate of return as compared to its risk. Individual securities are considered to be plotted on the graph of SML (Sharifzadeh, 2010, pp. 63-66). If the risk of a particular security as compared to its expected return is considered to be plotted above the SML, it is considered as undervalued and the investor in this regard can expect a higher return as compared to its risk. A security that is considered to be plotted below the SML is considered to be overvalued and as such investors may make lesser returns in this regard as compared to its risk (Simon, 2012, pp. 71-75). If a security is considered to be correctly priced, it will be plotted on the SML itself. Conclusion The CAPM is considered to have several advantages over other methods which seek to calculate required returns. CAPM only considers market risks or systematic risks which are considered as quite realistic because investors tend to hold diversified portfolios where unsystematic risks have been essentially diversified away. It is considered to generate a theoretical relationship between systematic risk and required rate of return and is considered to be subject to several empirical testing and research. It is also considered as a much improved calculation method of cost of equity for an organization as compared to the DGM or Dividend Growth Model as it is considered to only take into consideration an organization’s systematic risk relative to the stock market as a whole. Research has also shown that CAPM has stood up well to criticisms although attacks against it are considered to increase in a significant manner. But until something better is developed in this regard, CAPM is considered to be an important tool in the area of financial management. References Armitage, S., 2005. The Cost of Capital: Intermediate Theory. New York: Cambridge University Press. Fabozzi, F., 2009. Institutional Investment Management: Equity and Bond Portfolio. Hoboken: John Wiley & Sons. Kürschner, M., 2008. Limitations of the Capital Asset Pricing Model (CAPM). Norderstedt: Books on Demand. Levy, H., 2006. Stochastic Dominance: Investment Decision Making under Uncertainty. New York: Springer. Sharifzadeh, M., 2010. An Empirical and Theoretical Analysis of Capital Asset Pricing Model. Florida: Universal-Publishers. Simon, A., 2012. CAPM vs Behavioral Finance: Risk and return: Does behavioral finance provide better explanations than the CAPM? Munich: GRIN Verlag. Read More