Analysis of the Relative Merits of the Capital Asset Pricing Model and Empirical Approaches to Asset Pricing - Research Paper Example

Critically Analyse the Relative Merits of the Capital Asset Pricing Model and Empirical Approaches to Asset Pricing (Such As FAMA and French Model) Table of Contents Introduction 3 Basic Concepts of CAPM 4 Critical Analysis of Relative Merits of the CAPM 5 Advantages 5 Disadvantages 6 Empirical Approach towards CAPM- The Fama-French Model 7 Example of Empirical Evidence of the CAPM vs. Fama-French Model Based On the Lodging Industry 8 Explanations: Irrational Pricing or Risk 8 CAPM vs. Arbitrage Pricing Theory (APT) 9 Conclusion 10 References 11 Introduction The research paper has been designed to throw a light on the relative merits of Capital Asset Pricing Model (CAPM) in determining the return for an investor that helps him to take investment related decision. The paper also emphasises on the few flaws of the model and thus brings the additional approaches towards the model, that is, Fama-French Model and Arbitrage Pricing theory (APT). The objective of the study is to critically analyse the merits of the CAPM, the challenges that this is facing in the global economy and also to focus on the other approaches that provides CAPM another dimension towards its application. The basic essence of the model is that it determines the amount of return that an investor is going to earn for putting their money at risk. Basic Concepts of CAPM It would be helpful to have a brief and basic idea about the concept of CAPM with the intention that the understanding of relative merits of it becomes easy. According to the model and ultimate derivation, it can be said that the return which an investor expects to earn by investing on a security or a portfolio is the rate on a risk-free security and a risk premium. The formula for this finding is written like: ra = rf + βa (rm – rf) where, rf = Risk-free rate βa = Beta or systematic risk of the security rm = Expected market return The basic concept behind the above model is that the investors are required to be compensated in two ways: risk and time value of money. The compensation for time value of money is represented by the risk-free rate which an investor earns by putting his money on investment over a period of time. The other part of the formula on the right hand side is a factor of risk and it determines the compensation the investors should get for taking an additional amount of risk. This amount is calculated by a risk measure (beta). There are certain implications of the model: 1. The investors invest their money in only two assets: the risk-free asset and a portfolio of risky assets. 2. All the investors in a market invest in the same risky portfolio and in the same proportion. This is also called the tangent portfolio. 3. The above mentioned tangent portfolio is the market portfolio. 4. There is an efficient frontier line which is formed by the combination of the risk-free asset and the market portfolio. 5. Risk is the only systematic risk that is correlated with the market portfolio and unsystematic risk can be removed by diversification. 6. For holding the systematic risk, the investors are awarded (Massachusetts Institute of Technology, 2010). According to Michailidis (2006), an examination of the emerging Greek Securities market was done based on the CAPM by considering weekly stock returns of 100 companies that were listed on the Athens Stock Exchange for the period 1998-2002. The findings of the test did not support the basic statement that higher risk (beta) means higher levels of return. However the model explains excess return and ultimately supports the linear structure of the CAPM equation (Michailidis & Et. Al., 2006). Critical Analysis of Relative Merits of the CAPM Advantages There are several merits of this model in relation to other methods of calculating required return and for the reason of which it has remained popular for over 40 years: The model considers reality in explaining risk factor where it assumes only systematic risk associated with the investment options. The unsystematic risk can be removed since there are diversified options for investors and thus can be eliminated. CAPM derives a theoretical relationship between return and systematic risk which has provided the basis to many researches and tests. Relatively, it has been assumed to be better than the dividend growth model where a company’s systematic risk has been correlated to the market as a whole. CAPM has been considered to be better than Weighted Average Cost of Capital (WACC) to be used in investment appraisal. Disadvantages There should be a balanced framework in discussing CAPM critically. Therefore, the disadvantages related to it are discussed below: CAPM are only used by assigning values to the risk-free rate of return. The substitute for the risk-free asset is generally government security whose yield keeps on changing from time to time according to the economic variables. This creates certain amount of difficulty for its implementation. There can be problem in calculating discount rate for a project. For example, for finding suitable proxy betas, problems can arise because proxy companies are normally indulged in many activities. Another difficulty can arise in calculating beta due to complex capital structure of the companies. Companies can have different capital structure and all the information may not be readily available. In investment appraisal, multi-period time horizon has to be considered, whereas in CAPM, a single-period assumption is made (PDFCast, 2008). Empirical Approach towards CAPM- The Fama-French Model The Fama-French Model in the recent years has proved to be the most viable challenge towards the CAPM. Empirical evidence