The Capital Asset Pricing Model (CAPM) - Essay Example

The Capital Asset Pricing Model (CAPM) Introduction For an open market place, an idealized framework is assumed. In this market, stocks available for trade are assumed to risky assets. Moreover, there are also those assets that are not associated to any risk and customers borrow whichever the quantity they want since there are no stipulations limiting quantities to be borrowed. However lending has an interest rate attached to it. In the open market, it is also assumed that traders have all relevant information rates of stocks and other co-variances. Traders in an open market are also assumed to be rationale about being risk averse and all investors have same assets to choose from given all information concerning the assets and same decision methods are applied (Burton, 1998). This brings us to the concept of the capital asset pricing model (CAPM). The model is very useful and is widely used in the industry, although it is based on very strong assumptions. This paper will focus on brief theory of arbitrage theory of the CAPM model, main theories behind this model and their critique. First, the model is quite useful as it focuses on determining the required rate of return appropriate for a company’s assets. The model requires various firms to have a portfolio that is well diversified, as long as the risks prone to the assets cannot be diversified (Brealey, et al 2009). Practically, most companies utilize CAPM model to determine the price of a security or a portfolio. In this case, a security market line that defines the relationship existing between the beta and expected rate of return of an asset is utilized. The line also enables firms to calculate a ratio that equates an asset’s rewards to its risks. It is also through the model that firms are able to determine the rate at which an asset’s cash inflows expected to be generated in future should be discounted. This takes into account the cash inflows in relation to the risks existing in the market. The arbitrage model was an alternative to the means variance capital asset pricing. Currently, the model has become a crucial tool in explaining the phenomenon mostly observed in the capital markets that deal with risky assets. One assumption of the capital asset pricing model is the assumption of normality in returns. It is from this assumption that the linear elation stipulated above originates. The assumption has had critique since theoretically, there does not exist guarantee to such efficiency. However, there is restrictiveness that underlie the mean variance model; therefore being the evidence of the existence of the linear relationship between risks and returns. This led to the popularity of the model. It was until later that Ross introduced a new model that would yield better results when pricing risky assets. The arbitrage model would hold both in equilibrium and all sorts of disequilibria unlike the mean variance analysis. However, there are some weaknesses in relation to this theory. For instance, when dealing with the number of assets, as assets increase, their returns are also expected to increase. This will result to an increase in risk aversion to investors. The arbitrage model has the law of large numbers where the noise term becomes negligible as the number of assets expands. Where the degree of risk aversion increases with the increase in the number of assets, the two effects cancels out, leaving the noise term to have a persistent effect on the pricing decision. In developing the arbitrage theory, several assumptions were put into consideration. First is the assumption of limitations on liability. It is assumed that there exists at least one asset which has a limited liability. This means that there are some bound per unit to the losses for which an investor is liable. The second assumption was based on the homogeneity of expectations. All the investors hold the same expectations, since all have the same assets, information and are risk averse. There also exists at least one investor who believes that returns are generated by the arbitrage model and is not negligible. The arbitrage theory overcomes the mean variance theory in that it does not require the strict conditions of homogeneity of the anticipations (Ross, 1976). According to the capital assets pricing model, an investment carries systematic risk- associated with its existence in the market and is also referred to as beta. Unfortunately, this risk cannot be diversified. The other is the unsystematic risk that is specific to the company’s assets. However, appropriate mitigation measures can be put in place through appropriate diversification. Moreover, the CAPM helps in measuring risks and returns associated with a portfolio and the information generated is useful to an investor as he can utilize it before taking the risk of an investment. There are various assumptions underlying the CAPM. First, it is assumed that there are many investors in the market. They compete for the assets available; therefore being price takers. This means that the price of assets is determined by factors influencing the market; therefore investors have to settle on the price set. It is also assumed that all investors have equal access to all securities. This is so since they have all information regarding assets available in the market. All investors are assumed to be looking ahead of the same planning horizon since there is uniformity on the assets available. Same asses are available to investors; therefore each of them makes individual decisions based on one common factor. It is also assumed that there are no taxes charged and no commissions are incurred by either party. Moreover, each investor is concerned with the rate of returns to be expected and the market variances. The use of the CAPM model ranges from the valuation of a company’s common stock for the purpose of capital budgeting to analysis of mergers and acquisitions as a result of the valuation of convertible securities and company’s warrants. The above assumptions were stipulated by William Sharpe for the investors to operate in market equilibrium. Various critiques are laid on different assumptions for instance; it is assumed that there is homogeneity on returns. This is