Capital Asset Pricing Model - Essay Example

Introduction One of characteristic features of economic relations is a pragmatism of its participants. Any value of material or non-material character in such relations is interesting only in case it promotes achievement of any purposes, first of all of economic character. The basis of business activity is the increase of economic potential of a company. On investing the capital in any investment project the businessman believes that after some time he will not only compensate the invested capital, but also to receive the certain profit. An estimation of this profit is based on forecasts of the future taking from the investment. Any investment decision is based on: an estimation of own financial condition and expediency of participation in investment activity; an estimation of the size of investments and sources of financing; an estimation of the future taking from realization of the project. The concept of enterprise and financial risk consists in the fact that the perspective decision of financial character has the stochastic nature, being hence subjective, and the degree of its objectivity depends on different factors, including accuracy of predicted dynamics of a monetary flow, the price of sources, opportunities of their reception, etc. In the basis of such estimations lay statistical data. Any financial manager constantly faces a problem of a choice of sources of financing. The particular feature of the problem moreover consists in the fact that that service of this or that source manages to the company unequally. Each source of financing has the price, and this price can have the stochastic nature. Decisions of the financial character are as efficient as good and objective the information base is. The level of objectivity depends on in what degree the market of capitals corresponds to the effective market. Capital Asset Pricing Model. Pro and Contra. Capital Asset Pricing Model (CAPM), the model of an estimation of profitability of financial assets, forms a theoretical basis for some various financial technologies on management of profitableness and risk, applied at long-term and intermediate term investment in stock. CAPM considers profitableness of the stock depending on behaviour of the market as a whole. Other initial assumption of CAPM consists in the fact that investors make decisions, considering only two factors: expected profitableness and risk. Though this model is the simplified representation of the financial market, it is widely used in the activity of many large investment structures, for example Merrill Lynch and Value Line. The euphoria of researchers in the sixties and seventies about the validity of weak and medium-strong EMH has been weakened by the relatively poor empirical validation of the standard CAPM and a variety of excess returns of indexed price anomalies Even if the analytical sources of error found under (1) that relativize inefficiency are eliminated, fundamental criticism of the CAPM is still advanced1. According to the model the risk connected with investments into any risk financial object, can be of two kinds: systematic and non-systematic. The systematic risk is caused by the general market and economic changes influencing all investment objects and not being unique for a concrete asset. Non-systematic risk is connected with the concrete issuer company. It is impossible to reduce systematic risk, but it is possible to measure the influence of the market on the profitableness of financial assets. As a measure of systematic risk in CAPM the (Beta) parameter is used. It describes the sensitivity of a financial asset with respect to changes of market profitableness. Knowing the parameter it is possible to quantitatively estimate the value of the risk connected with price changes of all market as a whole. The more value of a stock , the more its price rises at the general growth of the market, and on the contrary. Non-systematic risk can be reduced by means of a well-diversified portfolio. The nice calculation of showing is necessary for financial managers to choose assets, which in the best way correspond to their strategy of investment. Using coefficient it is possible to form investment portfolios of the most different types: conservative, aggressive, balanced2. The CAMP formula is: Expected Security Return = Riskless Return + Beta x (Expected Market Risk Premium) or: r = Rf + Beta x (RM - Rf) Another version of the formula is: r - Rf = Beta x (RM - Rf) where: r is the expected return rate on a security; Rf is the rate of a risk-free investment, i.e. Cash; RM is the return rate of the appropriate asset class. Beta is the overall risk in investing in a large market3. As any other model CAPM has its advantages and disadvantages. The basic lacks of CAPM method are connected with factor, which: Shows comparative volatility