proves that the multi factor Fama-French model has certain advantages over the CAPM because CAPM assumes that investors price only the market risk. However, evidences show there are a number of non-market risk factors which needs to be priced. Fama-French Model thus assumes two more risk factors: SMB, which is the difference between the return on a small stock portfolio and return on a large stock portfolio and HML, which is the difference between the return on a high book-to-market stocks portfolio and return on a low book-to-market stocks portfolio. The CAPM has oversimplified the model of excess return which is rather complex. Fama-French model have considered the market as a whole. It considers market caps and book-to-market ratios. This model has gained recognition in portfolio management. For example, Morningstar.com classifies mutual funds and stocks on the basis of these factors (Bheenick & Brooks, 2009). Example of Empirical Evidence of the CAPM vs. Fama-French Model Based On the Lodging Industry According to Madanoglu (2005), Fama-French model continuously proves to be better than the CAPM in explaining the variability of returns of lodging stocks. It’s proved to be better in explanation of cross-sectional returns of lodging industry portfolio. The findings showed that the Fama-French model provides a more realistic estimate of cost of equity by making adjustment for financial distress and size of lodging portfolio (Madanoglu & Et. Al., 2005). Explanations: Irrational Pricing or Risk This part of the study explains that those who believe that the empirical evidences on the failure of CAPM are not valid should provide a second thought. The behaviourists views like the one in Fama-French model has evidence that taking investment decision on book-to-market ratio explains overreaction of investors to bad and good times. On correcting the overreaction, result come as value stocks yield high returns and growth stocks yield low returns. Considering CAPM assumptions, market beta cannot be a complete explanation of risk. This is evident that difference in return is not explained by the difference in beta. The asset pricing model does a better job in explaining expected return from a portfolio. CAPM vs. Arbitrage Pricing Theory (APT) In CAPM an efficient portfolio is singled out and return is related to its normal covariance with the market portfolio. This is the beta or the systematic risk. The other part of the total risk has been assumed to be removed. But in APT, it is assumed that the systematic risk is formed by a number of factors. The expected return is related to exposure to these factors. Thus it provides a vast explanation of risk factors. The APT unlike CAPM assumes that investors will hold assets depending on his own considerations of risk instead of concentrating on a single efficient market portfolio. APT can be called as the supply-side because its risks reflect the relationship of the asset with economic factors whereas the CAPM can be mentioned as the demand side of the model of asset pricing. Its result is somewhat similar to the CAPM but it arises from the maximisation of each investor’s utility meaning. But as a whole, for successful implementation of APT, the following characteristics of factors have to be present. Impact on the prices of assets should be apparent in their unexpected movements Their influences should be un-diversifiable. That is they should be more likely to be macroeconomic variables rather than micro The variables should have timely and accurate information On economic grounds, their relationship should be justifiable Conclusion The objective of this research paper was to critically analyse the relative merits of CAPM. Though CAPM has been proved to be a better approach than the earlier models like Dividend Growth and WACC but it has never been proved fruitful on empirical grounds. In the earlier years of its application though it was used effectively, but during the late 1970s, research evolved to incorporate more variables on the explanation of returns like size and price ratios. But it can also be mentioned that Fama-French model which appeared as a modification or as a new dimension to CAPM takes its bases from the CAPM and on that ground CAPM will always remain more popular (Fama & French, 2004). References Bheenick, E. B. & Brooks, R., 2009. Are Fama-French Factors Complements Or Supplements To Higher Order And Downside Models- An Analysis Using Sovereign Ratings? Monash University. [Online] Available at: http://www.efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2010-Aarhus/EFMA2010_0027_fullpaper.pdf [Accessed November 16, 2010]. Fama, E. F. & French, K. R., 2004. The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives. [Online] Available at: http://www-personal.umich.edu/~kathrynd/JEP.FamaandFrench.pdf [Accessed November 16, 2010]. Madanoglu, M. & Et. Al., 2005. Empirical Investigation of the CAPM vs. Fama-French Model: Evidence from the Lodging Industry. Journal of Hospitality Financial Management. [Online] Available at: http://scholarworks.umass.edu/cgi/viewcontent.cgi?article=1197&context=jhfm [Accessed November 16, 2010]. Massachusetts Institute of Technology, 2010. Capital Asset Pricing Model (CAPM). Road Map. [Online] Available at: http://web.mit.edu/15.407/file/Ch11.pdf [Accessed November 16, 2010]. Michailidis, G. & Et. Al., 2006. Testing the Capital Asset Pricing Model (CAPM): The Case of the Emerging Greek Securities Market. Eurojournals. [Online] Available at: http://www.eurojournals.com/IRJFE4%207%20grigoris.pdf [Accessed November 16, 2010]. PDFCast, 2008. CAPM: Theory, Advantages and Disadvantages. CAPM Formula. [Online] Available at: http://pdfcast.org/pdf/capm-theory-advantages-and-disadvantages [Accessed November 16, 2010]. Read More