as a result of investors utilizing identical information and behaves similarly with regard to risk in portfolios. According to William Sharpe, all investors have similar beliefs about the expected returns, investment strategies and options as well as risk preferences as long as they remain risk avert. This assumption does not take into account diversity; therefore leading to inefficiencies in the market where investors can easily predict booms and recessions. Deviations on the assumptions from the real investment decisions made determine effectiveness and viability of the CAPM model. Classical economists also assume that investors act on perfect information regarding the market. This assumption is challenged by the fact that in both way, both the market and investors influences the type of information available; therefore being difficult to get perfect information. Moreover, different investors utilize different sources of data, hence having varying expectations and diversification strategies. Over years, CAPM has remained famous and widely used model as it has various benefits over other methods of determining value of return on assets. The model pays a special focus on systematic risks that reflect reality as they are the ones investors have diversified portfolio. Currently, CAPM has been accepted as a crucial tool in calculation a company’s cost of equity in place of the dividend growth model. The preference is as a result of taking into consideration the firm’s level of systematic risks in relation to the general stock market. The moment CAPM was invented; it did not take long before researchers started criticizing the model. Under the model, risk is measured in terms of the asset’s standard deviation on its systematic risk relative to that of the entire market. Standard deviation is regarded as a measure of an investment’s volatility. However this concept received strong opposition from various scholars, with Fama and McBeth being the first to lay a critique. They insisted that the model is irrelevant in that standard deviation on an asset’s return does not explain an asset’s returns that are excess since no risks are measured on returns that are not distributed evenly around the mean. In 1977, Richard Roll stated that the model can hardly be tested, as there existed impossibility of testing the real market portfolio. This is the case as there existed difficulties in determining a suitable proxy, and also intestates that CAPM can hardly be tested mathematically (Roll, Richard. 1976). Economists such as Rolf Banz consider some other variables that are the cause of misspecifications in the CAPM model (Banz, 1981). In an article published in 1981 “the relationship between return and market value of common stock” Rolf pointed out that small firms have higher risks adjusted returns on average in comparison to large firms. At this point, he points out that the size effect as stipulated in the CAPM model is a misspecification. Rolf also pointed out that there did not exist any theory on which the effect was founded. In 1995, Berk came up with a critique of the size related anomalies. Here, he pointed out that the size of the company is not the evidence for the relationship between the company’s size and risk attached to it. He said that a firm indulging in higher risks will expect lower market values but returns are expected to be high (Berk, 1995). Fama and French argue that in the size effect of CAPM, there is no consideration of market ratio and index models. This leads to the model producing risks in returns that can hardly be diversified. Moreover, these risks are not linked to the beta factor; therefore not identified in the CAPM model (Fama& French, 1995). There also exist difficulties in quantifying investor behavior under the CAPM model. The two scholars conclude that their three factor model is in line with behavior of earnings; therefore being en excellent model for rational pricing (Fama and French, 2004). Conclusion CAPM remains the most widely used asset valuation model despite its shortcomings. The model allows comparison between two variables that are essential in capital budgeting; therefore being considered mathematically sound and simple to utilize. Moreover, there is a strong correlation between the expected and the actual results. For instance, riskier projects with higher returns justify companies extensive of their corporate finances. However, the model is based on strong assumptions that are not realistic in applications in the real world. Assessment of diversification as a tool in reduction of risk has also attributed to its wide use. However, the presence of deviations form the market security line are denoted as ?, hence the model cannot be fully relied on. These deviations could also be as a result of variables of risks not easily quantified in terms of calculations. The method can be relied as an accurate way of calculating firm’s return on common stock as it considers risk and returns expected. Moreover, it gives returns to be expected as is not easy to make the exact prediction of the future. Works Cited Banz, R. F., 1981, “The Relation between Return and Market Value of Common Stocks,” Journal of Financial Economics, 9, 3-18. Berk, J.B. 1995. A Critique of Size- Related Anomalies. The review of Financial Studies Summer, 8 (2) 275-286. Brealey, A.R.; Myers, C.S. & Marcus A.J. 2009. Risk, Return and Capital Budgeting. Fundamental of Corporate Finance. NY: McGraw Hill/Irwin. Burton, J. 1998. Revisiting the Capital Asset Pricing Model. N.d 28th November, 2012. http://www.stanford.edu/~wfsharpe/art/djam/djam.htm Fama, E. F., French, K. R. 1995. “Size and Book-To-Market Factors in Earnings and Returns”, The Journal of Finance, Vol. 50, No.1 (1995). Fama, E. F., French, K. R. 2004. “The Capital Asset Pricing Model: Theory and Evidence.” Journal of Economic Perspectives, Vol. 18, No. 3, (2004), pp. 25-46. Roll, Richard. 1976. “A Critique of The Asset Pricing Theory’s Tests.”Journal of Financial Economics 4, 1977. Ross, Stephen A. (1977). The Capital Asset Pricing Model (CAPM), Short-sale Restrictions and Related Issues. Journal of Finance, 32 (177). Ross, A. S. (1976). The Arbitrage Theory of Capital Asset Pricing. Journal of Economic Theory, 13 (341-360) Read More