of shares of the company in relation to the market as a whole (thus the company, which shares go up on the 'falling' market, will have 'bad ' and accordingly the high discount); Reflects market risks of shares of the company, instead of risks of its business that the rate of discounting should do. If it is supposed that the market soon will start to fall, how we can choose the discount for the company with , close to 1 And what will be, if there is a crisis not in the share market, but on commodity markets of the company or in the market of raw material for it; Is retrospective. In other words it considers the history of the company (more precisely, one of its components) while the rate of discounting is perspective as corrects possible miscalculations of an analyst at the forecasting the future monetary flows. Whereas some see "damning evidence" (as does Haugen4) others concede that "although we couldn't tell whether it was true or not, it does give us insight into behavior in capital markets" (cf. Elton, Gruber, Brown, and Goetzmann5). CAPM is not the theoretical model of expected profitability. It is competed by some models, in which expected profitability depends on beta of shares with respect to greater quantity of factors, than just a market. These factors can be both macroeconomic variables (for example, the five-factor model developed Chen, N. F., R. R. Roll, and S. A. Ross), or the portfolios generated on the basis of characteristics of the companies (for example, three-factor model developed by Eugene Fama and Kenneth French ), or even sequence of parameters of the profitability constructed with the use of methods of statistics, such as the factor analysis. According to Focardi & Fabozzi hence, Roll submits that the CAPM is not testable until the exact composition of the true market portfolio is known, and the only valid test of the CAPM is to observe whether the cx ante true market portfolio is mean-variance efficient. As a result of his findings, Roll states that he does not believe there ever will be an unambiguous test of the CAPM. He does not say that the CAPM is invalid. Rather, Roll says that there is likely to be no unambiguous way to test the CAPM and its implications due to the nonobservability of the true market portfolio and its characteristics6. The euphoria of researchers in the sixties and seventies about the validity of weak and medium-strong EMH has been weakened by the relatively poor empirical validation of the standard CAPM and a variety of excess returns of indexed price anomalies Even if the analytical sources of error found under (1) that relativize inefficiency are eliminated, fundamental criticism of the CAPM is still advanced. Conclusion There is no doubt that the CAPM model has a great influence on the finance area. The impact that the model has made in the area of finance is readily evident in the prevalent use of the word 'beta'. In contemporary finance vernacular, beta is not just a nondescript Greek letter, but its use carries with it all the import and implications of its CAPM definitions. CAPM is just a model, not an exact copy of the validity. Actually many researchers deny its value as they consider that some tendencies of dynamics of profitableness of stocks are not in accord with with this model. Does it mean that we should reject CAPM and rely only on the estimated parameters not connected with it, such as average selective profitableness By no means! Each model 'is mistaken', almost by it definition as it is based on the simplified assumptions about our complex world. But even the inexact model can be quite useful. Here we shoul recollect Bayesian Approach and combine everything that we get from data with our best initial guess. We may agree with Maringer, who stats that the question of whether the CAPM is valid or not is therefore still far from being answered7. Nowadays we may agree that the main criticism of the CAMP is not that it is wrong, but that it does not go far enough. References: "CAPM - Capital Asset Pricing Model." 12manage.com. 2000. 12 manage - Online Executive Education. 20 Apr. 2007 . "CAPM. Does it help to forecast stock market." e-MasterTrade. 19 Apr. 2007 . Elton E.J, Gruber M.J. Brown S.J. Goetzmann W.N. Modern Portfolio Theory and Investment Analysis, sixth ed. John Wiley & Sons. New York, 2003 Focardi, Sergio, and Frank J.Fabozzi. The Mathematics of Financial Modeling and Investment Management . John Wiley and Sons, 2004. Haugen, R.A.Modern Investment Theory. Prenctice Hall, London et al., 5th edn, 2001. Maringer, Dietmar. Portfolio Management with Heuristic Optimization. Springer, 2005. Tolksdorf, Norbert, and Lukas Menkhoff. Financial Market Drift: Decoupling of the Financial Sector from the Real Economy . Springer, 2001. Vidyamurthy, Ganapathy. Pairs Trading: Quantitative Methods and Analysis . John Wiley and Sons, 2004. Read More